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Bear Stearns & Co

Bear Stearns & Co

Bear Stearns & Co
Answer the following 10 questions, using the financial statement data from Blockbuster
Entertainment Corporation. Show your work (i.e., note what numbers you’re using).

On May 9, 1989, Bear Stearns & Co. issued a report on Blockbuster Entertainment Corp., which is
reproduced in part below.
Blockbuster-Entertainment (Ticker symbol: BV, Price per share: $33 ½) increased owned and franchised
video stores from 19 at the end of 1986 to 415 at December 31, 1988. In the same period revenue
jumped from $7.4 million to $136.9 million. Reported earnings also leaped; from $.34 per share in 1986 to
$.57 per share in 1988. The stock carries an historical Price to Earnings ratio of 59, and there were
25,741,549 shares of common stock issued and outstanding as of 12/31/88.
A) Some of Blockbuster’s mergers with other video rental companies have been recorded as purchases.
In a merger treated as a purchase, the price paid is first allocated to the fair values of assets that can
be kicked, picked up or painted. Any excess paid for the company beyond these “fair values”
becomes goodwill, which Blockbuster labels “intangible assets relating to acquired businesses.” APB
Opinion 17 requires that goodwill be amortized to income (expensed) over 40 years or less.
In the past, many companies automatically adopted 40 year amortization. Current practice (which is
usually required by the SEC) is to relate the amortization period to the nature of the business
acquired. Thus in a typical hi-tech acquisition the SEC requires goodwill to be amortized over 5 to 7
years; in bank purchases, over 15 to 20 years.
Other information: Eight of the eighty company-owned stores that appeared in the 1987 10-K (annual
filing with the SEC) are not on the 1988 list. The maximum term of the company’s franchise
agreements is 25 years.
1) What is Blockbuster’s amortization timetable? Do you think it is appropriate?
2) What would be the impact on Blockbuster’s 1988 earnings per share if 5 year amortization
were applied to this goodwill?
B) On April 20, Blockbuster announced an agreement to merge with its largest franchisee, Video
Superstore. Video Superstore was Blockbuster’s largest customer for videotapes, accounting for 10%
of such sales in 1988, 21% in 1987, and 48% in 1986.
Since intra-company transactions are eliminated from the financial statements (it doesn’t make sense
to record sales to yourself!), these sales will disappear next year.
3) What would have been the effect on earnings per share if Video Superstore purchases were
not included in 1988 revenues?
C) BV drastically slowed its depreciation (amortization) of “hit* video tapes at the start of 1988. In 1987
BV depreciated its rental videotape “hits” over nine months, straight line. At the start of 1988, it
switched to a method it called “36 month accelerated.” The financial statements do not disclose how
accelerated the curve is, but do say that the company uses 150% of straight line, computed on a
monthly basis. Thus, the resulting depreciation is as follows:
First 12 months

40%

Second 12 months

30%

Third 12 months

30%

4) Over what period does BV depreciate its “base stock” videotapes?
5) What was the effect on earnings per share of the change in depreciation method for “hit” tapes
(assume that hit tapes made up 25% of new tape purchases, and that the average hit tape
was owned for half the year)?
D) BV also sells videotapes. However, most of the sales are in bulk to new franchisees, rather than to
store customers. In 1988, 68% of sales were to franchisees.

Page 1 of 10

Bear Stearns & Co
6) What was the effect on earnings per share of these sales to franchisees?
E) BV charges franchisees various fees and discloses them in a somewhat confusing manner. The
income statement shows, in revenues:
Royalties and other fees $8,142,000
However, Note 1 to the financial statements lists:
Royalties and other fees $7,590,000
Area Development fees 550,000
Initial franchise fees

2,415,000

The first two items total to the income statement amount, the third seems to be buried, inexplicably, in
rental revenues.
7) What was the effect on 1988 earnings per share, of the non-recurring items: area development
fees and initial franchise fees?
8) What would BV’s 1988 earnings per share be after all of the above adjustments?
9) Ignoring #3 above, what would BV’s 1988 earnings per share be after
the above adjustments?
10) What would BV’s Price/Earnings ratio be, given all of the above
adjustments (including #3)?

Page 2 of 10

Bear Stearns & Co
Exhibit 2
Selected Excerpts: Blockbuster Entertainment Corporation 1988 Annual Report
BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations
For the Years ended December 31,
(in thousands, except per share data)

1988

1987

1986

$87,299
41,452
8,142
136,893

$19,009
21.546
2,673
43,228

$ 2,893
4,247
298
7,438

31,343
63,638
15,567

15,923
16,429
4,162

3,511
5,152
2,093

26,345

6,714

(3,318)

—

(954)

626
(2,066)
92

456
(569)
104

228
—
—

24,997

6,705

(4,044)

9,499

2,615

(823)

$ 15,498

$ 4,090

$(3,221)

NET INCOME (LOSS) PER COMMON
AND COMMON SHARE
EQUIVALENT

$.58

$.28

$(.34)

NET INCOME (LOSS) PER COMMON
AND COMMON SHARE
EOUIVALENT—ASSUMING FULL
DILUTION

$.57

$.28

$(.34)

REVENUE:
Rental revenue
Product sales
Royalties and other fees

OPERATING COSTS AND EXPENSES:
Cost of product sales
Operating expenses
Selling, general, and administrative
OPERATING INCOME (LOSS)
EQUITY IN LOSS OF AN AFFILIATE
INTEREST INCOME
INTEREST EXPENSE
OTHER INCOME, NET
INCOME (LOSS) BEFORE INCOME
TAXES
PROVISION FOR (BENEFIT OF)
INCOME TAXES
NET INCOME (LOSS)

—

Page 3 of 10

Bear Stearns & Co
Exhibit 2 (Continued)
BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations
For the Years ended December 31,
(in thousands, except per share data)
ASSETS
1988
CURRENT ASSETS
Cash and short term investments
Accounts receivable, less allowances
Notes receivable from shareholders
Merchandise Inventories
Other
Total Current Assets
VIDEOCASSETTE RENTAL INVENTORY, NET
PROPERTY AND EQUIPMENT, NET
INTANGIBLE ASSETS RELATING TO ACQUIRED
BUSINESS, NET
OTHER ASSETS

1987

$8,959
5,617
—
17,901
6,359
38,836

7,168
2,596
7,919
8,440
2,399
28,522

60,294
47,284

16,389
14,998

24,754
5,599
176,767

12,149
2,127
74,185

$3,139
34,131
8,108
189
3,653
49,220

$2,182
10,587
2,546
445
489
16,879

21,303
1,293
3,167

14,797
451
60

—

—

2,574
84,806
15,124

1,800
40,572
(374)

101,784
$176,767

41,998
$74,185

LIABILITIES AND SHAREHOLDERS’ EQUITY
CURRENT LIABILITIES
Current Portion of Long Term Debt
Accounts payable
Accrued liabilities
Current deterred income taxes
Advance payments from franchise owners
Total Current Liabilities
LONG TERM DEBT. LESS CURRENT PORTION
OTHER NONCURRENT LIABILITIES
DEFERRED INCOME TAXES
COMMITMENTS
SHAREHOLDERS’ EQUITY:
Preferred Stock, $1 par value; authorized 500,000 Shares;
none outstanding
Common Stock, $10 par value; authorized 40.000.000
and 20,000.000 shares, respectively; issued 25,741.549
and 17,995.092, respectively
Capital In excess of par value
Retained earnings (deficit)
Total Shareholders’ Equity

The accompanying notes are an Integral part of these statements.

Page 4 of 10

Bear Stearns & Co
Exhibit 2 (Continued)
BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES
Consolidated Statements of Operations
For the Years ended December 31,
(in thousands, except per share data)

1988

1987

1986

$15,498

$4,090

$(3,221)

22,223

4,776

1,038

—

—

954

(3,132)
(9,309)

(1,211)
(5,068)

(1,264)
(3,153)

24,797

8,947

2,619

3,164
(3,984)
(917)

(1,511)
1,138
1,378

2,000
346
346

48,340

10.263

(1,376)

CASH FLOWS FROM INVESTING ACTIVITIES
Collection of notes receivable
Purchase of videocassette rental inventory, net
Purchases of property and equipment, net
Used in acquisitions
Other

7,919
(51,255)
(31,224)
(9,843)
—

—
(14,281)
(10,519)
(2,814)
(2,805)

—
(3,053)
(4,133)
—
(1,174)

NET CASH USED IN INVESTING ACTIVITIES

(84,403)

(30,449)

(8,360)

CASH FLOWS FROM FINANCING ACTIVITIES
Proceeds from the issuance of common stock, net
Proceeds from long term debt
Repayments of long term debt
Other

36,094
39,847
(38,807)
—

17,800
9,184
(2,794)
(238)

3,898
1,400
—
150

NET CASH PROVIDED BY FINANCING ACTIVITIES

37,854

23,952

5,448

1,791

3,766

(4,288)

7,168

3,402

7,690

8,959

7,168

3,402

CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)
Adjustments to reconcile net income (loss) to net cash from
(used in operating activities)
Depreciation and amortization
Equity in loss of an affiliate
Changes in operating assets and liabilities,
net of effects from purchase transactions
Increase in accounts receivable
Increase in merchandise inventories
Increase in accounts payable and accrued
liabilities
Increase (decrease) in advance payments
from franchise owners
Increase in other working capital items, net
Other
NET CASH FLOW FROM (USED IN)
OPERATING ACTIVITIES

NET INCREASE (DECREASE) IN CASH AND SHORTTERM INVESTMENT
CASH AND SHORT TERM INVESIMENTS, BEGINNING
OF YEAR
CASH AND SHORT-TERM INVESTMENTS, END OF
YEAR

The accompanying notes are an integral part of these statements
Page 5 of 10

Bear Stearns & Co
Exhibit 2 (Continued)
BLOCKBUSTER ENTERTAINMENT CORPORATION AND SUBSIDIARIES
Notes to Consolidated Financial Statements
(000’s omitted in all labels except per share amounts)
I. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
The accompanying financial statements present the consolidated financial (Million and results of
operations of the Company and its subsidiaries All material intercompany accounts and transactions have
been eliminated in order lo maintain consistency and comparability between periods presented, certain
amounts have been reclassified from the previously reported fiscal 1987 and 1986 financial statements in
order to conform to fiscal 1988 presentation
The statements of changes in shareholders’ equity, all per share data and number of common shares for
all periods included in the financial statements and notes have been adjusted to reflect the two-for-one
stock splits that occurred in both March and August, 1988, as more fully described in Note 7.
The accompanying financial statements do not include the financial condition and results operations of
Major Video Corp., which was acquired in January, 1989. This transaction, which will be accounted for as
a pooling of interests, is more fully described in Note 10.
Short-Term Investments
Short-term investments consist of interest bearing securities with interest rates ranging from 5.20% to
9.13% with maturities of less than ninety days.
Accounts Receivable:
Accounts receivable includes an allowance for uncollectible accounts of $181,000 and $155,000 as of
December 31, 1988, and 1987, respectively.
Merchandise Inventories:
Merchandise inventories are stated at the lower of cost or market. Cost is determined on a moving
average basis and generally includes those costs required to purchase and ready products for sale or
utilization in Company-owned stores. Inventory transferred to Company-owned stores is reclassified to
non-current assets and amortized in accordance with Company policy.
Videocassette Rental Inventory:
Videocassettes are recorded at cost and amortized over their estimated economic life with no provision
for salvage value. Those videocassettes which are considered base stock (“non-hits”) are amortized over
thirty-six months on a straight-line basis. Beginning January 1, 1988, economics and the related
amortization period for new release feature films, which are frequently ordered in large quantities to
satisfy initial demand (“hits”), were revised to approximate 36 months on an accelerated basis.
During the six-month period ended December 31, 1987, the economic life of “hits” and related
amortization period approximated nine months on a straight-line basis with no salvage value. The
Company has determined that the economic useful life and related amortization for these “hits” more
closely approximates 36 months on the accelerated basis with no provision for salvage value.
Videocassette rental inventory and related amortization as of December 31, is as follows:
1988
1987
Videocassette rental inventory………………………………………
$76,390
$19,600
Less: Accumulated amortization…………………………………….
(16,096)
(3,211)
$60,294
$16,389
Amortization expense related to videocassette rental inventory was $15,659,000, $3,543,000, and
$545,000 in 1988, 1987, and 1986, respectively. As videocassette rental inventory is sold or retired, the
applicable cost and accumulated amortization are eliminated from the accounts and any gain or loss is
recorded.
Property and Equipment:
Property and equipment is stated at cost. Depreciation and amortization is provided over the estimated
useful lives of the related assets using the straight line method. Property and equipment as of December
31, consists of the following:

Page 6 of 10

Bear Stearns & Co
Exhibit 2 (Continued)
Buildings
Leasehold Improvement
Furniture and fixtures
Equipment and vehicles
Less: Accumulated depreciation and amortization

Life
15-19 Years
5-10 Years
5-10 Years
3-10 Years

1988
$639
26,378
11,141
14,631
52,789
(5,505)
$47,284

1987
$289
6,465
4,482
5,298
16,354
(1,536)
$14,938

Depreciation expense was $3,796,000, $993,000 and $492,000 in 1988, 1987 and 1986, respectively.
Additions to and major improvements of property and equipment are capitalized. Maintenance and repair
expenditures are charged to expense as incurred and amounted to approximately $454,000, $191,000
and $125,000 in 1988, 1987, and 1986, respectively. As property and equipment is sold or retired, the
applicable cost and accumulated depreciation or amortization are eliminated from the accounts and any
gain or loss is recorded.

Intangible Assets:
Intangible assets relating to acquired businesses as of December 31, 1988, and 1987 consist primarily of
the cost of purchased business in excess of market value of net assets acquired. The cost in excess of
market value of net assets relating to businesses acquired is being amortized on a straight-line basis over
a period of 40 years. The accumulated amortization of intangible assets amounted to $769,000 in 1988
and $196,000 in 1987.

Revenue Recognition:
Revenue from Company-owned stores is recognized at the time or rental or sale. Revenue from franchise
owners is recognized when all material services or conditions required under the franchise agreement
have been performed by the Company. The only significant commitment and obligation the Company has
under its franchise agreements is to provide products to franchise owners. The Company derives
substantially all of its franchise program revenue from the following sources: (1) Initial franchise fees, (2)
Product sales to franchise owners, (3) Area development fees and (4) Royalties and other fees.
Franchise owners purchase their initial tape inventory, equipment and supplies from the Company at cost
plus a mark-up. Revenue for these items is recognized when the products are shipped. In addition, they
pay a royalty based on monthly revenue and a monthly software license fee, which are recognized as
revenue when earned. Certain franchise owners pay an initial franchise fee and a non-refundable area
development fee under their franchise agreement. Revenue is recognized from these fees when the store
is opened.
Revenue included in the consolidated statements of operations from the Company’s franchise program
for the years ended December 31, is as follows:
1988
1987
1986
Product Sales
$28,334
$19,163
$3,793
Royalties and other fees
7,590
2,583
298
Area development fees
552
90
-Initial franchise fees
2,415
270
-$38,891
$22,406
$4,091
Approximately 10%, 21%, and 48% of total revenue in 1988, 1987, and 1986, respectively, was derived
from one franchise owner: BLOCKBUSTER Midwest, L.P.
Income Taxes:
The Company has applied Statement of financial Accounting Standards (SFAS) No. 96 – Accounting for
Income Taxes to all years presented.

Page 7 of 10

Bear Stearns & Co
EXHIBIT 2 (Continued)
2. SUPPLEMENTAL CASH FLOW INFORMATION
Supplemental cash flow information for the years ended December 31, is as follows:
1988
1987
Cash received (paid) during the year for:
Interest income
$578
$486
Interest expense
(2,760)
(130)
Income taxes
(3,338)
(789)
Investing activities in connection with acquisitions (none in 1986):
1988
Videocassette rental inventory
$8,846
Property and equipment
5,090
Other non-current assets
572
Intangible assets relating to acquired businesses
13,093
Working capital other than cash acquired
(4,037)
Long-term debt issued and assumed
(5,527)
Common stock and warrants issued
(8,194)
Cash used in acquisitions
$9,843

1986
$268
(45)
46
1987
$2,575
1,316
-11,992
(384)
(10,290)
(2,365)
$2,844

3. BUSINESS COMBINATIONS
All businesses acquired through December 31, 1988, and accounted for as purchases are included in the
financial statements from the date of acquisition. Those businesses acquired through December 31,
1988, and treated as poolings of interests have been included retroactively in the financial statements as
if the companies had operated as one entity since inception.
In early 1988, the Company acquired Video Library, Inc., a 42-stor retail video chain based in San Diego,
Calif., for $6,380.861 in cash and 885,508 shares of common stock. In addition, during 1988, the
Company acquired four other businesses for $4,840.462 in cash and notes, and 449,889 shares of its
common stock. The aforementioned acquisitions were accounted for under the purchase method of
accounting.
The Company’s consolidated results of operations on an unaudited pro forma basis, assuming these
acquisitions had occurred as of January 1, 1987, are as follows:
Pro forma revenue
Pro forma net income
Pro forma earnings per share

1988
$144,624
15,532
.56

1987
$61,936
4,216
.27

This pro forma information does not purport to be indicative of the results that actually would have been
obtained if the operations had been combined during the periods presented and is not intended to be a
projection of future results.
Effective May, 1987, the Company acquired Movies To Go, Inc., a 29-store retail video chain based in St.
Louis, Mo., $14,500,000 in cash, notes and warrants representing 880,000 shares of common stock. This
acquisition was accounted for under the purchase method of accounting.
In March, 1987, the Company acquired the net assets of Southern Video in exchange for 321,840 shares
of common stock of the Company. The transaction was accounted for under the pooling of interests
method of accounting.

Page 8 of 10

Bear Stearns & Co
EXHIBIT 2 (Continued)
4. LONG TERM DEBT
The details relating to long term debt as of December 31 are as follows:
1988

1987

$15,000

6,905

9,121

Payable to a bank under an unsecured revolving credit agreement,
interest at prime (8.75% at December 31, 1987), due 1989.
Interest payable quarterly with principal due at maturity. —

—

7,500

Payable to others, interest at various rates ranging from 6% to 14%
due at various times through 1992. Monthly principal payments of
approximately $89,000 plus interest. Secured by certain inventories
and real estate.

928

988

1,609

—

24,442
(3,139)
$21,303

17,609
(2,812)
$14,797

Notes Payable:
Payable to banks under an unsecured revolving credit agreement,
interest at prime plus ¼% (10.50% as of December 31, 1988),
due 1992, interest payable quarterly with principal due at maturity.
Payable to former shareholders of Movies to Go, interest rates
escalating annually from 6% to prime plus 2% due 1992.
Periodic annual principal payments ranging from $427,000
to $2,570,000 plus interest.

Capitalized lease obligations secured by furniture
and fixtures, computer equipment and vehicles
Total long-term debt
Less: Current Portion
Long term debt, less current portion
The long term debt as of December 31, 1988, is due as follows:
1989
$3,319
1990
2,670
1991
3,003
1992 and thereafter
15,630

In June, 1988, the Company entered into a revolving credit agreement with Security Pacific National
Bank, for itself and as agent and Southeast Bank, N.A., for itself, pursuant to which the banks have
agreed to loan the Company an aggregate of $50,000,000 on an unsecured basis. No principal payments
are required until the maturity date in 1992. Interest on current loans is the lower of the prime rate in
effect of the agent plus ¾ of one percent, depending on the aggregate principal amount of the advances
outstanding of the London Interbank offered rate plus 1 and ¾ percent or two percent, depending upon
the aggregate principal amount of advances outstanding. There is a commitment fee of ½ percent per
annum on the average unused portion of the available commitment plus ¼ percent per annum on a
portion of the banks’ average daily inactive commitments and ½ percent on such part of the inactivated
commitment when activated. There are no compensating balance requirements in connection with the
revolving credit agreement. The agreement requires the Company to maintain certain financial ratios and
imposes certain restrictions on, among other things, additional debt, payment of cash dividends and
capital expenditures in excess of specified amounts.

Page 9 of 10

Bear Stearns & Co
5. INCOME TAXES
The income tax provision (belief) for the years ended December 31, consists of the following components:
1988

1987

1986

$4390
373
4,763

$1,925
80
2005

$(790)
-(790)

4,323
413
4,736
$9,499

582
28
610
$2,615

(33)
–(33)
$(823)

Current:
Federal
State
Total Current
Deferred:
Federal
State
Total Deferred

A reconciliation of the expected income tax provision at the U.S. federal income tax rate (34% in 1988),
40% in 1987, and 46% in 1986) to the Company effective income tax provision for the years ended
December 31, is as follows.

Income tax provision (benefit) at statutory rate
Amortization expense not deductible for tax
Tax benefits of temporary differences not recognized for
financial reporting
Effect of future lower tax rate on temporary differences, net
State income taxes, net of federal income tax benefit
Intercompany profit eliminations of pooled entity
Other, net
Total

1988
$8,499
157

1987
$2,682
78

1986
($1,860)

–786
-57
$9,499

-(137)
108
-(116)
$2,615

800
–160
77
$(823)

Deferred taxes reflect the impact of “temporary differences” between the amount of assets and liabilities
for financial reporting purposes and such amounts as measured by tax laws and regulations.

Report of Independent Public Accountants
To BLOCKBUSTER Entertainment Corporation:
We have audited the accompanying consolidated balance sheets of BLOCKBUSTER Entertainment
Corporation (a Delaware corporation) and subsidiaries as of December 31, 1986 and 1987, and the
related consolidated statements of operations, changes in shareholders’ equity and cash flows for each of
the three years in the period ended December 31, 1988. These financial statements are the responsibility
of the Company’s management. Our responsibility is to express an opinion on these financial statements
based on our audits.
We conducted our audits in accordance with generally accepted auditing standards. Those standards
require that we plan and perform the audit to obtain reasonable assurance about whether the financial
statements are free of material misstatement. An audit includes examining, on a test basis, evidence
supporting the amounts and disclosures in the financial statements. An audit also includes assessing the
accounting principles used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a reasonable basis for our
opinion.
In our opinion, the financial statements referred to above present fairly. In all material respects, the
financial position of BLOCKBUSTER Entertainment Corporation and subsidiaries as of December 31,
1988 and 1987, and the results of their operations and their cash flows for each of the three years in the
period ended December 31, 1988, in conformity with generally accepted accounting principles.
ARTHUR ANDERSON AND COMPANY
Ft. Lauderdale, Florida, Feb. 17, 1989

Page 10 of 10

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