Marvel case study

University Degree Business and Administrative studies

HBS CASE STUDY

Bankruptcy and Restructuring at Marvel Entertainment Group

Why did Marvel file for Chapter 11? Were the problems caused by bad luck, bad strategy or bad execution?

We believe that Marvel filed for Chapter 11 mainly because of its bad business strategy. As of year-end 1995, Marvel had 6 business lines: Sports and Entertainment Cards, Toys, Children's Activity Stickers, Publishing, Confectionery and Licensing of characters. Trading cards, Stickers and Comic Books started facing the decline in sales after year 1993. There were 2 main reasons for this decline: First, these businesses increasingly had to compete with alternative forms of child entertainment (mainly video games). Second, the decline in sales was driven by disappointed collectors who had viewed comic books as a form of investment and stopped buying them as company stopped increasing the prices. We believe that the company should have foreseen these events pregnant with dangerous consequences, while performing a market research and forming a long-term business and financial strategy.

As one can see from the diagram below, the three unpromising business lines (filled in red colors) accounted to 61% of total revenues of a company in year 1995. At the same time, the company's financial strategy was based on highly optimistic business expectations and was not suitable for unfavorable turn of demand for entertainment products towards video games. Due to its high leverage (52%), the company was not able to serve all the debt in case of sharply declining revenues. It is obvious that the company did not anticipate the change in customers' preferences and was wrong in prediction of market trends, focusing on cards, stickers and publishing business lines and leveraging itself.

With this revenue structure, Marvel lost $48,5m in 1995 due to the losses in its comic book and publishing segments. Despite these problems, in 1995 Marvin continued its leveraged expansion into entertainment cards business, acquiring a SkyBox (another maker of trading cards) for $150m. This decision was extremely imprudent, as the company was already on the threshold of financial distress and should have sought for high growth opportunities to expand in order to boost its revenues instead of adding debt to buy business which produces non-demanded products.

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As can be seen in the table above, Marvels operating ratios dropped dramatically. The cost of Sales/Sales (what can be seen as the costs of sold items) rose from 51% in 1991 to 64% in 1996, together with the SG&A expenses/Sales rising from 19% to 29%. Additionally Marvels Net Income/Sales (what can be seen as the Return on Sales) dropped from 14% to -5%.

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Looking at management policy and comparing the leverage ratios from that time together with its operating ratios, it occurs to us that Marvel made an extremely impudent move to acquire Skybox for 150m in 1995. While their operating margins where deteriorating and their leverage coverage ratio (EBITDA/Interest) where falling, they should have acquired a different policy.

For all above stated reasons, we believe that the company's financial problems were caused mainly by bad strategy and poor management. The company could have avoided them in case it was more demand oriented and if it considered unfavorable scenarios while forming its high-leverage financial strategy.

Evaluate the proposed restructuring plan! Will it solve the problems that caused Marvel to file for Chapter 11?

The proposed restructuring plan consists of three stages. It aims at providing liquidity to Marvel, lifting its debt burden and expanding its existing toy business. This is to be achieved by means of a recapitalization of the company through an emission of 427mn additional shares of common equity for a total value of USD 365mn. Additionally, the outstanding public debt of the company shall be retired with debt holders being paid in the shares that acted as collateral for their loans. With the proceeds of the emission and the lowered debt burden, Marvel is then supposed to acquire the remaining stake in ToyBiz, its toy manufacturer subsidiary.

The recapitalization through the issue of 427mn new shares would solve the acute liquidity problems of the firm and the retirement of the firm’s public debt would lower the debt burden of the firm significantly. However, we believe that Marvel, under the proposed plan, would use its newly gained liquidity and flexibility to the wrong end. The acquisition of the remaining shares of ToyBiz would mean the continuation of an already ill-fated strategy that led to the current crisis. We therefore believe that the restructuring plan can only solve part of the problems that Marvel is facing. More precisely, the plan offers a solution for the symptoms of the underlying problems only. It solves the liquidity problem that caused Marvel to violate some of its debt covenants and it also lowers the company’s debt burden. The core problem in our view, the business strategy of Marvel, is not abandoned but even pursued further. We therefore believe that the proposed restructuring plan will not solve the actual problems that Marvel is facing but only provide temporary relief to the company that is not sustainable.

To the holders of public debt the restructuring plan is particularly unfavorable. The shares that were pledged to their bonds as collateral are valued significantly lower now than they were when the bonds were first issued. The result is that they can only recover a fraction of the face value of their bonds in the form of equity now and a breaking even again seems questionable. This argument does not necessarily hold for the investors who bought the deeply discounted bonds but given the valuation of Bear Stearns it is questionable whether they will recover their investment either.

How much is Marvel’s equity worth per share under the proposed restructuring plan? Assuming it acquires Toy Biz as planned?

Marvel’s equity before the acquisition is simply the current market price that is 2 dollars. However this figure does not reflect reorganization value of Marvel, according to Bear Sterns & Company Marvel’s equity is negative.

With the aim to calculate Marvel’s equity with the proposed acquisition of Toy Biz we used DCF model. We used Free Cash Flow to Equity model with the following assumptions:

New number of shares is 101.8 + 427 = 528.8
Growth rate in terminal period is 4%.
Risk free rate is equal to U.S. 30-year T-Bonds.
Market risk premium is 5.55% (average for the period from 1970-1997).
Marvel’s leverage ratio is 55% (taking into account market value of equity).
In terminal cash flow Depreciation & Amortization equals Capex; Amortization of goodwill is equal to zero.

Discount rate is equal to Return on Equity that was obtained from CAPM model:

Re=Rf+beta(Rm-Rf)=6.89%+1.46(5.55%)=15%

Free cash flows to equity were obtained from the projected data by Bear Sterns, calculations can be found beneath:

Finally we calculated value of Equity that is equal to 184.86 mln dollars (terminal value is 156 mln dollars). That equals to 0.35 dollars per share. Thus we can conclude that Mr. Perelman pays 143% premium for new shares (he pays 0.85 dollars per share).

Will it be difficult for Marvel and other companies in the MacAndrews and Forbes holding to issue debt in the future?

The outstanding debt of Marvel has been downgraded by two rating agencies. In 1995 S&P and Moody’s downgraded the holding companies’ debt from B to B-. In 1996 Moody’s downgraded Marvel’s public debt. After that, Marvel had announced that it would violate specific bank loan covenants due to decreasing revenues and profits.

Downgrading of debt increases the change of default. After downgrading of debt, the process of probability to default increased substantially.

The low credit rating indicates a high risk of defaulting on a loan and, hence leads to high interest rates or the refusal of a loan by the creditor. Investors realise this risk and therefore would demand a higher default premium. The increased default premiums raised the cost of capital for the holding company. Given the increased risk premium and default possibilities, Marvel and other companies in the MacAndrews and Forbes holding group would having more difficulties issuing new debt in the future.

Debt holders and creditors where raising questions about the integrity on the judgement decisions from Perelman. Judge Balick approved Marvel did not discriminate unfairly against non-affecting creditor classes and provided it was fair and equitable to all classes. In reaction, a lawyer challenged the Bearn Stern’s conclusions and insinuated Bearn Sterns had multiple levels of conflicts due to the contingency fee provided by Perelman. In the end even the Vice-Chairman of the Andrew group had to come with a statement to overcome all the negative sounds in the market. Anyhow it looks like Perelman’s reputation was damaged already.

After the bankruptcy, the MacAndrews and Forbes holding companies raised again big amounts of debt, somewhere around an extra 100m. For some reason it appears that these companies didn’t have to pay extra for the debt and thus, implying that additional default and risk premiums did not take place!