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BscB 6. Semester Department of Economics The First of May, 2013 Authors: Peter Fedders Examination Number: 301668 Rasmus Villadsen Examination Number: 301667 Advisor: Baran Siyahhan Characters: 135853
Bachelor Thesis
LEGO GROUP ------------------------------------------- A STRATEGIC AND VALUATION
ANALYSIS
Aarhus University
Business and Social Sciences
Spring 2013
Page 1 of 84
1. Abstract:
The purpose of this thesis is to quantify and estimate the value of Danish toy manufacturer
LEGO. Thus the external and internal environment in conjunction with recent years financial
statements, will assess the hypothetical value associated with the projections and assets
related to said company.
LEGO operates in a market, which has seen interesting developments within the past decade.
During this period LEGO managed to recover from the severe difficulties they faced at the
beginning of the second millennium. With impressive recent growth rates, exceeding 25 % in
2012, the thesis set about valuation whether this could be sustained.
To arrive at a concrete firm value, future revenue steams was estimated and evaluated based
on strategic performance along with historical financial ratios. Within the strategic analysis
several leavers was identified, providing LEGO with competitive advantages. Among others
these advantages included the successful use of licenses from well-known franchises and
skillful handling of their operating processes. In addition areas of opportunity such as blue
ocean markets and widening of the product portfolio was argued to help sustain growth,
whilst threats from entrants to the market and price competition constituted future
uncertainties.
Given the inflow of additional competitors on the construction toy market, and as the current
market structure changes from a dominant firm and oligopolistic competition structure, to a
more balanced competitive market, lead us to conclusion that future revenue growths
eventually in the year 2019 will growth in line with the overall market.
Through enterprise discounted cash flow, together with estimations regarding weighted
average cost of capital, future free cash flows has been discounted back to the present value.
This discount rate is based on a fixed capital structure, using 10-year government bonds along
with a synthetic company specific beta and market return estimations. Through these
estimations a total weighted average cost of capital (WACC) was estimated at 6.61 %. Given
this discount rate, a total firm value of roughly 140 billion DKK was estimated, based on a
seven-year explicit period.
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Contents
1. ABSTRACT: ........................................................................................................................................................... 1
2. INTRODUCTION ...................................................................................................................................................... 4 2.1 LIMITATIONS: .......................................................................................................................................................................... 5 2.2 LEGO COMPANY PROFILE: ................................................................................................................................................... 6
3. THEORY ..................................................................................................................................................................... 7 3.1 PHILOSOPHICAL FOUNDATIONS ........................................................................................................................................... 7 3.2 STRATEGIC PART ..................................................................................................................................................................... 8
3.2.1 Porterβs Value chain .......................................................................................................................................................... 8 3.2.2 Porterβs five forces .............................................................................................................................................................. 9 3.2.3 PEST ....................................................................................................................................................................................... 10 3.2.3 SWOT ..................................................................................................................................................................................... 10
3.3 VALUATION PART: ............................................................................................................................................................... 11
4. STRATEGIC ANALYSIS ......................................................................................................................................... 13 4.1 VALUE CHAIN ANALYSIS ..................................................................................................................................................... 13
4.1.1 Primary activities ............................................................................................................................................................ 14 4.1.1.2 Inbound logistic ............................................................................................................................................................................................... 14 4.1.1.3 Operations .......................................................................................................................................................................................................... 14 4.1.1.4 Outbound logistic ............................................................................................................................................................................................ 15 4.1.1.5 Marketing and Sale ......................................................................................................................................................................................... 16 4.1.1.6 Service .................................................................................................................................................................................................................. 18
4.1.2 Support Activities: ........................................................................................................................................................... 19 4.1.2.1 Firm infrastructure ........................................................................................................................................................................................ 19 4.1.2.2 Human resources management ............................................................................................................................................................... 19 4.1.2.3 Technology development ............................................................................................................................................................................ 20 4.1.2.4 Procurement ...................................................................................................................................................................................................... 21
4.2 PORTERS FIVE FORCES ........................................................................................................................................................ 22 4.2.1 Bargaining power of suppliers: ................................................................................................................................. 23 4.2.2 Buying power of consumers: ...................................................................................................................................... 24 4.2.3 Threat of new competition .......................................................................................................................................... 25 4.2.4 Threat for substitutions ................................................................................................................................................ 26 4.2.5 Rivalry ................................................................................................................................................................................... 27
4.3 PEST FRAMEWORK ............................................................................................................................................................ 29 4.3.1 Political ................................................................................................................................................................................ 29 4.3.2 Economic ............................................................................................................................................................................. 31 4.3.3 Societal factors ................................................................................................................................................................. 34 4.3.4 Technological .................................................................................................................................................................... 36
4.4 SWOT ANALYSIS ................................................................................................................................................................. 37
5. VALUATION ANALYSIS ........................................................................................................................................ 39 5.1 REFORMULATION ANNUAL REPORTS ................................................................................................................................ 39
5.1.1 Reformulation of balance sheet ................................................................................................................................ 39 5.1.2 Reformulation of income statement ....................................................................................................................... 41
5.2 HISTORICAL ANALYSIS ........................................................................................................................................................ 41 5.2.1 Return on Invested Capital .......................................................................................................................................... 41 5.2.2 Invested capital ................................................................................................................................................................ 43 5.2.3 Net operating profit less adjusted taxes ............................................................................................................... 44 5.2.4 Free cash flow .................................................................................................................................................................... 46 5.2.6 Efficiency analysis ........................................................................................................................................................... 47
5.3 FORECAST ............................................................................................................................................................................. 47 5.3.1 Competitor growth comparison ............................................................................................................................... 48
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5.3.2 Revenue growth in explicit period ........................................................................................................................... 49 5.3.3 Explicit period ratios ...................................................................................................................................................... 50
5.3.3.1 Explicit period: NOPLAT .............................................................................................................................................................................. 51 5.3.3.2 Explicit period: Invested capital .............................................................................................................................................................. 52 5.3.3.4 Explicit period: Free cash flow ................................................................................................................................................................. 52
5.4 COST OF CAPITAL ................................................................................................................................................................. 53 5.4.1 Capital structure .............................................................................................................................................................. 53 5.4.2 Cost of debt ......................................................................................................................................................................... 54
5.4.2.1 Company Spread: ............................................................................................................................................................................................ 55 5.4.2.3 Risk Free Rate ................................................................................................................................................................................................... 56
5.4.3 Cost of Equity ..................................................................................................................................................................... 57 5.4.3.1 Market Risk Premium: .................................................................................................................................................................................. 58 5.4.3.2 Beta ........................................................................................................................................................................................................................ 60
5.4.4 WACC ..................................................................................................................................................................................... 63 5.5 EXPLICIT AND CONTINUING VALUE PERIOD VALUATION .............................................................................................. 63
5.5.1 Projected company value ............................................................................................................................................. 63 5.6 COMPETITOR COMPARISON ................................................................................................................................................ 64 5.7 SENSITIVITY ANALYSIS ........................................................................................................................................................ 65
5.7.1 Scenario 1: Change in WACC ...................................................................................................................................... 65 5.7.2 Scenario 2: Change in revenue growth in the explicit period ..................................................................... 66 5.7.3 Scenario 3: Change in net-profit margin .............................................................................................................. 67
6. CONCLUSION .......................................................................................................................................................... 68
7. LITERATURE LIST ................................................................................................................................................ 70 7.1 BOOKS .................................................................................................................................................................................... 70 7.2 ARTICLES AND INTERVIEWS............................................................................................................................................... 70 7.3 WEBSITES ............................................................................................................................................................................. 72 7.4 REPORTS AND PAPERS ........................................................................................................................................................ 76 7.5 LEGO GROUP PUBLICATIONS ............................................................................................................................................. 76
8. APPENDIX ............................................................................................................................................................... 78 APPENDIX 8.1: THE LEGO GROUP HISTORICAL BALANCE SHEET ...................................................................................... 78 APPENDIX 8.2: ............................................................................................................................................................................ 80 APPENDIX 8.3: REFORMULATED BALANCE SHEET ............................................................................................................... 81 APPENDIX 8.4: REFORMULATED INCOME STATEMENT ........................................................................................................ 82 APPENDIX 8.5: EQUATION CALCULATIONS ............................................................................................................................ 83
Equation 1: N-firm concentration ratio ........................................................................................................................... 83 Equation 2: HH-index ................................................................................................................................................................ 83 Equation 4: ROIC ......................................................................................................................................................................... 83 Equation 5: Cost of debt ........................................................................................................................................................... 83 Equation 6: Cost of equity ....................................................................................................................................................... 84 Equation 7: Arithmetic average ........................................................................................................................................... 84 Equation 11: Equity beta ......................................................................................................................................................... 84 Equation 12: WACC .................................................................................................................................................................... 84 Equation 13: Continuing value in period 7 ..................................................................................................................... 84 Equation 14: Present value of continuing value ........................................................................................................... 84
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2. Introduction
βConsumer companies from Mattel Inc to AutoNation Inc. are beating analystsβ sales estimates
by the broadest margin in Standard & Poorβs 500 Index as shoppers help spur growth in the U.S.
economyβ (Burritt, 2013) Immediately after this leading paragraph in a recent article from
financial company Bloomberg, stock prices rose as the positive critique helped boost
anticipations regarding the future for the respective companies. The stock market is quick to
react to news regarding sales or other company and market specific news in order to make a
profit. In this way the stock markets help discipline companies and managers to return profits
and outperform its competitors, in order to satisfy investors expectations. At any given point,
these expectations can be measured in terms of stock prices and market capitalization; for
private companies however, the same scrutiny and observation is not present, therefore the
βcurrent estimated market valueβ are often not up-to-date, nor reflecting the latest market
developments.
With the American company Mattel often attributed as the worldβ biggest toy manufacturer, it
would be interesting for us to try and estimate one of their biggest private contenders, namely
LEGO, to valuate this claim. Therefore we wish to investigate and divulge the current internal
and external marked and strategic situation applicable to said company, so as to estimate the
future performance necessary in valuating the underlying assets and growth potential. Taking
its point of departure primarily from Mckinseyβ βmeasuring and managing the value of
companiesβ along with acknowledged theoretical frameworks, within the business
environment, the aforementioned estimations will be forecasted so as to arrive at a concrete
valuation of the LEGO group.
LEGO have since 2004 experienced tremendous growth and transformation allowing them to
recover from a morass of inefficient strategies along with sever financial difficulties that
characterized the years leading up to this date. At early spring 2013, LEGO disclosed yet
another superb annual report, with revenue growths around 25 % following years of
aggressive growth in an otherwise declining market toy market. This naturally raise the
question whether LEGO can sustain these phenomenal performances into the future, or if they
faces significant challenges in the future, that might dampen growth along the future value of
the company.
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Research question:
Given this introduction, our researches question can be stated as follows: βDetermining the
overall firm value, for the Danish toy manufacturer LEGO, through a discounted cash flow
analysis, with projections from a strategic and financial performances.β
2.1 Limitations:
Given the extent and steep learning curve when faced with examining and learning a new and
unfamiliar subject, such as company valuation, this naturally imposes some restrictions on the
extend of content. Having previously touched upon subjects such as WACC, CAPM and
Discounted cash flow, we only had very limited experience within these fields, at the initiation
of the writing process. In addition to said issue, additional restrictions are imposed by the lack
of perfect information, prohibiting accuracy within certain estimations and forecasts.
Therefore we have sometimes resorted to assumptions and approximations, which albeit
sincere, might have mitigated the sense of reality. These assumptions are especially related to
the estimations of growth and cost of capital, where issues such as growth in the continuing
value period or the amount of debt/equity to value ratios have been derived under the
presence of either pseudo or proxy variables.
This paper do not wish to argue and include the discussion, whether an introduction to the
stock market would be beneficial from an economical point of view; given the relative amount
of time and focus spend on the strategic and valuation part, that only renders a small section
left to elaborate whether this would be beneficial. Nor have each of the elements within the
strategic analysis been completely desiccated in minute details, as this would make this
portion un-proportionally extensive.
We still believe however, that our approach serves as a decent approximation given the
abilities and skills available at the initiation of this thesis.
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2.2 LEGO Company Profile:
The historical foundation of the LEGO group dates back to 1932, when the original founder,
Ole Kirk Christiansen, started making wooden toys, in the small provincial Danish town of
Billund, emphasizing the motto βOnly the best is good enoughβ; a motto which is still in use
today. Deriving their company name from the Danish words βLeg godtβ loosely translating into
βplay wellβ and coincidentally βI createβ in Latin. Following years of hardship, with many
setbacks through most of the 1930βs and early 40βs, along with the death of the founder Ole
Kirk Kristiansen in 1958, the control of the company was handed over to one of his four sons,
Godtfred Kirk Christiansen. Godtfred had being working alongside his dad for the most of his
life, and continued the development of plastic bricks and toys, which only had been
introduced a few years earlier. This development resulted in the patent submission of the
LEGO brick, which we know today, in 1958(Christiansen, 1961). Following a fire in 1960,
where most of the wooden toy manufacturing facilities was damaged, Godtfred chose to
disclose the production of wooden toys, in favor of producing only plastic products. This
proved to be a good decision as sales, helped by an introduction of their products to
neighboring north European countries, quickly rose. With increased international sales,
Godtfred decided to open Billund airport, which would allow easier distribution and means of
travel, today Billund airport is Denmarkβs second largest, but not longer have any direct
connection to the LEGO group.
Sales of LEGO continued to increase through the later half of the twentieth century, however
with the rise of electronic entertainment and more sluggish sales, the company began to
diversify away from their historical core products. Management hoped that with increased
innovation and more autonomous control, sales would improve. This, however, proved to be a
disastrous experiment, as the many new products failed to compete with already established
producers. Furthermore the number of different components used for the individual sets rose
at unprecedented speed, deteriorating operating costs. Perhaps one of the most famous failed
attempts, was the renaming in 2001 of the LEGO subsection βDuploβ to βExplorerβ, sales quickly
dropped, as parents no longer recognized the new name, which had no brand equity, and
ultimately LEGO had to change the name back to Duplo (Lipkowitz, 2012).
As a result of the failed strategies and high losses, LEGO had to make a turnaround; this was
materialized with the resignation of Kjeld Kirk Christiansen, and the promotion of the new
Page 7 of 84
CEO, JΓΈrgen Vig Knudstorp. Knudstorp emphasized the need to reduce the wide product
portfolio, narrowing down the number of different components, and going back to basic.
Under Knudstrops management, LEGO have managed to increase their revenue by more than
15 percent for eight consecutive years.
3. Theory
3.1 Philosophical foundations At the philosophical level, this thesis takes its point of departure within case study-oriented
accounting and organization research. Related to this are our philosophical position, which
can be stated as positivistic. Coined by Auguste Comte, positivism refers to the assumption
that empiricism i.e. βobservations and measurements are the essence of scientific endeavorβ, are
the true way to acquire new knowledge (Eriksson & Kovalainen, 2008, p 18). Published texts,
such as annual reports and announcements are studied as βartifactsβ (Ryan et al. 1992-2002, in
Eriksson & Kovalainen, 2008), therefore the texts used are taken as a representation of
reality, as we believe in their ability to inform about the issues they represent, may they be
financial or managerial.
According to Cresweel (1998) a case study is the exploration of ββa bounded systemβ that can
be defined in terms of time and placeβ (Eriksson & Kovalainen, 2008, p 118). Given this
definition, our study regarding LEGO can be said to evaluate their strategic and financial
performance in the period 2007 and onwards. According to Humphrey and Scapens (1996 in
Eriksson & Kovalainen, 2008 p 100) βestablishing the case itself as the focal point of the
research process (rather than focusing on a particular social theory), accounting research
becomes driven by problems and issues relating to account practice, rather than by the concerns
of social theoristsβ. Based on this definition our analysis focuses on the issues relating to the
value retention and creation employed by LEGO.
However some degree of observation-expected effect is inevitably, which naturally are going
to interplay with the final conclusion and total firm value. Given the degree of freedom in the
future estimation of performance measures and economical drivers, one might argue that we
subconsciously tweak or manipulate said estimates to arrive at a biased or preconceived
result. Therefore the ultimate findings, to some degree, represent our subjective
interpretation.
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3.2 Strategic part This section of the report describes the theory used in the strategic analysis of the LEGO
group. The different theories are described and criticized to determine strengths and
weaknesses of incorporating a specific model.
The strategic analysis is used to create a basis for the forecasting process related to the firm
valuation. The analysis will be summed up in a SWOT analysis which determines the
strengths, weaknesses, opportunities and threat for the LEGO group, as this will help us better
determine the future growth potential. To create a SWOT analysis both the internal and
external environment of the LEGO group will be analyzed.
3.2.1 Porterβs Value chain To evaluate the LEGO groupβs internal environment we have chosen to use Michael E. Porterβs
value chain concept. The theory suggest a way to evaluate a companyβs competitive advantage
by analyzing the basic activities within the company that create value. The model is divided
into primary and secondary processes. The primary processes in the value chain is inbound
logistics, operations, outbound logistics, marketing and sales and customer service. These are
the activities, which directly affect the companyβs product, which is why they are the main
contributors in creating value. Beneath the primary activities there are activities that is not
directly related to the product or service that the company provides, usually denoted support
activities, and consists of firm infrastructure, human resource management, technology
development and procurement (O'Brien & Marakas, 2009). When using this theory it is
important to remember that all the activities are generic and therefore could vary between
industries. This is by far one of the biggest weaknesses of the value chain model because the
value chain is not necessarily the same in all industries and if it is customized to a specific
company then it is hard to compare with competitors and identify competitive advantages.
Many have suggested changes to the value chain model and some believe that it is outdated
but we believe it is the most suitable way to analyze a companyβs internal environment and
capabilities if adapted correctly.
For the analysis of the their external environment, Porters five forces are employed to
evaluate the microeconomic external environment alongside the PEST framework to clarify
macroeconomic perspectives.
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3.2.2 Porterβs five forces To analyze the external environment there will be formed an analysis of the competitive
situation by using Michael E. Porterβs theory of competitive forces. Porter suggests that five
different forces, which a company must find a way to deal with to be successful, decide the
competitive situation within an industry. The model evaluates the rivalry within the industry
and tries to describe how fierce the competition is (O'Brien & Marakas, 2009). Here it would
be natural to introduce industry concentration ratios to describe how concentrated the
industry are. In this thesis both the n-firm concentration ratio and Herfindahl-Hirschman
index will be used to describe the rivalry in the industry, through their measurements of
concentration. The model then describes how the industry must cope with the threat of new
competition, threat of substitution, buying power of consumers and the bargaining power of
suppliers (O'Brien & Marakas, 2009).
These forces are good general factors to evaluate an industry but the model has been a
recipient of fierce criticism through the years and as with the value chain, many believe that
the theory has become outdated in todayβs society and it is not a model that you are able to
build your entire competitive strategy by.
One of the factors, which should be taken into consideration when using this framework, is
that it assumes that the industry it analyses is a perfect market where there are not
interventions from government or other sort of regulation.
Consultant and author, Larry Downes, gives Porterβs five forces this criticism for being
outdated and tries to impose 3 new forces. The new forces Downes (in Recklies, 2001) wants
to introduce are digitalization, globalization and deregulation. He believe that these new
forces will give a more comprehensive picture of the competition situation and emphasizes
that especially that digitalization has become the biggest driver in modern economics but it is
not a natural part of the five forces model. But as Dagmar Recklies (2001) argues then the five
forces framework havenβt become obsolete because in every competitive industry you will see
the forces from Porterβs theory and Larry Downes have only made it more complicated.
Even though the framework received a lot of criticism through the years, we still believe
however, that it will help us with a good framework for analyzing the external competitive
situation within the toys and games industry, especially when itβs combined with the PEST
framework.
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3.2.3 PEST As already briefly mentioned, there will be conducted a PEST analysis to assess the
macroeconomic environment of the LEGO group. The PEST model analyses the
macroeconomic factors of political, environmental, social and technological components
(Kumar & Gopinathan, 2009). These components are analyzed because of their great
importance in the external environment of the LEGO group. A change in any of these factors
can create new opportunities or threats, which the organization will have to cope with to
create a successful business. Since macroeconomic factors are country specific and the LEGO
group is a multinational organization then it is important that all relevant countries will be
analyzed to give a credible evaluation of the LEGO groupβs macroeconomic environment.
There is another variation to the PEST analysis and that is the PESTLE analysis (Barrows &
Neely, 2010), which also includes a legal and an environmental perspective. These two
perspectives was in some form already a part of the original PEST analysis but have been
extracted because they have become more significant over the years. These two new
parameters should only the analyzed separately if they are of significant importance to the
organization or else they should be mentioned as a part of the original PEST analysis. In this
thesis these legal and environmental parameters will not be analyzed individually.
One of the weaknesses of the PEST analysis is that all factors effect each other in various ways.
A political factor like a tax reduction will always have a great impact on the economy and a
change in the technological perspective could change political parameters like trade
restrictions.
3.2.3 SWOT When the three subcomponents of the strategic environments have been conducted, they will
be summarized within a SWOT analysis. The strengths and weaknesses will primarily be
coming from Porterβs value chain, which analyses the internal environment, whilst the
opportunities and threats are assessed through Porterβs five forces and a PEST framework.
The SWOT will be included so as to give a clearer picture of the LEGO group competitive
advantages and basis to forecast from.
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3.3 Valuation part:
When going about valuating a company, there are many methods, which could be applied;
among others are methods such as enterprise discounted cash flow DCF, adjusted present
value APV or equity cash flow (Koller, Goedhart & Wessels, 2010). We have chosen to apply
the methods, which are related to the discounted cash flows approach. As will be visible later
through the valuation, assumptions such as stable capital structure renders DCF more
attractive, then had we allowed for unstable capital structures, - a situation where adjusted
present value, might have been more suitable (Koller et al, 2010). Furthermore as one of the
most commonly used methods when valuating a set of assets, or a going concern, along with
the amount of existing literature and theoretical material in connection with DCF attributes to
this approachβs attractiveness.
Originally invented by the two Nobel laureates, Franco Modigliani and Merton Miller, DCF sets
itself apart from equity valuation models, which value equity holders claim again operating
cash flow, by recognizing that the value of a companyβs economic assets must equal the claim
against them. The enterprise DCF also allows the user to value multiple strategic business
units or projects separately using a single methodology. As the name discounted cash flow
implies, this valuation method discounts future cash flows so as to arrive at the present value
of these future streams of income. Therefore it is the analystβs job to estimate future cash
flows, based on the information available at the moment of valuation. In order to arrive at
these estimations, the analyst estimate future growth or decline in total capital invested, net
operating profit less adjust tax and the return on the invested capital. These performance
measures are then discounted back using discount rates, which themselves are estimates of
cost of debt and equity. Since this requires quite subjective assessments about growth in
revenue and other drivers of earnings and costs, some have argued that valuation is not really
a true science, but rather an βart formβ or βskillβ that is acquired through a long career
(Damodaran).
In the process of finding the net operating profits less adjusted tax, total invested capital and
the return it generates, the usual point of departure are the companies annual reports. While
there is a difference from account and financial performance measures, the need for
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separation or βcleansingβ of non-financial and financial items arises, so as to arrive at the
correct returns that only relates to the companyβs core business, and not e.g. the income they
generate on unrelated investments. In our case the provided excel sheet along with the
historical and reformulated balance and incomes sheets in the appendix, shows this process
of separation.
In our case, we will try and use relevant methods and approximations to estimates the
individual line items, that are associated with the before mentioned forecast requirements.
The main source of theory will be derived from the book titled βMeasuring and Managing the
Value of Companiesβ from the esteemed management consulting firm McKinsey & Co.
Furthermore we will try and included different scenarios so as to allow for both pessimistic
and optimistic views about that future. Being that LEGO is a private company, they are not
subjected to the regular laws in connection with disclosure of financial health and accounting
standards that a public company faces. The company, however, still manages to attract good
coverage from the financial medias, because of the size and their profound impact on the toy
market. When relevant we will try and included news articles to the extent they are relevant
as pointers for the future development of LEGO. The main source of inspiration when
forecasting into the future, will stem from the strategic analysis, including its findings on the
internal and external environment to help predict about future development in sales or
competition and their associated impact on the future financial performance.
There are naturally many limitations to the discounted cash flow approach, most profoundly
is itβs reliance on estimations. Another limitation is that a large amount of estimated value
that captured within the terminal or continuing value period, which naturally also are the
most difficult period to predict. Therefore an explicit period of seven years has been chosen,
as this constitutes a manageable timeframe. Albeit nobody have yet invented a crystal ball to
look into the future, these are the downsides one would have to accept when try to give their
best estimation on the future value.
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4. Strategic analysis
In this section, the internal and external environment of LEGO will be investigated. Due to the
nature of traditional valuation exercises, which take their point of departure in the historical
financial performance, it is important to also devote attention to the other factors, which are
also is of significant importance for the future value of the company, so as to give a holistic
picture, as stated earlier the findings from the following sections, will be included later when
forecasting for the future performance of LEGO, therefore the strategic analysis remains of
major importance. To achieve this holistic picture, the use of the aforementioned theoretic
frameworks from within the areas of strategic organization and marketing, will be applied so
as to highlight the internal and external environment of LEGO.
4.1 Value Chain Analysis
As the name implies, a value chain analysis, is a tool that is useful when trying to uncover and
highlight the process in which the company adds value to their products through the
manufacturing sequence (Whittington, Scholes & Johnson, 2011). A value chain analysis is as
such nothing ground breaking, but serves as a good tool that emphasizes the incremental
primary and secondary (support) processes, which ultimately add value to the final product.
These individual steps will next be examined respectively, starting with the primary activities.
However while relating LEGO to these activities, a natural point of departure would be to
highlight some of the previous implementations LEGO has undertaken in order to improve
some of the most predominant processes in the value chain.
Previously LEGO had several plants and distributions centers located throughout Europe,
Latin America and Asia, with Europe being the main place of production. During the first years
of the twenty-first century, particular the period until 2003, the number of different elements
used in the respective products exploded, along with an increasingly difficult production
schedules (Delingpole, 2009). Therefore the need to restructure the supply-chain steadily
increased; something that was immediately recognized by the new management who had
replaced the previous senior management during the major reorganization of LEGO in 2004.
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In dealing with its multiple sites throughout Europe, LEGO as the first manufacturing
company ever, decided to serve all of its European and Asian markets from new locations in
Hungary and the Czech Republic, whilst drastically imposing restrictions on the introduction
of new components in future assembly kits. This has proved to be an extremely wise decision
as LEGO managed to cut logistic costs by more than the projected 20 % whilst at the same
time improving handling time of the daily operations (Madsen, 2012). After this strategic
decision, LEGO have on several occasions announced that they would expand their operations
in Hungary and the Czech Republic, greatly increasing their production capabilities, whilst
gradually transferring more of the production from labor expensive Denmark. Furthermore,
following their record breaking annual report for the fiscal year of 2012, LEGO announced a
new factory in China, which in the future are going to serve the rising Asian markets (Riising,
2013).
4.1.1 Primary activities
4.1.1.2 Inbound logistic Sharing many activities with outbound logistics, inbound logistics are concerned with the
transportation, warehousing, inventory management and control, what primarily separate the
two, are inbound logistics emphasis on raw materials. LEGO receives the main bulk of their
chemical raw materials, used in the production of plastic bricks, from the German company
Lanxess, a subsidiary of the worldwide chemical cooperation Bayer AG. Whilst the properties
of the final brick is specially developed to LEGO and their needs, the ingredients can be
assumed as fairly standardized commodities, therefore LEGO as such, do not face any special
bottleneck situations, which could hamper their future production.
Although with the introduction of 3d printing, and its potential widespread applicability,
future raw material prices might be influenced, either positively or negatively giving its
utilization of the same materials as in the production of LEGO brick (Heathcote & Roux, 2012).
4.1.1.3 Operations Through the daily operations, which are the actual manufacturing of the final product, LEGO
strives to correctly forecast future demand, so as to have the right amount of product mix to
meet future demand. This is naturally a complicated procedure, however LEGO has been
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increasingly better at projecting future demand, through the use of sophisticated software
and a analytical approach to their given assignment and allocation problems (Madsen, 2012).
On the mechanical side, even though the very high output of elements, LEGO has managed to
optimize their manufacturing processes enough to reduce waist and limit the amount of faulty
elements, only 18 of every million elements produced, fail to meet the rigorous quality
requirements, which among other things require the products to be within 5 my accuracy
(0.005mm)(Company Profile, 2012). LEGOβs patented plastic ingredient a derivative of
Acrylonitrile butadiene styrene, usually abbreviated ABS, insures the right durability and
color properties that LEGO desires. All LEGO products adhere to the European CE-labeling,
which insure that their products and production methods are aligned with the concurrent
legislation within the European union (Sikkerhedsstyrrelsen, 2010). Furthermore LEGO is a
member of several Toy industry organizations with the aim of promoting and harmonizing
safety and quality standards (Jensen, 2012).
The wish to always deliver top quality and reliable products, with no missing elements or
components, is consistent with their identified values about quality, and zero product recalls.
Relating these values and operational procedures to the value chain, it can be concluded that
LEGO tries to imbue their products with superior quality and safety standards along with the
right practical management to insure, correctly forecasted availability of products of the right
standards.
4.1.1.4 Outbound logistic In connection with LEGOβs production expansion in Eastern Europe, LEGO opted to outsource
distribution to DHL Excel Supply Chain, as much of their sale is seasonal based. By
outsourcing the distribution, they do not need to carry excess capacity during the summer,
where sales usually are lower. Furthermore by outsourcing these activities, from a βmake or
buyβ perspective, LEGO get to do what they do best: Product innovation and creative designs,
and establishing new product licenses, whilst leaving distribution in the hands of experts.
When relating in/out bound logistics along with operations to the financial performance of
LEGO, there has been a clear tendency of optimization, befitting from the aforementioned
improvements. Below table 1 illustrates the historical reductions in production along with
selling and distribution expenses. Since nominal values would have displayed rising costs due
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to the increase in sales, the relative costs compared to operating revenue have been reported
instead. LEGO managed in the period 2008 β 2012 to reduce their relative cost of production
along with selling and distribution expenses by 4.35% and 4.89% respectively, constantly
improving their performance in all years except 2011 (LEGO.Bachelor.xlxs). These findings
substantiate the aforementioned initiatives that LEGO have undertaken to improve said
accounts. Whether LEGO will be able to continue improving their performance in this
connection remains uncertain, there do however appear to be a tendency for a reduction in
the efficiency improvements.
Table. 1
Annual relative changes in costs associated with in/out logistics and operations in percentage changes.
Source: Own calculations, based on annual reports. See βAnalysis tabβ LEGO.Bachelor.xlsx
4.1.1.5 Marketing and Sale According to E. Jerome McCarthy marketing is the mix of price, product, place and promotion
that are associated with the company or good in question (In Kotler, Keller, Brady, Goodman
& Hansen, 2009). On the product side, LEGO now follows a portfolio of successful themes and
licenses. This was a reaction to the before mentioned period where LEGO had diversified too
far away from their initial core products, into a morass of different themes and product lines.
LEGO was among other things, saved by entering into strategic partnerships with companies
such as Lucas Arts and Warner Bros, who hold the licenses for Star Wars and Harry Potter
respectively. Therefore Star Wars and Harry Potter have often been attributed as the saviors
of LEGO during their recent crisis (Sielen, 2013). With a predominantly male audience, LEGO
have recently tried to increase its product portfolio to included products, which targets the
female segment. During the financial year 2012, LEGO launched its new product βLEGO
friendsβ with this particular audience in mind, proving to be a major success (TrangbΓ¦k,
2013). Following these successes LEGO has been able to identify additional areas of
cooperation, example of which includes: Batman, Pirates of the Caribbean, and Lord of the
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Rings. Some of the most immediate benefits from these strategic partnerships are the synergy
effects that can be assumed to arise from the combination of contemporary and well-known
fictional fantasy realms and the many combination possibilities of LEGO. Not only will LEGO
enjoy the indirect marketing of their licensed products, but episodes and event in the
respective movies, serves as a good basis of inspiration, that can be recreated as LEGO
products e.g. the Death Star from Star wars or Bilbo Baggins βBagendβ from Lord of the Rings.
In the light of the financial success following from these portfolio changes, LEGO proves its
ability to choose correctly among license holders and the future themes, giving them a
positive outlook for the future.
In relation to the place of sales, LEGO have in recent years dramatically increased their points
of sale. Previously relying on external companies to buy and sell their products, LEGO have
increasingly sold its products through both the Internet and its own specialized retail stores.
These specialized stores offer exclusive products, activities and exhibits, which only can be
acquired and experienced there (Yohn, 2012). These features add to the purchasing
experience while also aid in retaining their large fan base and promoting the company to
future costumers. Further up the supply chain, with its recent announcement of expansion on
the Asian market, LEGO are also increasing their presence to the markets, by expanding with
production facilities closer to their customers (Knudstorp, 2013).
Lego utilizes several promotional strategies, ranging from traditional medias such as
television ads and social medias to philanthropic charity (Progress report, 2012). Covering all
however, would be beyond the scope of this segment. Besides regular promotion, LEGO also
receive large exposure through their collaborating with Merlin entertainment, the main
shareholder of the LEGOLAND theme parks (Merlin Entertainment Group, 2013) and the
promotion done via their specialized stores and annual returning event created by their large
fan communities.
Finally turning to the pricing strategy, LEGO has always pursued a pricing strategy of superior
prices, not engaging in price competition. Whilst adhering to the βonly the best is good enoughβ
motto, LEGO justifies its relative expensive products with their superior quality and designs.
Price per piece has however, declined in recent years, this price reduction has though been
mitigated by the increase in the average number of pieces included in the product sets (Sielen,
2013) maintaining the perception as an expensive toy. Whilst being more expensive than its
direct competitors such as MEGA BLOCKS and Mattel, LEGO face competition from direct
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substitutes, who offer pieces that fit together with traditional LEGO but at cheaper prices
(Hansegard, 2013). This threat of substitution is examined further in the external analysis
more specifically porters five forces.
4.1.1.6 Service Beyond the LEGO group pledge to superior quality, they utilize costumer retention schemes
via its official website, these schemes include βVIPβ points that is awarded to costumers for
online purchase; These purchases can then be used as an online currency, giving price
reductions for future purchase (Enjoy the VIP treatment (LEGO), 2013). In addition to these
services, a lot of material are available online, customers who lost their construction manuals,
are able to download them in PDF form via their website, or to contact the company directly
for special requests.
Given its large fan base, LEGO have dedicated staff to sever and maintain contact with LEGO
clubs throughout the world. Often these clubs host annual events, where they exhibit special
recreations of famous buildings or special scenery. Given this help building on the LEGO
reputation and gives great promotion to a wide audience, LEGO naturally has a large interest
in maintaining these communities and therefore actively tries and collaborate and engage
with their community (Community Team Blog, 2012).
Generally LEGO actively interact with their audience providing additional service and a loyal
fan base. This might be one of the reasons why βsubstitute LEGOβ i.e. Mega brands or Mattel,
have not yet caught more on, although their significantly cheaper prices. As analysts, the
impression we get as we investigated these communities online, are very loyal fan bases,
which spots βobviousβ flaws in their competitors products, and who would never consider
mixing their LEGO bricks with βnon-pureβ LEGO. Therefore the catering and service of these
communities should not be neglected, even though it comprises an axillary activity, with no
βapparentβ revenue streams.
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4.1.2 Support Activities:
4.1.2.1 Firm infrastructure
It has been a prevailing strategy within the LEGO organization to delegate many activities to
individual companies who have superior knowledge within their respective fields of
expertise. Whilst several of the assets that LEGO posses have been mentioned, especial in
connection with production capabilities, it is important to highlight the additional
infrastructure components that is at their disposal. One of these additional components is the
usage of IBM solutions in connection with the production and accounting management,
through the use of business applications such as SAP. This strategic partnership gives LEGO
the right capacities to manage daily operations and utilize their production capabilities in the
most efficient manner (Case Study (IBM), 2010). As mentioned earlier DHL excel supply chain
handles most of the distribution, pulling on their large network and big capacity, alongside
announced expansions of production facilities throughout LEGO is rapidly enhancing their
infrastructure to be as cost efficient and productive as possible.
4.1.2.2 Human resources management βThrough our approach we want to play an active part in improving the wellbeing for all
employees, in our supply chain, as this helps protect our companyβs strong reputationβ (LEGO
Progress report 2012, p. 135). This is one of the ways that Lego describes its active
involvement in the wellbeing of its employees. There are many theoretical frameworks that
emphasize different motivators and drivers for good employee performance. These
frameworks are usually divided into either content or process theory (Buelens, 2011). In
terms of content theory, where professors such as Herzberg and Alderfer are recognized
framework setters, LEGO strives to ensure a motivating work environment. It does this
through what Herzberg calls hygiene factors, i.e. remuneration, benefits, and other
quantifiable monetary rewards, but also with motivators such as an exiting work
environment, challenging tasks, and a strong culture and collegial bond (LEGO Process report,
2012).
Their moral ethics do not only apply to those directly employed by LEGO. To insure that
throughout the entire value chain, there are no moral hazards LEGO require that partners
fulfill a range of metrics. Those requirements are summarized in their code of conduct, which
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among others require partners and suppliers to recognize the rights of the employees, their
right to minimum payment, and discrimination free workplace (LEGO progress report 2012).
LEGO performs unannounced audits to insure that there is no violation of these terms of
conduct, which is contractual binding between LEGO and the suppliers. With its numerous
and widespread presence through the world along with a contemporary and modern
corporate firm structure, LEGO are assumed to be able to continue attracting a qualified and
effective workforce in the future. Along with their rigorous requirements to their suppliers,
there is not deemed to be any future reputational hazards regarding human relations in the
supply chain, albeit the information provided is one sides.
4.1.2.3 Technology development
LEGO has always had a close connection to the educational world, one example of which could
be the close relationship with prestigious universities such as Massachusetts Institute of
Technology (MIT media lab). This close relationship to the educational sector follows from the
natural extension of the creative possibilities and functional combinations of products such as
LEGO Technic and Mindstorm, both of which include programming and mechanics. To
capitalize on their applicability to the educational sector, LEGO employ their subgroup LEGO β
Education, which product segment ranges from preschool to the secondary level of education
(LEGO education). LEGO utilizes several development departments to enhance their current
products and activities, earlier we mentioned the constant improvement of the quality and
durability of the plastic components, and the progress on improving their forecasting
methods through IT solutions, derived from academic research (Madsen, 2012).
Equally important in relation to the value chain are technological capabilities related to the
development of new products and production methods. As identified under marketing and
sales, the acquisition of rights to concurrent and well-known brands and themes are of vital
importance to LEGO, in this connection technology, or maybe more specifically product
development, which means having to keep pace with the introduction of new product lines.
This put constraints on the technological capacity of LEGO to make quick adjustments and
introductions of said products. This responsiveness has been greatly improved through the
latter part of the first decade of the new millennia, via both formularized design schedules
(Design Council LEGO case study) and capacity improvements, giving LEGO the flexibility to
meet these constraints.
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Although some maybe would consider LEGO to be analogue players in a digital world, LEGO
have managed to employ technological features such as cloud computing and software. Online
project communities such as LEGO Cuusoo, enable fans and innovators to submit their own
suggestions to new products; designs which often are created through free LEGO software
programs that allow the user to build the idea three dimensionally before actually assembly. If
chosen the respective designers are entitled to 2 % (Cuusoo (LEGO)) of the revenue their
ideas generate, whilst LEGO benefit from the relatively inexpensive creativity that their
community posses, and the inspiration that fans give to one another, hopefully generating
excess sales. Continuing on the software front, LEGO has through joint venture collaborating
with TT games (TT Games, 2013) experiences good results, with title series such as Harry
Potter, Indiana Jones and Star Wars all having being well received, and helped LEGO mitigate
the impact from virtual games on traditional toys.
To aid their in-store sales and make their products stick out relative to their competitors,
LEGO has also introduced technology such as βaugmented realityβ via the in-store kiosk, which
allows you to view what is inside the packages in an innovation and capturing way. This
feature gives enhanced buying experiences that most certainly make their products stick out
(Metaio).
The abovementioned initiatives and competences, combined with their long company history,
manages to secure LEGO a more active community and fan base, this ultimately is a
competitive advantage relative to their competitors. Together with increased responsiveness
to new product launches that employs the right features and creative designs, often inspired
by their fans, LEGO can be said to hold an competitive advantage. This advantage could not
have been sustained without the use of informational technologies and the use of technology
altogether.
4.1.2.4 Procurement Whilst being closely related to logistics and operations, procurement is inherently different,
since these activities also include the acquisition and provision of items not necessarily
directly included in the production of the companyβs final product. Since the procurement of
raw materials and supplies already have been discussed, leaving yet another description
redundant, the attention turns to the procurement of financial assets and credits.
Together with their parent company, LEGO has engaged in multiple transactions, assisting
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each other with several loans and financial support, with these activities being labeled
βtransaction to related partiesβ in the balance sheet. During the fiscal year of 2012, these
transactions amounted to roughly 26 billion DKK, more than the total revenue of the year. The
net amount to related parties at the end of the year however, was considerably lower, with a
net loan investment of 3,442 billion DKK. The sheer volume of these transactions goes to
show, the financial capabilities of LEGO and their mother company, and can therefore be view
positively. As will be seen later in the valuation section, the coverage ratio of LEGO, i.e. their
abilities to meet their financial obligations, was considerably high, with an EBIT/Interest ratio
of 400! This goes to show, that the capital structure of LEGO highly favors an equity approach
where debt are kept low and hence also interest payments, the ratio has however also been
inflated violently by the rapid increase in earnings before interest and tax (since interest is an
tax deductible). With this leverage ratio, LEGO can be assume to conform to an AAA rating in
terms of creditworthiness, which further allows them to secure further financing at relatively
lower interest rates (Damodaran, 2013) This however will be explained more deeply in the
cost of capital section.
With their rigorous requirements discussed in the human relations section, the list of
potential suppliers naturally diminishes. However, this is deemed a competitive necessity, as
a global company like LEGO, could potentially face large reputational damage, if they were to
cut cost excessively in the procurement process.
From the above mentioned, LEGO is evaluated to have a good source of financing
opportunities along with a good market knowhow that enables for future procurement.
4.2 Porters five forces When analyzing the LEGO groupβs non-financial value, it is important to analyze the industry
they are acting within. To do so, Michael Porters five forces were chosen and explained under
the theory section.
The LEGO group acts within the toys and games industry. Toys and games can be divided into
several sub-industries and this analysis will take into account that the LEGO group have a
larger stake in some parts of the industry compared to other, although in general the
preceding analysis of the toys and game industry on a more holistic level.
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4.2.1 Bargaining power of suppliers: Within the toys and games industry and in relation to the LEGO group the most important
supplier is within the chemical market. LEGO bricks are produced mainly out of a plastic
material called ABS (Virksomhedsinformation (LEGO), 2013). It was hard to gain access to
information regarding the chemicals market and the competition within plastic chemicals, but
we believe that this market is very competitive and therefore the suppliers does not possess
any threatening bargaining power over the toy manufacturers.
It is important to evaluate whether the suppliers to a specific industry have any bargaining
power towards the companies. Suppliers have bargaining power if there is a high industry
concentration for the given market. From the theory of supply and demand, we know that a
decrease in supply will increase the prices, and if there is only few firms within the given
supplier industry they will be able to control the supply and therefore have a higher
bargaining power. High supplier bargaining power will increase the production prices within
the industry and it will create an entry barrier.
The big companies within the toy and industry sector have demands when it come to the code
of conduct of suppliers. The companies have to protect their image and brand equity, which is
why they cannot allow their suppliers to slack on the code of conduct. The LEGO group have
divided their suppliers into categories after how high the risk is of the LEGO groupβs code of
conduct being broken. The largest part of their suppliers are in low risk countries but the
second largest group of suppliers are in high risk countries. (Progress report 2012) We
believe that it is reasonable to generalize this for the industry, which is why some suppliers
might not be able to compete with the other suppliers due to poor code of conduct. This will
reduce the amount of suppliers eligible for the toy industry and increase the bargaining
power of the suppliers.
A threat from suppliers worth valuating is whether if they decide forward integrate in their
value chain. In this case chemical producers would start making toys, which seems highly
unlikely because the lack of expertise need to achieve with such and conglomerate
diversification. Furthermore the competition within the target area along with value in their
own industry further inhibits these threats.
An untraditional supplier in the toy and games industry, compared to other industries, is the
film industry. The companies within the industry buys the license from different movie
franchises to benefit from the brand equity created by popular movie franchises. A large part
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of the LEGO groups revenue growth in the last couple of years have been due do license
agreement with the like of Warner Bros, Lucas Arts and Disney for movie franchises with a
large fan basis (Bomsdorf & Hansegard, 2013).
Mattel and Hasbro also have several movie licenses and it has become common for these
companies that there are also being produced movies based on original toys. The best
example is the Transformers trilogy, soon quad-trilogy, which originated as a toy produced by
Hasbro (Transformers (Hasbro)). Alone in admission fee the trilogy it has generated more
than 2.6 billion USD putting it in eight place of the most grossing movie franchises of all time
(Adams, 2011). So the toy and games industry are very dependent of these movie franchises
and that there are not only being produced new movies, but also that existing series are being
maintained. This gives the film industry a great power over the toy companies, and which
companies to choose collaboration with; this might emphasize why the companies are paying
several billions to the franchise holders, to benefit from popular movie themes.
4.2.2 Buying power of consumers: One of the most important factors within the subject of consumers buying power is whether
the individual buyer have economic muscle towards the actors within the industry. In this
case it is not the case that the consumers on the toy market have any kind of economic power
over companies within the industry. A single person is not able to force a company down in
price or inflict damageable impact on the company. The consumers is of course the most
important buyer in the industry and they are the ones who determine if a product is
successful or not but you should not neglect how vital the B2B market is for the industry. On
the B2B market, the manufacturers are co-operating with retailers who are their face to the
final consumer. The retailers possess some form of power over the toy companies because
they decide how they sell their products and they are their main distribution channel, which
puts them in a favorable position. However most toy companies distribute an increasingly
larger portion of products through their own retail stores or online sales.
By segmenting consumers into geographies then some continents possess more power over
the industry compared to the number of people who lives there. The Asia Pacific accounts for
52.5% of kids between 0-14 but they are far from purchasing an equivalent amount within the
toys and games market. USA, Western Europe accounts for 61% of the retail sales of toys and
games worldwide (Daujotas, 2013). The fact that the highest part of toy and games sold in
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more developed countries is of course strongly connected with the fact that there is a larger
disposable in these places. The skewed distribution of sales means that the toy companies
have a larger risk if the economy takes a downturn. In the future, the Asia pacific markets will
probably become a bigger part of the toy and games market due to the economic development
in this area.
An obstacle for the toy manufacturers is that the buyers are tied to their specific product and
there are no severe cost of switching to another product. In an industry where the clientele
have rapidly changing preferences, it can be lethal for the toy manufacturers that there are no
costs of switching from one product to another. This problem is something that the players
within the industry tries to avoid by constantly improving their brand quality for instance by
buying licenses to famous movie themes which kids associates themselves with.
4.2.3 Threat of new competition Within the toy industry, there are some difficult entrance barriers, which a new competitor
would have to penetrate. The players within the industry is benefiting from economies of
scale to give them a big cost advantage. Big players like Mattel, Hasbro and LEGO produce
their products in countries where they can benefit from low wages to reduce their production
cost. The companies who are already in the industry also have a lot of expertise to help them
make the correct decisions and help them optimize their value chain. A new entrant to the
market would not be able to take advantage of economies of scale because of their assumed
limited expertise within production and limited resources.
The actors already in the toy industry is benefitting from a high brand equity, which they have
created through several years on the market creating toys, which have been a part of society
through generations. Mattel created the Barbie doll in 1959 (Barbie Media) where parents of
today were kids themselves and the doll have followed several generations who can
remember the doll when they get kids themselves and of course they will buy one for their
children. Since 1959 it is estimated that there have been sold more than 1 billion Barbie dolls
(Sherman, 2009) this is an extremely tough brand to compete with. Companies like Hasbro
and LEGO have similar stories with their product lines and it is hard to defeat brands who
have sold continuously through decades.
As mentioned in the section of bargaining power of suppliers, the toy and games industry is in
some sort benefitting from other industries like the film industry. LEGO have several patents
on movie franchises like Star Wars, Harry Potter and Indiana Jones. This gives them a
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possibility to benefit from strong franchises and give them an advantage in the industry. A
new competitor would have difficulties to compete with high profiled movie franchises and on
the other hand, it would ease the entry if a new competitor would be able to buy the license
for a popular movie franchise because they would buy a set of costumers, which are the fans
of the movie.
Because of the importance of these movie franchises, it would be a great threat if a studio like
Warner Brothers would cut all their license agreements and begin to produce all toys
themselves. They would make a shortcut into the market because they already have a very
large fan base and would be able to compete for market shares relatively fast.
In the favor of new entrant is the fact that childrenβs preferences changes swiftly and the costs
of switching from one toy to another is relatively small. The preferences of children changes
according to what is fashionable now and that is why the established companyβs theme
licenses are important. However, a new entrant will be successful if it is able to draw the
childrenβs attention toward their product and establish a brand equity, then they will be
successful.
It is important to notice that the preferences of toys are different from continent to continent,
so a new entrant might have success by only entering one market and then build a business
from there. The producer concentration will be discussed under the Rivalry sections in the
Porters Five Forces analysis.
4.2.4 Threat for substitutions The biggest threat for substitution in the perspective of toys and games industry is the
increasing modernization of kidβs entertainment. This means that kids are playing more
computer games than before and some are making the switch from traditional toys. The LEGO
group have tried to cope with this issue by moving into the electronic gaming scene
themselves. They have made several LEGO games (Games (LEGO)) and are trying to create a
diversified portfolio, which will cover the most parts of children entertainment.
When assessing the threat for substitutions it is important, to evaluate if there is high
switching cost for the consumers to choose another product. Here we believe that traditional
toys in general are cheaper than computer games and therefore it would be more expensive
to make the switch. It can be discussed whether the kids will get a higher satisfaction from
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switching to computer games but so far we believe that the parents still prefer the traditional
toys over computer games because of the educational aspect there are in toys like LEGO, along
with higher perceived stigmatization associated with computer games, relative to traditional
toys.
If it is only the basic need of entertaining a child, substitution could be quite easy, through
differentiation LEGO tries and position themselves differently from other toys, by having a
unique concept, which activates kids. Having a play system instead of a finished solution.
One of the biggest threat of the LEGO group is the fact that several big players have moved
into the construction toys market. The worldβs second largest toy manufacturer have created
an almost identical product to LEGO, which they call Kre-o. Mega brands, who have produced
a product identical to LEGO in several years, called Mega Bloks, and have received several law
suits from the LEGO group. Furthermore they have entered into a strategic alliance with
Mattel where Mega Brands will produce toys within the popular themes Barbie and Hot
Wheels (Mega Bloks, 2012). If this strategic alliance between Mattel and Mega Brands
continues then it will give Mega Brands an improved position on the market since they will be
able to benefit from Mattelβs strong brand and distribution channels.
Even though this seems as a large threat for the LEGO group, they themselves refuse to
acknowledge the extended to this threat. LEGO believe that these new companies usually just
imitate the LEGO groupβs popular themes, and they are not able to keep up with their
innovation and high quality. However, Jorgen Kudstorp, CEO of the LEGO group, believes that
their biggest threat comes from competition, which just covers the same needs as LEGO, but
not necessarily βcheaper LEGOβ (Knudstorp, 2013).
4.2.5 Rivalry When discussing the rivalry within the toy and games industry it is important to define the
competition situation within the market. This will be done by valuating the industry
concentration. We could have incorporated the industry concentration in ββThreat of new
competitionββ to describe the entry barrier but we decided to discuss this problem in this
section.
The industry concentration can be evaluated by several measures and we will do so by using
the n-firm concentration ratio along with the Herfindahl-Hirschman (HH) index. The n-firm
concentration ratio (denoted CRn) simply measures the largest firms within an industry, we
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have decided to measure the concentration for the largest four firms and the largest eight
firms. The advantage of CRn is that you only need limited data and only from the largest four
and eight firms (Lipczynski, Wilson & Goddard, 2009). The formula for CRn is as follows:
Equation 1:N-firm concentration ratio
πΆπ π = β ππ
π
π=1
Source: Lipczynski et. al. 2009
From the data collected from Euromonitor (2012) it is calculated that CR4 is equal to 29.54%
in 2011 and CR8 is equal to 36.59%. The general notion is that if CR4 is smaller than 40% then
there is a strong competition within the industry. Within the Toys and Games industry there is
only 29.54% and CR8 is 36.59% this tells us that there is a high level of competition within the
industry. N-firm concentration ratio does not however meet several of the Hannah-Kay
criteria and are therefore only a good indicator of the industry composition (Lipczynski et al.
2009).
We want to assess whether de distribution of the market share is skewed, which the n-firm
concentration ratio fails to evaluate. Basically the CR4 could give the same number if the
industry leader had 25% of the market and the remaining 3 companies shared the remaining
4.54%. The HH index gives larger weight to the big companies, which makes it possible to
evaluate if the distribution of the market share is skewed. The HH index ranges from 0 to 1
where 0 is equal to full competition and 1 is equal to monopoly. Full information regarding
market shares is demanded by this model to get an exact number but there can be made a
reasonable approximation by only using the data available. The formula for the Herfindahl-
Hirschman index is:
Equation 2: Herfindahl-Hirschman
π»π» = β ππ2
π
π=1
Source: Lipczynski et al. 2009
In 2011, the HH-index was 0.027, which indicates that the industry is very close to perfect
competition, which also was the notion we got from the n-firm concentration ratio. In the
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period from 2008 to 2011, both indexes showed a small increase in the concentration ratio
but far from rapid growth. Even though there is a high level of competition then Mattel have a
market share of 12.29%, which is a lot higher than their competitors.
The fact that there is a high level of competition in the Toy and Games industry explains that
there is a high level of rivalry in the industry and it would be easy for a new competitor to
enter the market.
Even though there is a high level of competition within the market for traditional toys then
the market for construction toys are completely different. As mentioned competitors are
trying to move into this part of the market where the LEGO group are enjoying oligopoly-like
(if not even monopoly) conditions with more than 60% of the market (Euromonitor, 2012)
The industry has an intense rivalry through several distribution channels. The companies
tries not only to sell their products through retailers but also through own shops and online
sales. This intense competition is being confirmed by the CEO of the LEGO group, JΓΈrgen
Knudstorp, who believes that the intense retailer competition is lowering the value of the
market (Hansegard, 2013).
In the industry it is all about being the next trendsetter within the industry, because the next
big thing is what creates a larger revenue and opportunities to increase your market share
and brand equity.
4.3 PEST Framework
4.3.1 Political There are several factors, which effect a global organization like the LEGO group. The LEGO
group have facilities all over the world, some places more than others, but they are constantly
affected by the political situation in the countries where they are present. The LEGO group are
present in Denmark where they still have some production and most of their administration
and research and development they also have production in Hungary, Czech Republic and
Mexico. They are planning to begin building a new factory in China in 2014, which should be
ready to produce in 2017 (Ritzau, 2013). These places are off course where they are most
affected politically but they are distributing their product to more than 130 countries (LEGO
(About us), 2013) and therefore they are affected of all local political decisions.
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An increasing debate in the western part of the world is the issue of gender neutrality. Gender
neutrality is not differentiating between boys and girls in general and in the case of the toys
and games industry, it concerns not advertising specific toys to a specific gender. In Sweden
there was a case not too long ago concerning a toy retailer who received a lot of criticism for
gender profiling changed their catalogue so both genders would be in a picture (Gara, 2012).
The LEGO group also took a lot of criticism after launching their new product, LEGO friends,
which they tried to target against girls in the age of 0-14. LEGO friends has been one of the
LEGO groupβs biggest successes so it could have some negative effects to change the
marketing mix for this product. Some are trying to get a petition signed to make LEGO stop
their allegedly genders biased advertising and include both boys and girls in their marketing
of their products (Miller & Gray, 2012). The increased awareness of genders neutrality could
turn out to change laws in some of the LEGO groupβs core markets, which is something they
will have to adapt to in the future.
In recent months the Danish corporate tax have received a lot of attention after the
government proposed the opposition that the corporate tax in Denmark should be reduced
with 1% each year until 2016 so that the new tax rate would be 22% (Matzen, 2013) This
reduction in the corporate tax rate was agreed upon the 24. Of April 2013. The concrete
corporate tax reduction will be 0.5% in 2014, 1% in 2015 and 1.5% in 2016
(Finansministeriet, 2013). A reduction of the corporate tax level will have an increasing effect
on the earnings of the LEGO group because corporate taxes is a large part of expensives. Even
though the corporate tax rate in Denmark are not that high, then the personal tax rate is one
of the highest in the world, which drives the wages up to a high level. LEGO have already
realized that Denmark are not able to reduce the wages to the level of countries like Czech
Republic, Hungary, Mexico and China, which is why they are moving all of their production to
these countries and only keep ββdesk jobsββ in Denmark (Kristensen, 2013).
Of political factors one of the most discussed for the Toys and Games industry is labor politics.
The industry are notorious for producing their products in low waged countries and have
been heavily criticized for the working conditions in these factories (Clark, 2007). There are
constantly being created more awareness in these developing countries on labor rights and
therefore this is of course of great importance for the LEGO group because of their production
facilities all over the world.
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4.3.2 Economic There are several economic factors, which affect the LEGO group. Change in different
economic parameters in the LEGO groupβs external environment can have crucial impact on
their sales and business in general.
In the latest projection from the International Monetary Fund (IMF) they state that they
believe that the general world economy will see a gradual upturn in growth in 2013. They
believe that there will be a global growth of 3 percent in 2013 when combining both
developing and advanced economies. An increase in growth will create more wealth in the
public and therefore increase the spending of public. An increase in spending will be
beneficial for the toy and games industry, as it will increase sales.
Source: IMF, 2013
As mentioned the LEGO groupβs most important markets are Western Europe, USA and Japan,
which all are part of advanced economies. IMF believes that the growth in advanced
economies will increase from 1.3 in 2012 to 1.4 in 2013 and 2.0 in 2014. The LEGO groupβs
biggest market USA will see a small decrease in growth in 2013 but in 2014, it will increase to
more than 2012 level. Thereby IMF keep their growth outlook even on Japan, which are
struggling with recession but they believe that it only will be a short-term crisis.
0%
1%
2%
3%
4%
5%
6%
7%
2011 2012 2013 2014
Graph 1: GDP growth
World Advanced Economies Developing economies
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There are several threats concerning the economy. The EURO area, which is one of the LEGO
groupβs core markets, are still trying to survive a persistent debt crisis in southern Europe.
The IMF believes that there have to be taken political action to limit the downside risk of the
euro area. If the crisis in euro continues and maybe spread to northern Europe, it would have
a negative effect on the LEGO groupβs revenue growth (IMF, 2013).
The middle class is of great significance to not only the LEGO group but to the toy and games
industry in general since this must be recognized to be where the biggest part of consumers
are located. An economic crisis in core markets like North America would have a slowing
effect on the markets since the advanced economies by far have the highest consumption
compared to size of middle class population. Table 2 describes the distribution of the worldβs
middle class and how large the consumption is for each geographical segment. Homi Karas
(2010), from OECD, defines the middleclass as the people with expenditures between 10 USD
and 100 USD. The table shows us that North America accounts for 18% of the global middle
class but has 26% of the consumption and Europe have 36% of the middle class and consume
38% of the total. These are the only geographies who consumes more than they account for,
all other consumes less than their global share of population. This tells us that a crisis in
either of these areas will reduce the global consumption significantly.
Table 2: Distribution of middle class and consumption
Source: Kharas, 2010
The LEGO group are targeting the emerging companies as a new big market and the growth
will keep on the same high level and even increase in the next couple of years. The increase in
the growth in emerging economies is particularly important for LEGO, as it will get more
people into the middle class and into the LEGO groupβs target group. This is confirmed by
North America 338 18% 26%
Europe 664 36% 38%
Central and South America 181 10% 7%
Asia Pacific 525 28% 23%
Sub-Saharan Africa 32 2% 1%
Middel East and North Africa 105 6% 4%
World 1845 100% 99%
ConsumptionNumber of People (Millions
and global share)
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OECD, who believes that the middle class will increase from 1.8 billion people in 2009 to 3.2
billion in 2020, almost twice as many in 2009 (Pezzini, 2012).
As a multinational corporation, the LEGO group are highly effected by currency fluctuation.
They try to limit the risk from currency by hedging currencies by using contracts and options.
In their annual report they state that they have significant inflows of EUR, GBP and USD.
Denmark has a fixed exchange rate policy towards EUR, but the other currency pairs have
been quite fluctuating. Graph 2 displays the historical development of important currency
pairs for the LEGO group.
Source: (Danmarks statistik, 2013)
The periods where the currency pairs are above one hundred are the periods where the LEGO
group have earned a currency premium on their products due to a high exchange rate in the
LEGO groups advantage. Vice versa they have lost money on products when the currency pair
is below 100, of course compared to the level in 1993. There are also some benefits from
having a cheaper currency. A cheap currency will improve the LEGO groupβs competitive
power towards foreign competitors because their product will be cheaper and therefore more
attractive for the consumers.
The interesting thing about LEGO is that during the last couple of years economic downturn
they have only improved their business and grown it bigger and bigger and therefore the
change in economic growth might not have as big an impact as it will with other companies.
60
70
80
90
100
110
120
130
140
Graph 2: Historical Currency Pairs
DKK/EUR DKK/USD DKK/GBP
Page 34 of 84
However, it will without a doubt be important for the LEGO group that there is a continued
growth in the emerging markets which will get more people up in the middle class.
4.3.3 Societal factors
Due to the close interrelationship between politics and culture, the gender neutrality issue,
which have been widely debate within the Nordic countries, could easily have been included
from a societal aspect, however, to avoid any unnecessary repetition, this issue will not be
debate once more. There are however several external factors within the social aspect, that
might be of significant importance to LEGO.
A recent OECD report about fertility rates paints a negative forecast in relation to the future
target core audience for the company, namely children. Between 1984 and 2009, the fertility
rates within the whole OECD area fell from around 1.98 children per women, to 1.74 (OECD,
2011). The organization defines a self-sustaining level of reproduction to 2.1 children per
women, allowing for some child mortality, disproportional gender mixes etc. Since this level
for the entire region is well below this self-sustaining threshold, approximately 12.5%, at face
value, fewer potential costumers are to be expected in the future. Without divulging too much
into the exact numbers, one has however to take into consideration differences between
nominal values and the reported simple arithmetic mean for the OECD region.
Below the historic fertility rates for six of the important markets (Euromonitor, 2012) have
been reported:
Table 3: Fertility rates for selected markets
Source: (OECD, 2011)
Visible from the table is the trend in the fertility rate, within the latter part of the twentieth
and early twenty-first centaury, especially important markets such as Germany have
consistently experienced low fertility rates, with only 1.36 and children per women in 2009.
Furthermore different trends across regions are observed, some nations have experienced
stabilizing and recovering trends (Denmark, United States, France and the United Kingdom)
whilst others have remained consistent with the previous levels (Canada and Germany) and
Page 35 of 84
lastly only Japan experiencing a major negative structural decline. As the generations replace
themselves, however, it is reasonable to assume, the target audience consist of ever smaller
proportions, due to the fact that every market have remained below or adjacent to the self-
sustaining level, resulting in previous generations having fewer offspringβs.
Low fertility rates need not necessarily translate into lower sales, naturally it is fair to assume
there is some kind of correlation between number of children and sales, but one also has to
consider the reason for these developments. Increased participation in the labor market
among women, and increased standards of living and education (Rosling, 2012) have delayed
pregnancies, but conversely, these attributes also increase the spending power of the families
in question, increasing the amount they can afford to spend of toys. The question on whether
these developments will have negative or positive implications therefore remains somewhat
ambiguous and case specific.
Whilst the OECD area mainly covers the western hemisphere, and therefore do not include
emerging markets, other sources of information must be acquired. A recent overview from
Euromonitor concluded that, although experiencing declining birth rates, almost a third of the
global child population, would be located within the two nations of China and India. The
rapport further highlights the lack of causal relations between number of children and sales,
pointing to the need for threshold incomes in order to foster sales of self-actualization
products such as toys. Increasing disposable income and general economic growth in the
region, however, are expected to see a rise in the demand for such products, therefore these
areas will serve as good blue oceans in the future toy market.
Beyond the demographics, the societal aspect within the PEST framework, also consider
public opinion, health consciousness, culture etc. some of areas are dealt with, within LEGOβs
corporate social responsibility (CSR). LEGO have implemented several initiatives to be among
the top companies in the world in regards to work safety and renewable energy (Progress
rapport, 2012). There is no doubt that the decision to rely only on renewable energy, and
zero waste, is to counter the argument, that LEGO bricks in general the product of oil and
therefore a burden to the environment. As R. Edward Freeman argues in his Strategic
Management: a stakeholder approach, along with traditional stakeholder theory, companiesβ
do not necessarily only has a fiduciary duty to the shareholders, but also other relevant
stakeholders. As such this serves as a barrier to entry for future competitors who wish to
imitate LEGO and their products, to deliver on areas beyond the product itself.
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4.3.4 Technological
From an external viewpoint, the technological requirements to compete in a market such as
construction toys must be characterized as difficult. The machinery to match an equal
minimum efficient scale, to produce the approximately 36 billion bricks produced in 2011,
will require intense capital and technological investments. This barrier to entry helps protect
the incumbent against new entrants on the construction toy market, which might highlight
the lack of newcomers after the license on the LEGO brick expired in 1988, where only well
established companies can hope to achieve similar cost advantages (Bender, 2010).
During the fiscal year of 2012, 60 % of the sales revenue was generated through sales of new
product launches (Annual rapport, 2012); therefore technology and product development is
of vital importance to LEGO.
With the many technological capabilities possessed by LEGO being explored in the value-
chain, technology in this section should be viewed from an external perspective, which is the
main scope of the PEST framework. These capabilities, however, are useful in highlighting
some of the competitive requirements future competitors would have to align.
As a future risk for LEGO is the growth in novel markets such as three dimensional printing,
which use the same materials, acrylonitrile butadiene styrene, as LEGO in the printing
process (The Economist, 2012). One might therefore worry that someday people would be
able to download the patterns for the bricks required in each product and simply produce
them at home. While this also opens some possibilities, there net effect will still not only be
considered a threat the to existing business model, but for the whole industry.
Turning from technology related to the delivery and product of their products, the attentions
turns to the future substitution threats from new ideas and leisure products. The rise of
tablets and smartphones and the market for entertainment it provide, could be one of there
areas that might continue to diverge attention away from LEGO, due to their ease of use, even
by children. While it is difficult to predict the future interest in children and adults, relative to
not yet invented products, this becomes difficult to evaluate. Historically LEGO have been very
anxious towards the expansion of software entertainment, dreading that it would carve out
the basis for the traditional toy market. With their current mix of games and toys however,
they seem to found the right balance. Whether this mix holds true for the future is beyond the
scope of this paper to evaluate.
Page 37 of 84
4.4 SWOT analysis
Throughout the strategic analysis, several issues have been highlight, with the aim of which to
provide a holistic insight into future and current events, ultimately affecting the entire
valuation. Below table 4 highlight some of the issues that has been raised throughout this
process:
Table 4: SWOT analysis
Strengths Weaknesses - High brand equity - Loyal customers - Exclusive Licenses - Market experience - Solid distribution network - Financial liberty
- Expensive products - Narrow product portfolio - Low presence in Asia -
Opportunities Threats - Economic growth in core markets - Increasing global middle class - Further acquisition of market share - Continued franchises collaboration - Blue ocean markets in Asia
- Skewed geographical distribution - Low switching cost - Increased modernization of children
entertainment - Easy to enter the industry because of
a low industry concentration - Low fertility rates in core markets - If the film industry is not able to
deliver new movie franchises - Vertical or horizontal integration
from suppliers or the film industry - Other toy companies starting to sell
construction toys - Environmental concerns - Increased raw material prices - Reduced interested in construction
toys
Although the above table displays quite a number of threats, the overall impression, we as
authors get, through that strategic analysis, are a very solid market leader position, with many
valuable resources that are difficult to imitate. (Whittington et al 2011) argues that resources
and capabilities can be valuated through the so-call VRIN test, essentially asking whether the
issue at hand either provides value or rarity along with non-imitability and substitutability,
not possessed by competitors. Whilst this test has not been explicitly carried out, several
unique components has been recognized as attained by LEGO.
Page 38 of 84
LEGO has a very high brand equity that enables them to price their products at superior
prices relative to their competitors and still maintain an advantage. The price level, can still
however be seen as a weakness in the long run, as their competitors catch up, along with the
market recognizes cheaper alternatives. Traditional microeconomics dictates that markets
that are characterized by abnormal profits, entice future entrants to the market, which
correspond with recent events from either Hasbro or Mattel. The current market situation
might though be somewhat characterized by a dominant firm price leadership, where LEGO
manage to sell at price greater than marginal cost, whilst its competitors must resort to lower
prices (Lipczynski et al 2009). Although the overall toy industry might be defined by high
competition the construction toys marked, as concluded earlier, might be of a more
oligopolistic structure furtherer attributing to this pricing strategy view.
Their utilization of well-known franchises has given them very popular exclusive rights,
whilst at the same time inhibiting their competitors, providing them with additional market
barriers. The experience of senior management along with a long company history has
provided LEGO with good ballast to navigate the competitive environment and the abilities
needed in the successful exploitation of current assets related to their operating processes
and value creation.
Beyond high prices further weaknesses or liabilities exist; the narrow product portfolio
relative to e.g. Mattel, makes LEGO more susceptible to a slowdown in the enthusiasm of their
core products (Metcalf & LaFranco, 2013); along with a weak presence on future growth
markets, such as India or China, essentially giving them the same point of departure as their
competitors.
It is not surprising that although the solid position of LEGO, several threats are recognized, as
this can be considered a natural extension from the dominant position, given they have so
much more to lose. Throughout the internal and external analysis we highlighted some of the
threats that might affect LEGO in the future, although ranging in probability, these accounts
will be factored into the valuation, so as to account for those most likely. The same applies to
some of the many opportunities they face, given some of the threats inverse relationship with
opportunities.
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5. Valuation Analysis
5.1 Reformulation annual reports In this section of the thesis, the balance sheet and the income statement will be reformulated
to get invested capital and net operating profit less adjusted taxes (NOPLAT). These numbers
are used to calculate return on invested capital (ROIC) and the free cash flow.
5.1.1 Reformulation of balance sheet The formula for invested capital is.
Equation 3: Invested Capital
πΌππ£ππ π‘ππ πππππ‘ππ
= ππππππ‘πππ π€ππππππ πππππ‘ππ + πππ‘ πππππππ‘π¦ πππππ‘ πππ πππ’ππππππ‘
+ πΆππππ‘ππππ§ππ ππππππ‘πππ ππππ ππ + πππ‘ ππππππ‘πππ πππ ππ’πππππ‘ ππ π ππ‘π
Reformulation of the balance sheet and the income statement will be to deem what is
operational and what is non-operational (Koller et. al, 2010).
Operating working capital
Operating working capital is calculated to get to the invested capital. Operating working
capital are operating current liabilities, subtracted from the operating current assets. The next
section will include notes for the line items included and excluded from the assets and
liabilities.
Operating cash in the balance sheet has been reformulated so it is at a level of 2% of
revenues. The reasoning behind this is that excess cash is unnecessary for the core operations
and it would underestimate the invested capital of the LEGO group. The level of 2% are
chosen from a study of S&P 500 non-financial companies cash holdings from 1993-2000. The
2% operating cash level is evaluated as a good indicator of optimal operating cash and
therefore any above 2% is deemed as excess cash.
Other receivables are excluded from the balance sheet since it is not possible to tie it to the
core operation of LEGO. Other receivables could be if the LEGO group had loaned money out
and therefore it would be a marketable security and should not be included in invested
capital.
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Receivables from related parties are also excluded from the operating assets. This item are
valuated to be non-financial since it is receivables from the LEGO groups parent company,
Kirkbi, and not in direct relation to the core operation.
Trade account receivables, prepayments and tax receivables are all considered to be
operating assets. Tax receivables could be deemed non-operating but we consider it to be an
asset which is directly affected by the sale of goods.
Accounts payable are included in the operating current liabilities since et derives straight
from the LEGO groups core operations.
Current tax liabilities are also included on the same basis as tax receivables.
Borrowings, short term debt and provisions are all considered to bed non-operating current
liabilities and are therefore removed from the balance sheet.
Table 5: Operating balance sheet items
Operating Current assets Operating current liabilities
Operating cash Accounts payable
Trade account receivables Current tax liabilities
Prepayments
Inventories
Tax receivables
Net property plant and equipment are directly transferred from the balance sheet since all
notes are deemed operating.
Capitalized operating leases are computed to not make the company seem capital light. If it
was left out the LEGO group would seem far more profitable than they actually are because
the invested capital would be lower. Capitalizing operating leases makes the invested capital
far more theoretical because you have to assume an asset lifetime and a cost of debt unless
other is stated (Koller et. al, 2010). They state in their annual report that the leases consists of
buildings and therefore the asset life is set to be 40 which is the LEGO groups calculated life
time of buildings (Annual report, 2012). The calculation of the cost of debt is debated in the
section concerning WACC.
The reason why the LEGO group still have leasing contracts is that they leased production
facilities abroad when they first started producing abroad.
Net-operating non-current assets. All intangible assets are included under this line item
since it only includes items relevant to the core operation. Deferred tax assets, investments in
Page 41 of 84
associates and non-current liabilities are left out because they are considered as non-
operating.
5.1.2 Reformulation of income statement There is not subtracted any items from the original income statement in the LEGO groups
annual report. To calculate net operating profit less adjusted tax, the operating profit from the
annual report is used. Depreciations are subtracted once through sales and distribution
expenses, administrative expenses and other operating expenses.
In revenue there is included a license income. It was discussed if this post should be left out of
the revenue since it could be non-operating however, it is included on the basis that it is
probably an amount of money LEGO receives from companies who are paying to produce and
sell LEGO, making this an operating income.
Since the operating leases are capitalized then the original lease interest are added to
NOPLAT because in this theoretical frame they do not pay the interest.
To get the final NOPLAT the reported cash taxes are adjusted with the tax shield from interest
expenses and interest income.
5.2 Historical analysis In this section of the thesis there will be conducted a thorough analysis of the LEGO groups
historical performance. The focus of the analysis will be the reformulated balance sheet,
reformulated income statement and the free cash flow, although non-operating aspects are
considered as well. The period spanning the historical analysis, range from 2007 through
2012. This analysis is important when the forecasting on future cash flows within the
valuation, given its influence and explainable value on the respective line items. Therefore the
historical analysis will help create a basis to forecast where the LEGO group is heading.
5.2.1 Return on Invested Capital The best measure of a corporationβs performance is considered to be return on invested
capital (ROIC), as it describes how much of a return a given company generates on their
invested capital. It is a good measure to evaluate because it focuses on the operating side of
the organization, which is the focus of a valuation. ROICβs formula is:
Equation 4: Return on invested capital
Page 42 of 84
π ππΌπΆ =ππππΏπ΄π
πΌππ£ππ π‘ππ πΆππππ‘ππ
Source: Koller et. al, 2010
NOPLAT, or profit, are measured over a whole year since revenue and costs are generated on
a daily basis, but invested capital is only measured once a year, which is why the average
invested capital, is used to compute ROIC.
Graph 3 displays the development in the LEGO groups ROIC, NOPLAT and Invested capital
from 2008-2012.
Source: Own calculations, ββAnalysisββ tab in spreadsheet
From 2008 to 2010, there was a solid increase in the ROIC from 34% to 65% then a small
decrease to 54% in 2011 and back to higher levels in 2012 at 63%. From this graph, it is easy
to interpret that the LEGO groups NOPLAT increases at a higher rate than their invested
capital and in the year where invested capital increases by more than the NOPLAT is the year
were ROIC dropped. To give a better notion of what drives NOPLAT and invested capital there
will be conducted an independent analysis for these parameters.
34%
48%
65%
54%
63%
35%
50%
68%
8%
41%
-2%
15%
33%
26%
17%
-10%
0%
10%
20%
30%
40%
50%
60%
70%
80%
2008 2009 2010 2011 2012
Graph 3: ROIC
ROIC
NOPLAT
Invested Capital
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5.2.2 Invested capital In the period 2007 to 2012 invested capital increased by 136%. Operating working capital
accounts for roughly 50% of the invested capital and therefore it is the biggest influence.
Operating working capital increased by 149% from 2007 to 2012. The second biggest part of
invested capital is net property plant and equipment (NET PPE), which also faced aggressive
growth in the period. Net PPE increased to almost 4 times as much in 2012 compared to 2007.
In the period, the LEGO group have leased a smaller amount each year, which is why the
capitalized operating leases have decreased by 71%. It gives a good insight into the LEGO
group that the capitalized operating leases are decreasing while the net PPE are increasing,
from this we can interpret that they are transferring from leasing to owning. Net-operating
current assets is only a fraction of the invested capital but it faced aggressive growth from
2007 to 2012 where it increased by more than 500%.
Graph 4 displays a weighted average of how the different line items affect the growth in
invested capital. Graph 4 gives a clearer view of how much the different line items effect the
increase in invested capital and confirms the claim that operating working capital and net PPE
are the biggest contributors.
Source: Own calculation, ββAdjusted balanceββ in spreadsheet
To be able to forecast invested capital there will be conducted a line item analysis, which ties
the operating line items with a forecast driver. Revenues is without a doubt the most
-3,85% 4,46%
22,97% 21%
5%2,38%
14,46%
12,09%12%
13%
-2,33%
-6,80%-1,18% -7%
-1%
1,51%
2,77%
-0,89%
0%
0%
2008 2009 2010 2011 2012
Graph 4: Line item effect on Invested Capital
Operating Working Capital Net PPE
Capitalized Operating Leases Net-operating non-current assets
Page 44 of 84
significant driver to forecast onwards given it is what drives the free cash flow in the future
and after a thorough evaluation of the line items it have been chosen to be the forecast driver
for trade account receivables, Net PP&E, net operating non-current assets, tax receivables and
tax liabilities. Production cost is chosen to be the forecast driver of inventories and accounts
payables, since this directly affects these items. As we will highlight later production costs are
driven by revenues that is why revenues are the indirect driver of these line items.
Table 6 displays the development of these different ratios through the period 2008-2012.
Table 6: Invested capital, line item ratios
Source: Own calculations, ββAnalysisββ in LEGO.bachelor.xlsx
The biggest fluctuation of the line items is the significant increase in net PP&E compared to
the revenue. Net PP&E was 13.29% of revenues in 2008 and it have increased to a level of
19.51%. In 2012, as previously described this also confirms that LEGO have made significant
investments in property plant and equipment. There have also been an improvement in the
LEGO groupβs inventories, which was 27.49% of revenues in 2008 and reduced to 25.23% of
revenues in 2012. As previously mentioned this is because LEGO have made their distribution
more efficient. Tax receivables and liabilities have also decreased significantly during the
years, but they are only a fraction of the invested capital.
5.2.3 Net operating profit less adjusted taxes NOPLAT in the given period have faced extremely high growth with an increase from 2007 to
2012 on 421%. On average, they have increased NOPLAT by almost 1 billion DKK in the
period. This witness of a great increase in the revenue relative to operating costs.
In the period, operating revenues went from about 8,251 billion DKK in 2007 to 23,405 billion
DKK in 2012, which is an increase of 184%. By far the biggest part of the LEGO groupβs
revenue is organic since they do not try to grow through mergers and acquisitions but by
2008 2009 2010 2011 2012 Average
Trade account receivables/OR 19,13% 18,25% 21,64% 20,53% 21,15% 20,14%
Inventories/PC 27,49% 30,49% 30,07% 27,92% 25,23% 28,24%
Accounts payable/PC 10,88% 11,46% 9,48% 8,60% 9,02% 9,89%
NET PP&E/OR 13,29% 16,55% 16,04% 18,13% 19,51% 16,70%
Net operating non-current assets/OR 1,10% 1,99% 1,16% 1,01% 0,89% 1,23%
Tax receivables/OR 1,36% 0,95% 0,07% 1,30% 0,09% 0,76%
Tax liabilities/OR 0,87% 0,81% 1,85% 0,52% 0,41% 0,89%
Page 45 of 84
increasing market share and sales. Currency changes have not had a large effect on the
revenue in LEGO with the exception of 2010 where there was an extraordinary income of 143
million DKK due to favorable currency fluctuations.
In the period total operating costs only increased by 128%. By these numbers, we can infer
that the LEGO group improved their sales significantly better than their operating costs
increased. The LEGO group will be happy to know that they have improved all their major
expenses compared to revenues, especially selling and distributions expenses, which have had
a significant importance to the big increase in the NOPLAT.
Taxes is also a big part of any organization costs and so is it for the LEGO group. Since there
have not been a reduction of the statutory tax rate in Denmark between 2007 and 2012 then
the organizations effective tax rate have been just below the 25% due to tax advantages from
carrying debt.
Graph 6 displays the evolution of all costs and NOPLAT.
Source: Only calculations LEGO.Bachelor.xlxs
As displayed in graph 6 the NOPLAT have had an increasing share of the revenue through the
period. In 2007, the net profit margin (NOPLAT/revenues) was 14.26% and since then this
number have increased with the exception of 2011 where there was a small drop. By 2012,
they had an net profit margin of 25.93%. The LEGO groupβs biggest competitors, Mattel and
Hasbro reported net profit margins of respectively 12.09% (Mattel (Google finance)) and
8.22% (Hasbro (Google finance)) in 2012, which puts LEGO well above their direct
competitors.
0
5000
10000
15000
20000
25000
2007 2008 2009 2010 2011 2012
Mil
lio
n D
KK
Graph 6: Distribution of revenue
NOPLAT
Operating cash taxes
Other operating expenses
Administrative expenses
Selling and distributionexpenses
Production cost
Page 46 of 84
As with invested capital there will be also be conducted a line item analysis to forecast the
NOPLAT. All line items in the NOPLAT are driven by revenue. Tabel 7 displays the ratios.
Table 7: NOPLAT, line item ratios
Source: Own calculation, ββAnalysisββ in LEGO.bachelor.xlsx
As described earlier total operating costs increase by a lower growth rate than revenues and
this is analyzed in table 7. Production costs faced a significant decrease from 2008, where
production cost was 33.22% of revenues, to 2012 where they only accounted for 28.87% of
revenues, which is a significant improvement. The improvement is most likely because the
LEGO group have moved more production out of Denmark and into countries with lower
costs. Selling and distributions expenses have also improved significantly from 31.17% in
2008 to 26.28% in 2012. The reduction in selling and distribution expenses is also discussed
in the value chain analysis of the LEGO group. These two line items are by far the biggest part
of the LEGO groups operating costs along with taxes, which will be fixed in the forecast, and
administrative and other operating expenses are a far smaller part, but despite that, they have
also been reduced throughout the period.
5.2.4 Free cash flow This section will analyze the fluctuation in the free cash flow (FCF). FCF is directly tied to
many of the line items in the balance sheet and in the income statement because it is derived
from these calculations. However, there are still some objects, which are noteworthy. NOPLAT
is the main driver of the gross cash flow, but depreciation also contribute. Depreciations are
added back to gross cash flow because they are subtracted when calculating the NOPLAT, but
since it is not an actual cost then it is added back to complete the gross cash flow.
Depreciation is driven by property, plant and equipment and it have faced many fluctuations.
In 2008, depreciations was at 18% of net PPE, in 2009, it increased to 34% and in 2012, it was
at 19%.
2008 2009 2010 2011 2012 Average
ProductionCost/OR 33,22% 29,70% 27,56% 29,46% 28,87% 29,76%
Selling and distribution expense/OR 31,17% 30,89% 28,89% 29,12% 26,28% 29,27%
Administrative/OR 6,77% 7,33% 5,81% 5,89% 5,67% 6,30%
Other operating expenses/OR 7,80% 6,34% 5,79% 5,27% 5,21% 6,08%
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In the gross investment analysis, we can see that the LEGO group invested significant amounts
in operating working capital in 2010 and 2011. There was also significant investments in
property plant and equipment through the period and just in 2012, they invested more than 1
billion DKK in PP&E. This is confirmed by analyzing the LEGO groups reinvestment ratio, this
determines how much of the gross cash flow are invested. In 2009, they reinvested 27.76% of
the gross cash flow compared to 2010 and 2011 they reinvested respectively 41.18% and
38.86%.
These large investments of course effected the free cash flow in the period but the NOPLAT
have increased so significantly that the LEGO group have almost tripled their free cash flow
from 2008 to 2012. The major part of the increase came in 2012 where it increased from
3027 million DKK in 2011 to 5153 million DKK in 2012.
5.2.6 Efficiency analysis Various aspects of the LEGO groupβs efficiency will be analyzed and compared to its main
competitors in this section. This will give a better picture of their position on the market.
The LEGO group have a very stable asset turnover. The average turnover from 2008 to 2012 is
1.461 and have not fluctuated by more than a few percent in the period. Mattelβs asset
turnover in 2012 was 1.1 and Hasbroβs was exactly one. This tells us that the LEGO group
generates a far higher revenue compared to their competitors and it could hint that the LEGO
group have a higher return on invested capital than Mattel and Hasbro because NOPLAT and
invested capital derives from revenue and assets.
As previously described, the inventories at the LEGO group have become more efficient and
their inventory turnover have increased from 10.9 in 2008 to 13.27 in 2012. Mattelβs
inventory turnover was five in 2012 and Hasbroβs was 6.2. This tells us that the LEGO groupβs
inventory are far more efficient than its competitors are.
5.3 Forecast To be able to forecast the future growth in the LEGO group the will be conducted an analysis
of the LEGO groups historical growth compared to its main competitors and there will be
included expert opinions regarding the future of the toy and games market.
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5.3.1 Competitor growth comparison In the comparison of competitors, the revenue growth is calculated as an average of the LEGO
groupβs top five competitors (Mattel, Hasbro, Takara Tomy, Bandai Namco and Mega Brands).
By comparing their growth with the LEGO groups growth we will be able to determine how
the LEGO group have performed compared to the market. Graph 7 displays the development
from 2008-2012.
Source: Own calculation, ββCompetitorsββ in spreadsheet
It is obvious from graph 7 that the LEGO group by far have outperformed their competitors.
The only year were they come close to each other is in 2011 where the LEGO group had a
revenue growth of 17% and their closest competitors grew by 7%. When evaluating their
competitors individually, there are neither any who can match the LEGO groupβs growth rate.
An interesting observation of the competitors is that the average growth from 2008 to 2012 is
only slightly above 0% while the LEGO groupβs average growth is 24.1%.
There have been an upward trend in recent years though. From 2009, the yearly growth trend
have in upwards, which could give reasonable assumption that the growth also would be
increasing in 2013. This idea is being share by the actors within the industry who all believes
that they will gain revenue growths in the next couple of years. Mega Brands who produces
Mega Blocks, which is the most similar product to LEGO blocks, believes that they will face
growth in their net sales because of the uptrend they have seen in recent years and positive
feedback from toy fairs in core markets (Mega Brands (Press release), 2013).
-20,0%
-10,0%
0,0%
10,0%
20,0%
30,0%
40,0%
2008 2009 2010 2011 2012
Graph 7: Year to year growth
The LEGO group Average competitor growth
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Takara Tomy shares this optimism and have actually put a number to their future goals. They
are expecting an increase in 2013 of 1.5% and they have a 2015 goal of increasing their
revenue by 17.5%. Besides this they clearly state that they are aiming to become a significant
global player and start earning a minimum of 50% of their revenues overseas (Tomy
company, 2012).
Bandai Namco follows their compatriots from Takara Tomy in believing in future growth.
However, Bandai Namco believes that 2013 will be a negative growth year of -4.5% but in
total, they believe that they can increase their revenue from 2012 to 2015 by 22.5%. They
want to succeed with this by increasing their market share abroad, which will happen through
integrated brand management in the United States and Europe (Bandai Namco, 2012).
The worldβs two largest toy companies, Mattel and Hasbro, both reported strong financial
results in the first quarter of 2013. Mattel realized an increase in revenue of 7% (Mattel,
2013) and Hasbro saw an increase of 2% (Hasbro, 2013). Historically the first quarter is one
of the slowest during the year, which is why the results from Mattel and Hasbro are uplifting
for the forecast of the rest of 2013.
When it comes to expert opinions on the toy and games industry then it is very limited, but
toys and games is an industry, which is part of the sector ββConsumers discretionaryββ and for
this sector, there are several outlook reports from different investment firms. These reports
are used as a reasonable indicator of where the toys and games industry are headed. Portfolio
manager Gordon Scott (2012) from Fidelity investments points out several factors, which
have been mentioned in the strategic analysis of LEGO. He emphasizes that there are several
macroeconomic issues in Europe and the United States, which could have a negative effect on
the economic growth within consumer discretionary. However, Gordon Scott believes that
there will be an increase in earnings per share in the consumer discretionary sector.
5.3.2 Revenue growth in explicit period
The LEGO group also believes in growth in 2013, but even though they have performed well
above the market in recent years then they believe that the high growth rates will be reduced
in 2013 due to the economic slowing in Europe and North America (Wienberg, 2013).
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Due to the different above standing perspectives, we believe that the general toys and games
market will grow in the next couple of years. We also believe that the LEGO group will
continue to outperform the rest of the market in terms of growth due to a strong product
portfolio and the fact that there are still unexploited markets where they are able to gain high
revenues. As mentioned in the strategic analysis then the global middle class will grow
significantly in the future and make new markets attractive to LEGO, who will for instance be
able to exploit the middle class growth in China more effective due to their new factory.
However, we believe that the growth rate will not be able to sustain the same high level as it
have in the last couple of year. Not only due to the fact that there probably will be an
economic slowdown in the short term, but also because there are several big companies who
are trying to get a larger market share of the construction toys market with new themes and
cheaper products. This will have a reducing effect on the revenue growth, but we believe that
they will be able to fight some of the competition of by having products of higher quality and
more interesting themes especially through their licenses, which appeals to children. There
will also be new additions to the license portfolio in 2013 where the LEGO group have secured
the right for Disneyβs new franchise, The Lone Ranger, which they believe will become a
success as well (Knudstorp, 2013).
Based on the above discussion regarding revenue growth in the toy market and at the LEGO
group we assume that their revenue will increase by 8% in 2013 and also in 2014 where we
believe they are able to sustain the growth. Thereafter there will be a reduction of 2% in
growth, which will give a growth rate of 6% and then there will be a 1% reduction in growth
in 2017 and 2019. Table 8 shows out revenue growth estimate for the budget period.
Table 8: Revenue growth in explicit period
Source: Own calculations, ββforecastββ in LEGO.bachelor.xlsx
5.3.3 Explicit period ratios In the explicit period, there will be used different ratios for NOPLAT and invested capital
inputs, which helps us to find the future free cash flow. In the historical analysis, we computed
several line items ratios where the biggest part was driven by revenues growth. In the next
section, we will describe the ratios determined for the explicit period.
2013 2014 2015 2016 2017 2018 2019
Revenue growth 8% 8% 6% 6% 5% 5% 4%
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5.3.3.1 Explicit period: NOPLAT The historical analysis of the production costs showed that the LEGO group had continuously
reduced their production cost compared to revenues and we believe that it is reasonable to
assume that their production cost/revenue ratio of 29% is the same in 2013 and through the
explicit period.
Selling and distribution expenses will be 26% of revenue in 2013, 2014 and 2015 due to the
level in 2012 we believe that they are only able to reduce the expenses by a fraction in these
years. However, the ratio is reduced to 25% from 2016 and through the explicit value period.
This reduction of 1% is given because we believe that their new manufacturing facilities in
China will be done in 2016 and we believe that because they are closer to a new core market
they are able to reduce their distribution expenses.
Administrative expenses and other operating expenses are assumed to be respectively 5.5%
and 5% through the period, which is close to the ratios they posted in 2012. The reason why
these are assumed fixed is that we are not giving any information, which would give us the
possibility to make a reasonable estimation for the future.
As mentioned in the PEST analysis, then the Danish government have agreed to reduce the
corporate tax level from 25% to 22% in 2016. The reduction will be implemented gradually
so in 2013 the corporate tax level will be 24.5%, 23.5% in 2015 and 22% in 2016 and the rest
of the period. Table 9 displays the chosen ratios for the explicit period.
Table 9: NOPLAT, explicit period, line item ratios
Source: Own calculation, ββForecastββ in LEGO.bachelor.xlsx
Capitalized operating leases are assumed to be fixed through the explicit period. We do not
know the length of the LEGO groups leasing agreement and therefore cannot make a
reasonable assumption, which changes the capitalized operating leases. We keeping it fixed it
will not change the free cash flow and therefore not have any effect on the valuation.
2013 2014 2015 2016 2017 2018
Production Cost 29% 29% 29% 29% 29% 29%
Selling and distribution expense 26% 26% 26% 25% 25% 25%
Administrative expense 5,50% 5,50% 5,50% 5,5% 5,5% 5,50%
Other operating expense 5% 5% 5% 5% 5% 5%
Tax rate 25% 24,5% 23,5% 22% 22% 22%
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5.3.3.2 Explicit period: Invested capital Trade account receivables have increased a bit through the analytical period but we donβt
have reasonable to doubt to believe it will increase further in the future, which is why a level
of 21% of revenues are chosen.
Inventories are based on the increase in production cost and have been a seen some
fluctuations through the period. 28% of revenues is chosen for the explicit period since this is
the average of the historical period.
Accounts payable have been reduced a bit through the historical period and 9% of production
costs is chosen because this is what it is closest to in 2012.
Net property, plant and equipment is given a value of 20% in 2013 and is increasing by 1%
each year. This increase is based on the increasing trend in the historical analysis and the
LEGO groupβs own statements saying that there will be continuing investments in PP&E.
Net-operating non-current assets, tax receivables and tax liabilities are all chosen to be at the
same level as in 2012 because there are not any information, which indicates what these
levels should change in the future. Table 10 display the chosen levels for the explicit period.
Table 10: Invested Capital, Explicit period, line item ratios
Source: Own calculation, ββforecastββ in LEGO.bachelor.xlsx
5.3.3.4 Explicit period: Free cash flow The only line item, which needs to be estimated in the explicit period for the free cash flow is
depreciations. Depreciation have fluctuated a lot through the analytical period and because of
that the average depreciation from 2008 to 2012 are chosen. Depreciations through the
explicit period will be 25% of net PP&E. It is difficult to estimate what the actual depreciation
will be since we do not know the LEGO groupβs depreciation rates exactly, which is why an
average is the best proxy to use for the free cash flow analysis.
2013 2014 2015 2016 2017 2018 2019
Trade account receivables/OR 21,00% 21,00% 21,00% 21,00% 21,00% 21,00% 21,00%
Inventories/PC 28,00% 28,00% 28,00% 28,00% 28,00% 28,00% 28,00%
Accounts payable/PC 9,00% 9,00% 9,00% 9,00% 9,00% 9,00% 9,00%
NET PP&E/OR 20,00% 21,00% 22,00% 23,00% 24,00% 25,00% 26,00%
Net-operating non-current assets 1,00% 1,00% 1,00% 1,00% 1,00% 1,00% 1,00%
Tax receivables/OR 0,01% 0,01% 0,01% 0,01% 0,01% 0,01% 0,01%
Tax liabilities/OR 0,50% 0,50% 0,50% 0,50% 0,50% 0,50% 0,50%
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5.4 Cost of Capital
With the respective forecasts for revenue growth and its indirect and direct effect on
individual line items, combined with the other explicit forecasted items; we now need some
way of discounting the future cash flows, that these estimates, are expected to generate. To do
so practitioners of the enterprise discounted cash flow approach, the one in question, uses the
weighted average cost of capital (Koller et al., 2010). This cost of capital is a weighted average
of both the after-tax cost of debt and cost of equity, which themselves are estimates. This rate
represents the opportunity cost for both debt and equity holders for investing their funds in
this particular business instead of equally risky investments (Koller et al. p 235). Any amount
above the weighted average cost of capital, are the economic profit the firm are generating.
The total weighted average include several factors: the market beta and return for the
industry in question, risk free rate and premium, along with the capital structure and
corporate tax rate. Below follows a discussion on how each of these items has been estimated
and how they are expected to evolve in the time period chosen.
5.4.1 Capital structure
With the capital structure affecting both the cost of debt and equity, it therefore merits being
discussed first. Since the weighted average cost of capital (WACC) represents the inverse
relationship between the claim from debt and equity holders, the capital structure determines
the proportion that each of these elements contribute to the cost of capital. As debt rises the
relatively claim from debt holders increases, and vice versa for equity, as the proportion of
equity increases.
Within the time period examined, the capital structure of LEGO has transformed from being
considerably leveraged, to a more equity-financed company. Below the historically capital
structure of LEGO has been reported, by relating equity and liabilities to total equity and
liabilities.
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Source: Own calculations, annual reports 2007-2012; LEGO.Bachelor.xlxs
Visible from the above graph, the LEGO group has gone from having 72 % debt in 2007, to
40% in 2012. Throughout the period there has been a continuous reduction of the debt,
making the company more solvent. This improved solvency has significantly improved their
financial risk and reduced their cost of debt. For simplicity we have an assumed a stable
future capital structure of WACC along with equal market and book values of debt and equity.
However the affect of an increase in the equity/debt ratio will be examined further in the
scenario analysis.
5.4.2 Cost of debt
The cost of debt represents the cost to debt holders, which holds a share in the future capital
structure. Since this cost also entail some financing related benefits, that has not been
included in the calculation of the free cash flow, the tax shield arising from interest payments
must be incorporated into the cost of debt (Koller et al. 2010). As interest payments provide a
tax shield, this need to be deducted from the cost of debt; this after-tax cost of debt can be
evaluated by calculating the firms yield to maturity on its long-term debt multiplied with one
minus the tax rate. However in the case of LEGO, where there are no observable bonds or
promised cash flows, this approach cannot be use. According to Koller (2010) the companyβs
debt rating can instead be used to evaluate a pseudo or synthetic cost of debt.
72% 68%58%
50% 46% 40%
28% 32%42%
50% 54% 60%
0%
10%
20%
30%
40%
50%
60%
70%
80%
90%
100%
2007 2008 2009 2010 2011 2012
Graph 8: Debt-Equity ratio over time
Debt Equity
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This pseudo cost of debt (ππ) is estimated by adding the risk free rate (ππ) plus the company
spread (ππ ), which is based on the companyβs riskiness. Therefore the total cost of debt before
tax, can be estimated by the following equation:
Equation 5: Cost of debt
ππ + ππ = ππ
Source: Koller et. al. 2010
5.4.2.1 Company Spread:
As briefly mentioned in the procurement of financial assets in the value chain, LEGO currently
operates at very high coverage ratios (LEGO.Bachelor.xlxs, analysis tab). Whilst no official
credit ratings exist, at least that we know of, this led to the assumption of creditworthiness
equivalent to a βtriple Aβ rating. This rating can then be used as an indicator for the risk
premium above the risk free rate, aggregating the cost of debt. Below the current risk
premiums/default spread, associated with different credit worthiness has been reported.
Table 11. Synthetic credit rations and their associated default spread
Updated January 2013.
Source: Damodaran, 2013
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Visible from the above table are the associated credit rating along with the implied default
spread. From the table our assumption about βtriple Aβ status is substantiated, given its
coverage ratio (roughly 400) is substantially greater than the 8.5 coverage ratio usually
associated with βtriple Aβ status. This implies a default spread around 0.40 %, substantially
lower then those associated with lower credit ratings.
5.4.2.3 Risk Free Rate
Although there is no such thing as a risk free investment, since even those most secure are
still liable to extreme unpredicted events and situation. Usually however when taking about
the risk free rate, practitioners refer to long-term government bonds rates, as the default risk
for countries are often highly unlikely and not something that happens often. Given the
variation among individual countriesβ creditworthiness, some financial practitioners argue
that a country specific risk spread should be included in the cost of debt (Damodaran), this is
especially true for emerging markets, where investment grade long-term bonds are harder to
come by (Koller et al. 2010).
Turning to the case of LEGO, the issue about country specific risk are not deemed to cause any
noteworthy problems, as Denmark, which forms the bases for their risk free rate, are
considered a safe investment and do not merits an country specific spread (Damodaran).
Given recent years turbulent financial environment, something that we deem to be abnormal,
financial institutions such as the European Central bank and the Federal Reserve System, has
considerably lowered their interest rates, so as to stimulate the economics through the loans
markets. Ultimately this has suppressed long-run government bond rates to an exceptionally
low level, visible below the 10-year government bond rates in Denmark for that past 10 years
have been reported:
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Source: (European Central Bank, 2013)
Visible from the above graph is the upward trend associated with the economic expansion
during the period 05-08, following by the severe financial recession initiating around 08. By
using the Danish government bonds, we mitigate the influence from inflation, since both the
cash flow LEGO are expected to generate, and the yield from the bonds are denominated in
the same currency (Koller et al., 2010). As this turbulent timeframe is marked by many
unprecedented events occurring within this period, using either the highest or lowest rates
would either overstate or understand the risk free rate. This naturally complicates the
process of selecting an appropriate risk free rate, but given the complexity of accurately
forecasting decimal precise future risk free rates, a more simplistic assumption has been
made. By taking the average of the observed time frame we arrive at an arithmetic mean of
3.52 %.
Applying equation 4 by aggregating the risk free rate along with their company specific risk,
we arrive at a total before tax cost of debt on 3.92 % (3.52 % + 0.4%).
5.4.3 Cost of Equity Evaluating the βother side of the coinβ, return to equity holders, can be achieved in a variety of
methods. Such methods include the capital asset pricing model (CAPM), Farma French three-
factor model and the arbitrage pricing theory model (APT) (Koller et al., 2010). Although
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there are no definitively right methods, CAPM has usually been accepted as the most
commonly used method of choice. Originally proposed by Nobel Prize winner William Sharpe,
CAPM defines a stockβs risk as its sensitivity to the stock market (Koller et al. 2010). Equation
5 shows the calculation of the expected return on security I; which is the equation that we will
use as our cost of equity:
Equation 6: Cost of equity
Ξ(π π) = ππ + π½π [Ξ(RM) β ππ]
Source: Koller et. al., 2010
CAPM is calculated by adding a market risk premium ([Ξ(RM) β ππ]) to the risk free rate (ππ)
defined earlier. This market risk premium is multiplied by the volatility of company, usually
its share return, relative to the market (π½π), making this element the only company specific
component of the CAPM equation; given that both the risk free rate and the expected return of
the market is independent of the company in question.
While the Capital Asset Pricing Model, might be popular, it has in recent year been subjected
to criticism from a wide range. Kruger et al. (in Baker, 2011)) argue that using CAPM in the
calculation of a simple WACC in multidivisional companies, such as LEGO, causes companies
to overinvest in high beta divisions, and conversely underinvest in low beta divisions (in
Harris et al., Baker, 2011).
Another issue is the joint-hypothesis problem, which raises the conundrum that the two
simultaneous hypothesis concerning market efficiency and the particular method in question,
but affect the outcome. Given this ambiguity we can never be sure if the markets are actually
behaving efficiently (conversely rejecting inefficiency) or that this is the result of a wrong way
of measurement; rejecting the null-hypothesis concerning method (Ackert, 2010).
Nonetheless Koller et al. (2010) argues that CAPM still remains the best model for estimating
the cost of equity.
5.4.3.1 Market Risk Premium:
Calculating the market risk premium remains controversial and highly debated; The risk
premium represent that amount above the risk free rate, that investors require in order to be
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rewarded for the additional risk associated with the particular investments riskiness.
Although usually ranging within 4.5-5.5% Koller et al. (2010) suggest that there are three
general approaches to valuating the market risk premium: Extrapolating historical returns;
through regression analysis linking market variables and financial ratios, and finally through
DCF valuation together with its estimates on return on investment and growth, to reverse
engineer the markets cost of capital (Koller et al. 2010).
Historical market returns along with the risk free rate can be used give the assumption, that
the past decade mimics a decent proxy for future premiums. Below equation 6 and 7, depicts
the calculation for the historical market premium, stated as both the arithmetic and geometric
averages. Both equations use the S&P500 market portfolio as a benchmark for market
returns, and derived the risk free rate from historical 10 year US government bond rates:
Equation 7: Arithmetic average
π΄πππ‘βπππ‘ππ π΄π£πππππ = 1
πβ
1 + π π(π‘)
1 + ππ(π‘)
π
π‘=1
β 1
Source: Koller et al., 2010, p 243
Equation 8: Geometric average
Geometric Average = (β1+π π(π‘)
1+ππ(π‘)ππ‘=1 )
1/π
β 1
Source: Koller et al., 2010, p 243
With historical returns on both the risk free rates (FRED, 2013) and return to the market from
the period 1962 β 2012 (Damodaran, 2013), an arithmetic average of 4.46 % and a geometric
average at 1.62 % is calculated. Although the arithmetic average is significantly higher than
the geometric, Koller (2011) argues that the arithmetic mean always will excess the geometric
average given the volatility of returns. However when holding a portfolio for multiple years,
generating continuous cash flows; the simple arithmetic mean has to be used in conjunction,
with the geometric mean so as to correct the upward estimation error associated with the
latter. This is done through what is known as Blumes estimator, where an increasing weight is
given to the geometric mean, as the duration of the discount period increases.
Researchers at Navarra University conducted an inquiry into practitioners, consisting of
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professors, analysts and companies, own estimation of the market risk premium. The average
rate for the United States was 5.5 %, with a slightly lower rate of 5.4 % for Denmark
(FernΓ‘ndez, Aguirreamalloa & Corres, 2011). These findings are consistent with the range
mentioned earlier argued by Koller; however they deviation from those argued by
Damodaran, only having a risk premium in the period 1962-2012 of 3.91 % (Damodaran,
2013).
Given the above discrepancies between our own findings, and those estimated by others, a
risk premium on 5 % has been assumed. Whilst not being too skeptical, implying a high risk
premium, nor too overoptimistic, we think this figure represent a decent discount rate for
estimation of future cost of equity. Furthermore by assuming the market risk premium, we
avoid the problem from having in effect used two different risk free rates, by indirectly
including that historical US risk free rate in the calculation of the market risk premium, rather
than the one found in the cost of debt section.
5.4.3.2 Beta
Having estimated both the risk free rate, and that market risk premium, we now need the only
item related directly to LEGO, namely the company beta. The beta measures the companyβs
correlation to the market; with βthe marketβ derived from one of the major world stock indices
such as the S&P 500 used earlier, or the Morgan Stanley Capital International (MSCI) index.
This procedure involves regressing the companyβs stock return (π π) against the market return
(Ξ²Rm) as follows:
Equation 9: Market RP
π π = Ξ± + Ξ²Rm + π
Source: Koller et. al. 2010
The beta represents the slope of the companyβs return relative to the market. A beta with a
value of one should therefore move perfectly in relation to the market. Anything above
represents additional risk, and conversely below represents lower risk, relative to the market.
However since the shares or LEGO is not publicly traded, and therefore no stock return can be
observed, an alternative estimate of the beta has to be used.
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By turning to the toy industry, and the main competitors of LEGO, the following beta values
was observed:
Table 12: Competitor betaβs
Source: Bloomberg and own calculations, βLEGO.Bachelor.xlxs
If the above mentioned companies, correctly represents the relative riskiness of the industry
relative to the market, then we can impose the assumption that this average also would be the
same for LEGO. From the numbers in the table, the industry moves almost perfectly in relation
to the market, being neither cyclical nor acyclical, with an average Beta of 0.96. However
given that each of these companies have different capital structures, simply taking the average
would result in distortions, as shareholders in a company with more debt, face increased risk
that is reflected in the beta (Koller et al. 2010). Miller and Modigliani agues that the financial
claims equal the weighted average risk of a companyβs economic asset stated in the following
equation:
Equation 10: Weighted average risk of economic assets
ππ’
ππ’+ππ‘π₯ππ½π’ +
ππ‘π₯π
ππ’+ππ‘π₯ππ½π‘π₯π =
π·
π·+πΈπ½π +
πΈ
π·+πΈπ½π
Source: Koller et al., 2010, p 255
The above equation relates operating and tax assets, the first parts of the equation, with debt
and equity. Give the assumption about fixed future capital structure along with an assumed
beta of debt equal to zero, equation 9 can be rearranged to provide the following estimation of
beta equity:
Equation 11: Equity Beta
π½π = π½π’(1 +π·
πΈ)
Top competitors Beta(s)
Mattel 0.98 Hasbro 0.95 BANDAI NAMCO 0.75 Takara Tomy Co Ltd 0.93
The Walt-Disney Co 1.21
Average 0.9644
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Source: Koller et al. 2010
Under the assumption that unleveraged companies within the industry, face similar
operating risks, the operating betas should also be alike. By dethatching the betas from the
capital structure, making the all equity financed, we arrive at a unlevered industry average
beta on 0.7, calculated through equation 11:
Table 13: Unlevered beta for representative companies, aggregated averages and debt to market capitalization.
Unlevered Calculation Mattel Hasbro Bandai Namco
Takara Tomy
Walt-Disney Average
Regression based beta 0.98 0.95 0.75 0.93 1.21 0.96
Debt to equity 2012 0.11 0.30 0.55 1.48 0.18 0.52
Unlevered beta 0.88 0.73 0.49 0.38 1.03 0.70
Source: Own calculations, see: LEGO.Bachelor.xlxs
With the unlevered industry average in mind, usually practitioners would leverage the
company to its specific debt-equity ratio, where equity is measured by market capitalization
(Koller et al. 2010). Given the private firm structure of LEGO, we cannot observe the market
capitalization, restricting this approach. Instead we relay on the average debt equity ratio for
Mattel and Hasbro, the two most similar competitors of LEGO, to use as a proxy instead. This
amounted to an average debt to equity ratio of 0.2 ((0.11+0.3)/2) in 2012; applying equation
11 this gives a corresponding leveraged beta for LEGO on 0.84. To this value an additionally
beta increases has been added, given that LEGO do not reflect the marginal investor, and
hence not is fully diversified. Together with the rapid expansion in terms of assets in the near
future, they must be assumed to be additionally susceptible to the market environment; as a
result we have chosen to add an additional premium to the beta of 0.26 arriving at a total beta
of 1.1. This amount reflects the slightly higher volatility to the market, based on that above
arguments, that we deem associated with the future for LEGO and its financial performance.
Therefore with these estimations in place regarding beta, through equation 6 a cost of equity
of 9.02% is calculated (see appendix).
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5.4.4 WACC Now that all the components regarding the weighted average cost of capital are estimated,
showed in equation 11, we are ready to estimate the cost of capital for LEGO:
Equation 12: WACC
ππ΄πΆπΆ =π·
πππ(1 β ππ) +
πΈ
πππ
Source: Koller et. al., 2010
Given our assumption that the market value of both debt and equity equals the book value, we
arrive at a WACC equal to 6.61 % for 2013. Due to the recent political decision regarding
company tax discussed in the strategic analysis, this rate changes slightly to 6.65 % in 2016.
5.5 Explicit and Continuing value period valuation Given the complexity and difficulty to correctly estimate future performance, growth in the
continuing value period is difficult to assert. Although LEGO currently remains a dominant
player in the market, based on the strategic analysis, along with our own subjective opinions,
growth premiums above average GDP growth are assumed unreasonable.
Given these uncertainties the average GDP growth are assumed a reasonable approximation
for revenue growth beyond the explicit period (Koller et al. 2010). Using the historical values
a growth rate of 2.16 % is therefore chosen (Own calculations from Eurostats, 2013).
Return on incremental invested capital is set equal to WACC in the continuing period. Based
on the before mentioned arguments; We do not believe that the LEGO group will be able to
sustain their competitive advantage and competition will eventually reduce their ROIC to the
level of their WACC (Koller et al. 2010).
5.5.1 Projected company value With the cost of capital in place, along with the estimates for the future development in the
respective drivers that make up the future free cash flows, the overall firm value can be
projected. This value consists of the aggregated discounted free cash flows for all the explicit
years added to the present value of the continuing period. Equation 13 shows the calculation
for the present value of the continuing period, by discounting the continuing value after the
explicit period to the present value:
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Equation 13: Continuing value in period 7
πΆπππ‘πππ’πππ ππππ’π7 =ππππΏπ΄ππΆπ(1 β
ππ πππΌπΆ)
ππ΄πΆπΆ β πΊ
Source: Koller et al., 2010
Equation 14: Present value of continuing value
πΆπππ‘πππ’πππ ππππ’π0 =πΆπ7
(1 + ππ΄πΆπΆ)7
Source: Koller et al., 2010
By combining the present value of the continuing period with those of the explicit period, we
arrive at a total value for the LEGO Group at 140,433.06 mia, DKK.
This price is estimated to be a reasonable amount, given the assumption made concerning the
LEGO group. However, other financial analysts has also tried to value the LEGO group albeit
their firm value are significant lower. Sean MacGowan (in Okkels, 2013), who is a toy analysis,
believes that the value of the LEGO group is in the area of 20 billion USD (about 114 billion
DKK). Analysist, Gerrick Johnson (in Metcalf & LaFranco, 2013), confirms this lower value and
goes all the way down to a value about 15 billion USD (about 85.5 billion DKK) and that is
after have discounted the value from 17 billion because of the relatively narrow product
portfolio. These estimates from professional could lead to believe that our firm value is
overpriced but it is hard to conclude based on numbers where we do not know the underlying
assumptions. Another reason why these estimates might have been lower, could be due to
extrapolations of ratios and prices from their nearest competitors, thereby neglecting some of
the intrinsic values captured within our discounted cash flow.
5.6 Competitor comparison To get a deeper comprehension of the validity of our value we can compare P/E ratio with
their competitors. The P/E tells us how high a price investors are willing to pay for earnings. A
high P/E ratio will also tell us that the valuation suggests high growth in the future
(Investopedia, 2013).
The LEGO groupβs P/E ratio is 21.38, high compared to their main competitors, Mattel and
Hasbro, who have a P/E of 17.8 and 16.04 respectively. Whilst the average P/E of Mattel,
Hasbro, Disney and Bandai Namcoβs arriving at 16.7; putting the LEGO group well over. The
high P/E of the LEGO group could suggest that we have valued the organization too high.
Page 65 of 84
However, we do believe that if the LEGO group was available on the stock exchange their price
would be high because of the growth potential, above market growth, and strong market
position they hold.
Table 14: Competitors P/E ratio
Source: Bloomberg and own calculations, ββBetaββ in LEGO.bachelor.xlsx
5.7 Sensitivity analysis
The sensitivity analysis contains various scenarios and how these affect the firm value. In the
scenarios there is assumed that all parameters not indicated are held fixed from original level.
5.7.1 Scenario 1: Change in WACC
The first scenario will contain an overview of what will happen to the firm value if there is a
change in the weighted average cost of capital. A change in WACC could happen through a
different capital structure, unforeseen change in the risk free rate or in the risk premium.
Graph 10 shows what the firm value would be in case of different WACCβs-
Source: Own calculation, ββSensitivity analysisββ in spreadsheet
Company P/E ratio 2013
Mattel 17,80
Hasbro 16,04
Walt Disney 17,91
Bandai Namco 15,06
Average 16,70
The LEGO group 21,38
Page 66 of 84
As we can see from the graph, a change in WACC would have serious effect on the firm value.
A higher WACC would decrease the value significantly. This emphasizes the importance of
cheap cost of equities and debt, as this allows for greater firm value.
5.7.2 Scenario 2: Change in revenue growth in the explicit period
The second scenario contains an description of what happens to firm value when there is a
change in the revenue growth in the explicit period. There is assumed the same rate of
revenue growth through the explicit period.
Source: Own calculation, ββSensitivity analysisββ in spreadsheet
From graph 11 we can see that an increase in revenue growth would have a large effect on the
firm value. This also confirms that a too skeptical view on the revenue growth or to optimistic
view would have serious implication, which is why the revenue growth estimation have to be
done carefully or else the firm value will be either undervalued or overvalued. In a practical
situation the revenue growth should be a bit skeptic because you do not want to pay for
unrealistic growth.
Page 67 of 84
5.7.3 Scenario 3: Change in net-profit margin
In our analysis, we have not based our NOPLAT on a net-profit margin ratio but on several
ratios, which would give a net-profit margin. In this analysis, it is assumed that NOPLAT is
based on net-profit margin and graph 12 displays how a changing market affects the firm
value.
Source: Own calculations, ββSensitivity analysisββ in spreadsheet
It would have been easier to forecast on a net-profit margin instead of several line items,
because it would be easier to reduce an over-performing net-profit margin, compared to the
market. Along with profits aligning towards the level of competitors. Graph 12 illustrates how
a lower net-profit margin would significantly reduce the firm value.
Page 68 of 84
6. Conclusion
The goals throughout this thesis were to analyses the strategic and financial performance of
LEGO, so as to arrive at a concrete tangible value. This has been achieved through a variety of
acknowledged theoretical framework within strategic analysis, along with valuation
frameworks from within enterprise-discounted cash flow, each of which merits its own
strengths and weaknesses discussed in the theory section.
Analyzing the strategic environment highlighted the extend to which LEGO is affected by both
the general market externalities along with the internal company specific issues. Here it was
found that although difficult global financial performance, LEGO has managed to grow and
capture market shares; however facing increasing constraints as further growth are restricted
by the economical development on especially their core markets in Europe and America. In
relation to growth, the skewed global sales distribution, relaying heavily on cultivated
markets, both acts as a liability and opportunity for future expansions. We further argued that
their historical results were achieved through excellent operating performances along with
good value added, analyzed via the value chain. This revealed their effective utilization in
connection with their production facilities, along with relevant concurrent market strategies
allowing them to retain its dominant position with in the construction toy market.
Externally LEGO face increased competition as entrants into the construction toy market, join
in on the lucrative market. LEGO has however successfully navigated their competitors, but
we still assumed a somewhat pessimistic view, that eventually prices would decline as
essentially similar products drive up competition; driven by competitors such as Mattel,
Hasbro and Mega Brands.
Further externalities such as demographics along with political and societal factors accounted
within the PEST framework, highlighted the future demographic composition of their target
audience, painting a somewhat ambiguous picture as fertility rates decline, whilst average
income increase. The strategic analysis was sub-concluded by summarizing these individual
items within a brief SWOT table.
Page 69 of 84
Within the valuation analysis, the strategic conclusion was extrapolated helping estimate
future developments along with the historical financial ratios. Here it we firstly reformulated
the financial income statements along with balance sheets, so as to prepare them for the
enterprise discounted cash flow model. This involved determining and separating operating
and non-operating items within the aforementioned sheets so as to correctly forecast future
value only related to LEGO.
Secondly followed an historical analysis, where we uncovered items such as return on
invested capital, along with other measures showing impressive growth and superior
performance in relation to their competitors. This analysis was continued with accounts
regarding invested capital and net operating profit less adjusted tax. Furthermore an
efficiency analysis was conducted showing, that LEGO have managed to generate higher asset
and inventory turnovers than their competitors.
Combining these inputs forecasts about the future value was estimated. An explicit period of
seven years was chosen, as this was the time period in which we felt that we could give
relevant estimations. Most importantly was the estimation of future revenue, as this drives
almost every line item. With an expected growth rate around 8 % in 2013, eventually reaching
a market growth of 4 % in 2019, this is a major reduction compared to previous years. By
calculation the additional line items based on these revenue estimations future free cash flows
and net operating profits was determined.
Finally to arrive at the overall firm value, we calculated a weighted average cost of capital
equal to 6.61 % changing slightly during the explicit years due to changes from lower
corporate taxes. Using this cost of capital to discount free cash flows a total firm value of
140,433,06 billion DKK was estimate, which hypothetically would make the worldβ largest toy
manufacturer.
Page 70 of 84
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7.2 Articles and interviews
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7.3 Websites
- Barbie Media. (n.d.). History. Retrieved from http://www.barbiemedia.com/about-barbie/history/1970s.html
- Christiansen, G. K. (1961, October 24). Toy building brick. Retrieved from http://www.google.com/patents?id=dNtXAAAAEBAJ&printsec=abstract&zoom=4&hl=da
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- Damodaran, A. (2013, January). Ratings, interest coverage ratios and default spread. Retrieved from http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/ratings.htm
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- Madsen, B. (Performer) (2012). The future of supply chain part - 1/4 [Web]. Retrieved from http://www.youtube.com/watch?v=SU06UsXT2PE&feature=player_embedded
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- Mega Bloks. (2012, March 29). [Web log message]. Retrieved from http://blog.megabloks.com/posts/tag/mattel/
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- Recklies, D. (2001, June). Porters five forces. Retrieved from http://www.themanager.org/Models/P5F_2.htm
- Recklies, D. (n.d.). Beyond porter β a critique of the critique of porter. Retrieved from
http://www.themanager.org/strategy/BeyondPorter.htm
- Rosling, H. (Performer) (2012). Hans rosling: Religions and babies [Web]. Retrieved from http://www.ted.com/talks/hans_rosling_religions_and_babies.html
- Scott, G. (2012, December). 2013 outlook: Consumer discretionary. Retrieved from https://www.fidelity.com/bin-public/060_www_fidelity_com/documents/Sectors_2013_Consumer_Discretionary2.pdf
- Sielen, A. (2013, January 17). What happened with lego. Retrieved from
http://therealityprose.wordpress.com/2013/01/17/what_happened_with_lego/
- Sikkerhedsstyrrelsen. (2010, August 20). Hvad er ce-mærkning?. Retrieved from http://www.sik.dk/Professionelle/Produktsikkerhed/Maerkning-af-produkter/Hvad-er-CE-Maerkning
- The Economist. (2012, September 9). [Web log message]. Retrieved from http://www.economist.com/blogs/babbage/2012/09/3d-printing
- Trangbæk, R. R. (2013, February 21). Successful lego strategy delivers continued strong growth. Retrieved from http://aboutus.lego.com/en-us/news-room/2013/february/annual-result-2012/
- Transformers (Hasbro). (n.d.). Beast hunters. Retrieved from http://www.hasbro.com/transformers/en_US/play/games/
- TT Games. (2013). History. Retrieved from http://www.ttgames.com/history/
- Virksomhedsinformation (LEGO). (2013). Om os - virksomhedsinformation. Retrieved from http://www.lego.com/da-dk/aboutus/corporate-responsibility/product-quality-and-safety/
- Yohn, D. L. (2012, April 26). Brand experience brief: Lego. Retrieved from http://www.futurelab.net/blogs/marketing-strategy-innovation/2012/04/brand_experience_brief_lego.html
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7.4 Reports and papers
- Baker, M. P. (2011). Behavioral corporate finance: An updated survey. Informally published manuscript, National Bureau of Economic Research, Retrieved from http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1909013
- Bandai Namco. (2012). Annual report 2012. Retrieved from http://www.bandainamco.co.jp/en/ir/annual/pdf_bnh/en_2012_3.pdf
- Case Study (IBM). (2010, May 19). Lego creates model business success with sap and ibm. Retrieved from http://www-01.ibm.com/software/success/cssdb.nsf/CS/STRD-85KGS6?OpenDocument&Site=igf&cty=en_us
- Daujotas, G. (2013, January 09). Future markets for toys: Demographic outlook. Euromonitor International
- FernΓ‘ndez, P., Aguirreamalloa, J., & Corres, L. (2011).Market risk premium used in 56 countries in 2011: A survey with 6,014 answers. Informally published manuscript, IESE business school, University of Navarra, Spain. Retrieved from http://www.iese.edu/research/pdfs/di-0920-e.pdf
- Euromonitor. (2012). Lego group in toys and games (world).Passport,
- Kharas, H. (2010, January). The emerging middle class in developing countries. Retrieved from http://www.oecd.org/dev/44457738.pdf
- OECD. (2011). Society at a glance - oecd social indicators.Society at a glance, 6,
Retrieved from http://www.oecd-ilibrary.org/social-issues-migration-health/society-at-a-glance-2011_soc_glance-2011-en
- Tomy company. (2012, March 31). Annual report 2012. Retrieved from
http://www.takaratomy.co.jp/ir/financial/pdf/annual/12_annual_all.pdf
7.5 LEGO group publications
- Annual Report (2012). Retrieved from http://aboutus.lego.com/en-us/news-room/media-assets-library/documents/
- Annual Report (2011). Retrieved from http://aboutus.lego.com/en-us/news-
room/media-assets-library/documents/
- Annual Report (2010). Retrieved from http://aboutus.lego.com/en-us/news-room/media-assets-library/documents/
- Annual Report (2009). Retrieved from http://aboutus.lego.com/en-us/news-
room/media-assets-library/documents/
Page 77 of 84
- Annual Report (2008). Retrieved from http://aboutus.lego.com/en-us/news-
room/media-assets-library/documents/
- Company Profile (2012). Retrieved from http://aboutus.lego.com/en-us/news-room/media-assets-library/documents/
- Progress Report (2012). Retrieved from http://aboutus.lego.com/en-us/news-
room/media-assets-library/documents/
- Progress Report (2011). Retrieved from http://aboutus.lego.com/en-us/news-room/media-assets-library/documents/
Page 78 of 84
8. Appendix
Appendix 8.1: The LEGO group historical balance sheet
Assets
Non-current Assets 2007 2008 2009 2010 2011 2012
Development Projects 30 90 116 78 12 37
Software 13 33 26 102 104
Licences, patents and other rights 4 2 83 81 76 68
Intangible assets 34 105 232 185 190 209
Buildings and installations 543 549 699 863 1140 1688
Plant and machinery 431 500 766 983 1239 1615
Other fixtures and fittings, tools and equipment 126 139 246 384 502 746
Fixed assets under construction 54 78 219 338 514 517
Property, Plant and equipment 1154 1266 1930 2568 3395 4566
Deferred tax asssets 281 132 94 180 114 131
Investments in associates 3 3 3 3 3 3
Other non-current assets 284 135 97 183 117 134
Total non-current assets 1472 1506 2259 2936 3702 4909
Current assets: 2007 2008 2009 2010 2011 2012
Inventories 946 870 1056 1327 1541 1705
Trade receivables 1796 1822 2128 3321 3845 4950
Other receivables 681 439 604 618 603 630
Prepayments 0 0 0 462 226
Current tax receivables 71 130 111 12 244 22
Receivables from related parties 600 0 1956 1950 3442
Cash at banks 1001 1129 1630 802 557 468
Non-current assets classified as held for sales 42 0 0 0 0 0
Total current assets 4537 4990 5529 8036 9202 11443
Total assets 6009 6496 7788 10972 12904 16352
Page 79 of 84
Equity and Liabilities
Equity 2007 2008 2009 2010 2011 2012
Share captial 20 20 20 20 20 20
Reserve for hedge accouting 22 49 49 -114 -252 39
Reserve for currency translation -319 -302 -281 -138 -140 -117
Retained earnings 1948 2291 3488 5684 7321 9888
LEGO A/S' share of equity 1671 2058 3276 5452 6949 9830
Non-controlling interests 8 8 15 21 26 34
Total equity 1679 2066 3291 5473 6975 9864
Liabilities
Non-current liabilities 2007 2008 2009 2010 2011 2012
Sobordinate loan capital 1100 500 0 0 0 0
Borrowings 237 839 832 826 818 210
Derferred tax liabilities 128 98 82 21 50 21
Pension obligations 63 50 56 52 55 54
Provisions 93 63 20 75 72 71
Other long-term debt 79 72 71 92 63 72
Total non-current liabilities 1700 1622 1061 1066 1058 428
Current Liabilities 2007 2008 2009 2010 2011 2012
Borrowings 77 4 5 6 7 608
Trade payables 778 1036 1336 1518 1611 2112
Current tax liabilities 121 83 94 297 97 96
Provisions 174 138 100 3 103 64
Other short-term debt 1480 1547 1901 2609 3053 3180
Total current liabilities 2630 2808 3436 4433 4871 6060
Total liabilities 4330 4430 4497 5499 5929 6488
Total Equity and Liabilities 6009 6496 7788 10972 12904 16352
Page 80 of 84
Appendix 8.2:
Income statement 2007 2008 2009 2010 2011 2012
Revenue 8027 9526 11661 16014 18731 23405
Production costs -2812 -3165 -3463 -4413 -5519 -6758
Gross profit 5215 6361 8198 11601 13212 16647
Other operating income 224 0 0 0 0 0
Sales and distribution expenses -2794 -2969 -3602 -4627 -5455 -6150
Administrative expenses -575 -645 -855 -931 -1104 -1326
Other operating expenses -599 -743 -739 -928 -987 -1219
Special items -100 -142
Impairment of non-current assets 24 -20
Restructuring expenses and other special items -46 116
Operating profit 1449 2100 2902 4973 5666 7952
Profit/Loss from associates after tax -1
Financial income 123 41 131 21 34 19
Financial expenses -157 -289 -146 -105 -158 -449
Profit before income tax 1414 1852 2887 4889 5542 7522
Tax on profit for the year -386 -500 -683 -1171 -1382 -1909
Net profit for the year 1028 1352 2204 3718 4160 5613
Page 81 of 84
Appendix 8.3: Reformulated Balance sheet
Total Funds invested2007
20082009
20102011
2012
Operating cash160,54
100%190,52
119%233,22145%
320,28200%
374,62233%
468,1292%
Trade account receivables1796
100%1822
101%2128118%
3466193%
3845214%
4950276%
Prepayments462
226
Inventories946
100%870
92%1056112%
1327140%
1541163%
1705180%
Tax receivables71
100%130
183%111156%
1217%
244344%
2231%
Operating current assets2973,54
100%3012,52
101%3528,22119%
5125,28172%
6466,62217%
7371,1248%
Accounts payable778
100%1036
133%1336172%
1518195%
1611207%
2112271%
Current tax liabilities121
100%83
69%94
78%297
245%97
80%96
79%
Deferred revenue0
00
00
0
Other accrued expenses0
00
00
0
Operating current liabilities899
100%1119
124%1430159%
1815202%
1708190%
2208246%
Operating working capital2074,54
100%1893,52
91%2098,22101%
3310,28160%
4758,62229%
5163,1249%
Net property and equipment1154
100%1266
110%1930167%
2568223%
3395294%
4566396%
Capitalized operating leases1433,0218
100%1323,988
92%1012,461
71%950,1558
66%482,866
34%420,5607
29%
Net-operating non-current assets 34
100%105
309%232682%
185544%
190559%
209615%
Invested capital4695,5618
100%4588,508
98%5272,681112%
7013,436149%
8826,486188%
10358,66221%
Page 82 of 84
Appendix 8.4: Reformulated income statement
20072008
20092010
20112012
Revenue8027
100%9526
119%11661
145%16014
200%18731
233%23405
292%
Other operating incom
e224
100%0
0%0
0%0
0%0
0%0
0%
Operating revenue (O
R)8251
100%9526
115%11661
141%16014
194%18731
227%23405
284%
-Production cost (PC)2812
100%3165
113%3463
123%4413
157%5519
196%6758
240%
-Selling and distribution expenses2794
100%2969
106%3602
129%4627
166%5455
195%6150
220%
-Administrative expenses
575100%
645112%
855149%
931162%
1104192%
1326231%
-Other operating expenses
599100%
743124%
739123%
928155%
987165%
1219204%
-Total operating costs6780
100%7522
111%8659
128%10899
161%13065
193%15453
228%
EBITA1471
100%2004
136%3002
204%5115
348%5666
385%7952
541%
Add: Operating lease interest
92100%
8592%
6571%
6166%
3134%
2729%
Adjusted EBITA1563
100%2089
134%3067
196%5176
331%5697
364%7979
510%
Operating cash taxes
Reported taxes-386
100%-500
130%-683
177%-1171
303%-1382
358%-1909
495%
Marginal tax-rate
24,70%100%
23,93%97%
22,27%90%
22,62%92%
24,26%98%
23,93%97%
Operating cash taxes
386100%
500130%
683177%
1171303%
1382358%
1909495%
NO
PLAT1177
100%1589
135%2384
203%4005
340%4315
367%6070
516%
Page 83 of 84
Appendix 8.5: Equation calculations
Equation 1: N-firm concentration ratio
πΆπ π = β ππ = 12,29% + 8,46% β¦ . +1,37% = 36,59%
π
π=1
Equation 2: HH-index
π»π» = β ππ2
π
π=1
= 12,29%2 + 8,46%2 β¦ β¦ + 1,08%2 = 28%
Equation 4: ROIC
π ππΌπΆ =ππππΏπ΄π
πΌππ£ππ π‘ππ πΆππππ‘ππ=
6070
10358,66= 63%
Equation 5: Cost of debt
ππ + ππ = ππ = 3,52% + 0,4% = 3,92%
Company market share 2008 2009 2010 2011
Mattel 12,75% 12,10% 12,42% 12,29%
Hasbro 8,67% 8,72% 8,46% 8,46%
LEGO Group 3,67% 4,36% 5,06% 5,64%
BANDAI NAMCO group 2,76% 2,88% 2,95% 3,15%
Takara Tomy Co Ltd 2,45% 2,40% 2,50% 2,75%
Spin Master Ltd 1,01% 1,25% 1,52% 1,49%
MGA Entertainment Inc 1,58% 1,43% 1,51% 1,44%
Hallmark Cards Inc 1,25% 1,45% 1,44% 1,37%
The Walt-Disney Co 0,81% 0,94% 1,26% 1,35%
Simba-Dickie Group
GmbH & Co KG1,01% 1,02% 1,04% 1,08%
Page 84 of 84
Equation 6: Cost of equity
Ξ(π π) = ππ + π½π [Ξ(RM) β ππ] = 3,52% + 1,1 β (5% β 3,52%) = 9,02%
Equation 7: Arithmetic average
π΄πππ‘βπππ‘ππ π΄π£πππππ = 1
πβ
1+π π(π‘)
1+ππ(π‘)ππ‘=1 β 1
=1
51β (
1 + (β8.8%)
1 + 3.95%) β 1 + β― β¦ β¦ .
1
51β (
1 + 1.8%
1 + (β0.61%)) β 1 = 4.46%
Equation 11: Equity beta
π½π = π½π’(1 +π·
πΈ) = ( E.g. Mattle 2012) 0.98=unlevered beta*(1+0.11) =>
0.98/1.11=Unlevered Beta = 0.88
Equation 12: WACC
ππ΄πΆπΆ =π·
πππ(1 β ππ) +
πΈ
πππ = 40% β 3.92% β (1 β 0.25) + 60% β 9.02% = 6.61%
Equation 13: Continuing value in period 7
πΆπππ‘πππ’πππ ππππ’π7 =ππππΏπ΄ππΆπ(1 β
ππ πππΌπΆ)
ππ΄πΆπΆ β πΊ=
9975.12 β (1 β2.15%6.61%)
6.61% β 2.15%= 149905.09
Equation 14: Present value of continuing value
πΆπππ‘πππ’πππ ππππ’π0 =πΆπ7
(1 + ππ΄πΆπΆ)7=
149905.09
1,568= 95589.77
