- 1 - Avatars, Inc. Avatars, Inc is a poorly managed company. It used to be a AAA rated company but shamefully, it has lost this rating. It has a signi ficant amount of excess cash on hand, and the management is just sitting on its hands instead of using the money in positive NPV investments or giving it back to the shareholders... Chris P. Duck, CFO of Avatars, Inc, (AI) read the n ewspaper article with growing dismay. In the past few months, the company had been target ed by activist investor Karl Icant, who was mounting increasingly vicious attacks on the ma nagement in the popular press. Icant believed that the company had too much cash on hand and that this was a sign of poor management. AIs CEO Dee Zaster, and Duck had been trying to fend off Icant for some time and both believed that the best way to do so was to invest the excess cash in some way. Unfortunately, both Zaster and Duck disagreed on th e correct policy. Avatars, Inc is a massively multiplayer online role -playing gaming (MMORPG) company, based in the greater Chicago area. MMORPGs are a g enre of online computer role-playing games (RPGs) in which a large number of players int eract with one another in a virtual world. As in all RPGs, players assume the role of a fictio nal character (usually in a fantasy setting) and take control over many of that characters acti ons. MMORPGs are distinguished from single-player or smaller multi-player RPGs by the n umber of players, and by the games persistent world, usually hosted by the games publ isher, which continues to exist and evolve while the player is away from the game. Founded in 2001 by native midwesterner, Dee Zaster, AI had expanded from 20,000 users in 2001 to 65,000 paying users in 2006. Combining a rich game playing environment with superb graphics and a easily navigable interface allowed AI to retain its fan base against industry leaders such a s Liden Labs and Tornado Entertainment. Zasters major concern was that AIs recent growth had dramatically altered its capital structure. While AI had once been a debt-free, cash -rich company, it now carried enough debt that the companys debt rating had fallen from AAA to AA. Although the board viewed the costs of financial distress as negligible at the cu rrent debt level (due to the low turnover of the gamers who make up the main revenue stream for the company), Zasters mid-western background gave her a strong conservative streak. S he had a strong preference for bearing as little debt as possible. The companys recent growt h in player revenues had increased the companys cash balance well beyond the extent neede d to keep the company operating and Zaster wanted to use the excess cash of the company to retire some of the companys debt, enough to bring it back to a AAA debt rating. In ad dition, Zaster also wanted to issue new shares to the public and use the proceeds to furthe r alter its capital structure. Currently, AIs shares are trading at $26.65 per share in the marke t. Duck was more concerned that AI was falling behind in the rapidly evolving virtual world industry. Its interface, while easy for users to navigate, was still keyboard based. Duck had recently been approached by one of his software engineers, Ella Mentry, with specifications for a new natural language spoken in terface system, which would mark a quantum improvement in the player interface. From h is conversations with Mentry, Duck believed that implementing this project would give AI a head start over the competition. Duck advocated using the companys excess cash to invest in the project, issuing new shares, if necessary, to raise additional cash if the project requirements were large enough. Duck knew that D. Zaster would never agree to using debt to r aise the additional cash for the project. However, he did not feel recapitalizing the company was necessary and that a AA rating was appropriate for a young fast-growing company. Over the past two months, Duck had carefully amasse d a large amount of data that he considered relevant to the restructuring alternativ es. These data include AIs income statement for the most recent fiscal year (Exhibit 1), its cu rrent balance sheet (Exhibit 2), data on current yields on debt securities (Exhibit 3), historical r ates of return on various financial instruments (Exhibit 4), and financial data for other gaming co mpetitors (Exhibit 5). His plan was to conduct a thorough analysis of each alternative ind ependently. In other words, each alternative would be evaluated as if the other alte rnative was not being pursued. Then he planned to give D. Zaster both analyses and let her make the final decision as to which alternative to pursue. The Recapitalization Zaster believes that in order to achieve a AAA debt rating, AI must reduce its debt level. In order to determine the appropriate debt level, D uck has collected data on the debt structure of other gaming companies. These data are given in Exhibit 5. The exhibit also includes data on the cash balances of the other competitors. Duck believes that Icant is using the ratio of cash to total assets for AAA rated companies to det ermine the amount of excess cash AI is carrying. - 3 - In order to reduce debt, Duck is considering a publ ic issue of shares in addition to using the excess cash. The proceeds of the stock issue an d the excess cash would both be used to repurchase some of AIs existing long-term debt and to reduce the companys cash balance to the target level. Duck plans to assume that the deb t level following the equity issue will remain constant for the foreseeable future. After assessing how much equity to issue, Duck inte nds to evaluate the effects of the stock issue and corresponding recapitalization on t he market value of AI and on its share price. In making this assessment, Duck plans to assume tha t the companys current market value is based on the assumption that the current debt level will remain constant into the future. The Natural Language Interface Project By nature, MMORPGs are always online, and require s ome sort of continuous revenue (such as monthly subscriptions and advertisements) for maintenance and development. The majority of popular MMORPGs require players to eith er purchase the client software for a one-time fee or pay a monthly subscription to play. AI required players to do both. AI currently sells the client software for its best-se lling Malazan Empire game for $90 and charges a yearly subscription of $25 per gamer. According to Ms. Mentry, the cost of developing a n ew natural language interface would involve purchasing ten new Hitachi/Tsukaba CP-PAC s uper-computers. The equipment will be fully depreciated over 7 years. Projected capital e xpenditure and depreciation for the project is given in exhibit 6. In addition, hosting the game i tself would require the deployment of 750 new grid servers which would take up a significant amount of space. To implement the project therefore, AI would have to expand into the buildin g next door. The building was purchased by AI two years ago for $400,000. Currently, it is rented out to a tenant for $50,000/year (after taxes). While the lease can be easily broken, this necessitates that AI pay a penalty to the tenant for the amount of $40,000 after taxes. After the end of the project, Duck envisages being able to rent out the property once again for $50,000/year (after taxes). If the new project is successfully implemented, AI will be able to launch a new game Malazan Empire II two years from now. MMORPG populations tend to foll ow hyperbolic or parabolic curves. The most dramatic effect is immed iately after launch, where the rise in - 4 - population tends to be quite rapid, probably the re sult of how games are distributed and launched via traditional retail channels. Large n umbers of customers try the game out in a short period of time, and some of them sign up to b ecome subscribers, but within a few short months, the growth starts to slow appreciably. AI expects that launching the game in February 2009 (two years from now) would create an immediate user base of 10,000 new subscribers in the first year. Duck expects this base to increase each year at a decreasing rate. According to Mentry, after the initial year, the growth rate in subscribers per year for the next 3 years w ould be 10%, 8%, and 5%. After that, AI expects growth in subscribers to tail off to 1% per year. The horizon for new game projects is typically 6 years after launch. Duck envisages char ging the subscribers $100 for the client software. Because of the new interface, the client software would be incompatible with the previous game Malazan Empire . In addition, Duck envisages charging the subscrib ers $30 per year. The cost of signing up one new subscriber is a one- time cost of $30. This cost figure includes all the costs associated with developing t he game and advertising expenses, with the exception of the purchase of property and equipment . With the intense loyalty that MMORPG players typically feel for the virtual world, typic ally no additional costs are incurred to keep the gamer. Additionally, since the two gaming envir onments are very different, Ms. Mentry tells Duck that the new game will not cannibalize a ny players from the old game. Duck expects minimal changes in working capital thanks t o the project. Finally after the end of the project, Ms. Mentry tells Duck that the capital equ ipment could probably be sold on the second-hand market for $10,000. For simplicitys sa ke, in his analysis, Duck plans to assume that all cash flows are received or paid at the end of the year. - 5 - Questions 1. How much excess cash does AI have according to Ican t? How much equity should AI issue in order to achieve a debt rating of AAA and get rid o f its excess cash? At what price should the equity issue take place? How many shares will be i ssued? What will be the market value of AIs common stock following the equity issue? What will be AIs stock price following the equity issue? Should AI pursue this recapitalizati on? 2. Should AI implement the natural language interface? In answering this question, assume that the proposed recapitalization does not take place a nd AI stays at its current AA rating. 3. If you were Dee Zaster, which alternative would you choose? Assume that you are acting on behalf of the shareholders. - 6 - Exhibit 1 Avatars, Inc. Income Statement (in $ thousands) Sales $ 98,081 Cost of Goo d s Sold $ 76,914 Selling and A d m inistrative Expense $ 4,807 Operating Income $ 16,360 Depreciatio n $ 6,4 2 8 Earnings before Interest and Taxes $ 9,932 Interest Expense $ 7,357 Net Inc o m e b efore Taxes $ 2,575 Taxes $ 1,0 3 0 Net Incom e $ 1,545 Shares outstanding 3,600 Earnings per share $ 0.43 The companys marginal tax rate is 40%. - 7 - Exhibit 2 Avatars, Inc. Balance Sheet as of December 31, 2006 (in $ thousands) Assets Cash $ 112,882 Liabilities and Owners Equity Accounts Payable $ 14,173 Accounts Receivable $ 35,610 Current portion of long term debt $ 10,000 Inventory $ 60,528 Current Liabilities $ 24,173 Current Assets $ 209,020 Gross Property, Plant & Equipment $ 86,040 Long-term debt $ 176,255 Accumulated Depreciation $ 12,856 Common Stock ($1.00 par) $ 3,600 Paid in Surplus $ 2,400 Net Property, Plant & Equipment $ 73,184 Retained Earnings $ 75,776 Total Assets $ 282,204 Total Liabilities and owner's equity $ 282,204 - 8 - Exhibit 3 Current Financial Market Data Type of Bond Maturity Yield-to-Maturity as of February 2007 U.S. Treasury February 2008 5.23% U.S. Treasury February 2017 5.16% U.S. Treasury February 2027 5.40% AAA-Rated Corporate 10-year 6.24% AA-Rated Corporate 10-year 6.45% A-Rated Corporate 10-year 6.98% BBB-Rated Corporate 10-year 7.24% BB-Rated Corporate 10-year 7.61% Exhibit 4 Historical Financial Market Data Arithm etic Average Annual Return 1 Security 1926-1999 Common Stocks 13 .3% U.S. Treasury Bills 3.8% U.S. Treasury Long-term Bonds 5.5% Long-term Corporate Bonds 5.9% U.S. Inflation Rate 3.2% 1 Source: Ibbotson Associates. 8 Exhibit 5 On-line gaming industry comparison for the year 2006 A. Virtual world gaming Sales (in Book Cash EBIT (in Shares Stock Book Value Coupon Bond Beta thousands) Value of balance (in thousands) outstandi n g price of interest rating asse t s (in thousands) (in Long - term rate o n thousands) thousands) debt (in debt thousands) co m p anies 2 Icarus Projects $ 191,100 $ 159,250 $ 31,850 $ 7,240 3,250 $ 24.50 $ 34,125 6.24% AAA 2.77 Ultima Thule $ 357,630 $ 298,025 $ 44,704 $ 21,128 2,800 $ 25.31 $ 137,550 6.40% AA 4.98 Archmage systems $ 123,480 $ 390,200 $ 78,040 $ 6,223 2,500 $ 27.55 $ 29,520 6.20% AAA 3.02 Tornado Entertainment $ 982,500 $ 534,200 $ 26,710 $ 2,521 4,000 $ 3.68 $ 34,300 7.00% A 6.00 Liden Labs $ 878,580 $ 792,500 $ 63,400 $ 11,887 1,900 $ 20.66 $ 76,200 6.50% AA 4.55 B. Gaming machine manufacturers 3 EverGames $ 92,400 $ 77,000 $ 30,800 $ 1,723 3,800 $ 21.00 $ 14,000 7.24% BBB 2.76 NIMBY $ 41,850 $ 34,875 $ 15,694 $ 5,965 1,250 $ 23.25 $ 1,688 6.98% AAA 3.00 All companies have a marginal tax rate of 40% 2 Virtual world gaming companies are typically compan ies that host massive multiplayer gaming environmen ts on their computer servers and let players interact with each other in a virtual world . 3 Gaming machine manufacturers earn most of their rev enue selling dedicated consoles to play games (writ ten by other software developers) after attaching a TV or output device to the console. Typ ically, the games are either stand-alone games or c an be played with one or two other players over the Internet. 9 Exhibit 6 Projected Capital Expenditures and Depreciation, Na tural Language Interface project, 2007-2014 2007 2008 2009 2010 2011 2012 2013 2014 Capital expenditure $ 400,000 $ 450,000 $ 200,000 $ 150,000 Depreciation $ 250,000 $ 325,000 $ 125,000 $ 125,000 $ 125,000 $ 125,000 $ 125,000