Gremlin Case Study

1


Gremlin case study
Written by Pascal Quiry


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Gremlin Case Study


Vernimmen Case Studies 2006








Presentation of the company Gremlin PLC


Gremlin PLC was founded in Sheffield (United Kingdom) in 1984 by Ian Stewart. He created it
with a group of programmer friends in order to develop video games.

In 1998, through internal and external growth, Gremlin PLC had become the number 2 creator
of British video games. Its revenues were 17m and it employed 334 people primarily in
Sheffield and Dundee. Since 1995 it had been growing rapidly (that year, its revenues were
5.5m): +46 %/year.

Gremlin PLC was listed on the London Stock Exchange in J uly 1997 in order to finance its
development. At the end of 1998, its market capitalization was 51m. Ian Stewart and his wife
owned 54% of the shares.

The main products of Gremlin PLC are the Actua series: Actua Soccer, Actua Golf, Actua Ice
Hockey; Grand Theft Auto, Men in black, Premier Manager. 50% of its sales come from the
UK, 26% from continental Europe and 24% from the rest of the world (primarily the US).

Gremlin PLC is its own distributor in the UK and uses its competitors (Infogrames, Acclaim,
Bonnier ) to distribute its games outside of the British isles.


The Video Game Market


The video game market has grown rapidly since 1995, due to an ever growing ownership rate
of home video consoles and to the development of multimedia computers. In 1998, the video
game industry surpassed for the first time (with a total revenues of 15.6bn) the video tapes
industry and is now close to the movie industry.

Considering that the multimedia computer market should rise by 30% per year, some experts
forecast a 35% annual growth rate for the video game market.

The development cost of new products, often linked to cartoon or cinematic characters, is
constantly increasing. It is now 1.5m per product. On the other hand, the potential market is
not limited to one country anymore, but covers all of the OECD countries, because it is now
easy to adapt the products (by simply changing the language most of the time).

The main distributors are the large supermarkets, since video games have become a mass
product, requiring more and more expensive marketing campaigns (TV, movie). In the U.K., six
distributors represent 80 % of the total sales in the sector.


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The first fifteen corporations in the video game global market are:


Corporation
Revenues in 1995
(M)
Revenues 1998
(M)
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
Sony
Microsoft
Nintendo
Sega
Electronics Arts
GT Interactive
Midway
Acclaim Ent.
Activision
Infogrames
Eidos
Interplay Ent.
Ubi Soft
Titus
Cryo
31 596
5 703
3 161
3 037
474
225
174
545
39
40
2
76
36
5
4
53 484
13 927
4 067
2 629
874
614
376
314
250
223
211
122
97
42
24


Average rate of growth from 95 to 98: 20%
Average rate of growth from 95 to 98 (the first 4 corporations excluded): 25%

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Questions



1. Carry out a quick financial analysis of Gremlin PLC.


2. Using the accounting reports in appendix 3, explain the financial statements (Income
statement, statement of cash flows, balance sheet).


3. Using data in appendix 4, compute Gremlins operating breakeven point in 1996, 1997 and
1998.


4. Explain how to compute the profitability ratios given in this case study.


5. Explain how to compute the working capital ratios given in this case study.


6. What do you think about the changes and the composition of the inventory item?


7. If you were a banker, would you lend one million euros to Gremlin PLC at the end of 1998
for 5 years? Why?


8. If you were an investor, would you buy Gremlin PLC shares at the end of 1998, seeing that
the stock price is 1.75, which represents a market value of 51m? Why?
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Auditors Report on the Accounts for the 1998 Accounting Period




Auditors Report to the Shareholders of Gremlin Group Plc


We have audited the financial statements on pages 19 to 37 which have been prepared under
the accounting policies set out on pages 23 and 24. We have also examined the amounts
disclosed relating to emoluments, share options and pension entitlements of the directors
which form part of the report of the Remuneration Committee on pages 14 to 17.

1. Respective responsibilities of directors and auditors

As described on page 8 the Companys directors are responsible for the preparation of
financial statements. It is our responsibility to form an independent opinion, based on our audit,
on those statements and to report our opinion to you.

2. Basis of opinion

We conducted our audit in accordance with Auditing Standards. An audit includes examination,
on a test basis, of evidence relevant to the amounts and disclosures in the financial
statements. It also includes an assessment of the significant estimates and judgements made
by the directors in the preparation of the financial statements, and of whether the accounting
policies are appropriate to the Companys and Groups circumstances, consistently applied
and adequately disclosed.

We planned and performed our audit so as to obtain all the information and explanations which
we considered necessary in order to provide us with sufficient evidence to give reasonable
assurance that the financial statements are free from material misstatement, whether caused
by fraud or other irregularity or error. In forming our opinion we also evaluated the overall
adequacy of the presentation of information in the financial statements.

3. Opinion

In our opinion the financial statements give a true and fair view of the state of affairs of the
Company and the Group as at 31 J uly 1998 and of the Groups profit for the year then ended
and have been properly prepared in accordance with the Companies Act 1985.



3
rd
November 1998 Pannell Kerr Forster

Chartered Accountants
Registered Auditors
Sheffield


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Accounting Policies



Notes to the Financial Statements
Year ended 31 July 1998




Accounting Policies

The following accounting policies have been used consistently in dealing with items which are
considered material to the Groups affairs.

Basis of accounting

The financial statements have been prepared under the historical cost convention and in
accordance with applicable accounting standards.

1. Basis of consolidation and accounting for goodwill

The Groups financial statements consolidate the financial statements of the Company and all
its subsidiaries. Profits or losses on intra-group transactions are eliminated in full.

Under the principles of acquisition accounting, the assets and liabilities of acquired businesses
are incorporated at their fair value. Any difference between the fair value of the net assets
acquired and the fair value of the consideration, including any difference between the exercise
price and estimated market value of any options granted as part of the acquisition, is
accounted for as goodwill.

In accordance with FRS 10, purchased goodwill is capitalised and amortised in the profit and
loss account over its estimated useful economic life. The unamortised balance of goodwill is
reviewed at each reporting date. Where the balance exceeds the value of expected future
benefits, the difference is charged to the profit and loss account.

Previously, goodwill arising on acquisitions was written off immediately against reserves.

Tangible fixed assets and depreciation

Tangible assets are depreciated over their estimated useful lives at the following annual rates :

Freehold buildings - 2% straight line

Office improvements - 20% straight line
Computer equipment - 33% straight line
Fixtures and fittings - 25% straight line
Motor vehicles - 25% reducing balance

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Government grants

Government grants in respect of capital expenditure are treated as deferred credits, a
proportion of which is transferred to revenue annually over the life of the asset. Government
grants in respect of revenue expenditure are recognised in the profit and loss account so as to
match them with the expenditure towards which they are intended to contribute.

2. Foreign currencies

Assets and liabilities denominated in foreign currencies are translated at the rates of exchange
ruling at the balance sheet date. The results of overseas subsidiary companies are translated
at the average rate of exchange for the year.

Exchange differences of a trading nature are dealt with in the profit and loss account.
Exchange differences on the restatement of the net investment in overseas subsidiaries and
the difference between the profit and loss account translated at the average rate and the
closing rate, are recorded as movements on reserves.

Leases and hire purchase contracts

Assets held under finance leases and hire purchase contracts are capitalised as tangible fixed
assets and the obligation to pay future rentals under such leases and contracts is included in
creditors. Payments in respect of the finance charge element of the leases and contracts are
charged to profit and loss account so as to fairly apportion the charge over the duration of the
leases and contracts.

Rentals payable under operating leases are charged in the profit and loss account in the year
in which they are incurred.


3. Deferred taxation

Provision is made for deferred tax, using the liability method, to the extent that it is probable
that a liability will crystallise.


4. Turnover

Turnover represents royalty income and other sales at invoice value less trade discounts
allowed and excluding value added tax.

Royalties receivable on products released prior to the year end are credited to the profit and
loss account when due.

Guaranteed royalties falling due under contracts for products under development at the year
end are credited to the profit and loss account in full, and attributable product development
costs are charged in the same year.

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5. Research and development

Research and development expenditure not relating to specific projects intended for
commercial exploitation is written off in the year in which it is incurred.


6. Pension costs

The Group operates a defined contribution scheme providing benefits for certain employees.

Also for certain other employees the Group contributes regular payments to personal pension
plans of the employees choice.

The pension cost charge represents contributions payable by the Group to the schemes in
respect of the year.


7. Stocks

Stocks are stated at the lower of cost and net realisable value using the first in/first out method.

Cost of finished goods and goods for resale comprises the direct case of production and the
attributable proportion of all overheads appropriate to location and condition. Net realisable
value is the estimated selling price reduced by all costs of completion, marketing, selling and
distribution.

Product development expenditure including internal programming salary costs is carried
forward to the extent that it is considered to be recoverable. The amount carried forward is
written off on release over the expected sales life of each product.

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Gremlin: Consolidated Income Statement

Thousands of Euros 1996 1997 1998


SALES (100 %)


7 545

9 995

17 738

- Cost of Goods Sold
=GROSS MARGIN
- Selling and Marketing Expenses
- Administrative Expenses
3 247
4 298
798
1 627

57,0 %
10,6 %
21,6 %
4 480
5 515
961
2 319

55,2 %
9,6 %
23,2 %
9 637
8 101
2 427
2 913

45,7 %
13,7 %
16,4 %

= OPERATING INCOME
or EBIT (Earnings before interests and
taxes)

1 873


24,8 %

2 235


22,4 %

2 761


15,6 %


- Financial expense
+Financial income

1
39





33
24





87
27





= INCOME BEFORE EXCEPTIONAL
ITEMS


1 911


25,3 %

2 226


22,3 %

2 701


15,2 %


- Exceptional charge
+Exceptional income
- Income Taxes

-
-
679

187
113
712


-
-
804



= NET INCOME


1 232


16,3 % 1 440


14,4 %

1 897


10,7 %



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Gremlin: Consolidated Statement of Cash Flows


Thousands of Euros

1996

1997

1998

Net income
+Depreciation
- Gains +Losses on sale of fixed assets

=Net cash flow (1)
Change in inventories
+Change in accounts receivable
- Change in accounts payable

=Change in working capital (2)


1 232
207
-

1 439
672
19
679

12


1 440
519
74

2 033
1 643
688
689

1 642


1 897
653
-

2 550
2 523
4 477
1 906

5 094

Net cash provided by operating activity (1)(2) = (3) 1 427 391 (2 544)
Investment in fixed assets
- Sale of assets
397 1 628
113
1 323
= Net investing flow (4) 397 1 515 (1 323)
Free cash flow after financial costs (3)-(4) 1 030 -1 124 -3 867
+Equity issuance
- Dividends
= Net change in Cash
-
400
630

1 975
440
411

49
496
- 4 313

Net debt at beginning of accounting period
Net debt at end of accounting period
(465)
(1 095)
(1 095)
(1 506)
(1 506)
2 807

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Gremlin: Consolidated Balance Sheet

Thousands of Euros 1996 1997 1998
Intangible assets
+Net plant and equipment
+Long-term investments
0
816
0
0
1 738
0
193
2 215
0
= FIXED ASSETS (1) 816 1 738 2 408
Inventories at manufacturing stage
+Finished goods inventories
=Total inventories
+Accounts receivable
+Other receivables
- Accounts payable
- Other payables
539
430
969
919
50
557
779
2 009
603
2 612
1 306
351
603
1 422
4 283
852
5 135
5 567
567
2 327
1 604
= NET OPERATING WORKING CAPITAL (2) 602 2 244 7 338

TOTAL OPERATING CAPITAL = (1) + (2) 1 419 3 983 9 746
Capital and reserves
+Differences on consolidation and so on
2 514
0
5 489
0
6 939
0
= TOTAL STOCKHOLDERS EQUITY (3) 2 514 5 489 6 939

Debts to banks and other debts
- Cash and equivalents
0
1 095
544
2 050
2 812
5
= NET DEBT (4) (1 095) (1 506) 2 807
TOTAL OPERATING CAPITAL = (3) + (4) 1 419 3 983 9 746

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Working Capital Ratios




1996 1997 1998

Sales Net
capital working operating Net
x 365 days

sales Net
s Receivable
x 365 days
sold goods of Cost
s Inventorie
x 365 days



costs Operating
Payables
x 365 days




Reminder:
Average VAT

25 days




39 days




109 days




86 days






15 %

71 days




41 days




213 days




95 days






15 %

131 days




100 days




195 days




96 days






15 %


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Profitability Analysis




1996 1997 1998

Operating profit margin after taxes (1)

X

Total assets turnover (2)

=

Return on operating assets (ROA)

+

Debt ratio

=

Return on common equity (ROE)

16,0 %
5,3
85,0 %
-36,0 %
49,0 %

14,5 %



2,5



36,3 %



-10,1 %



26,2 %


11,0 %



1,8



19,9 %



7,4 %



27,3 %


(1) EBIT x (1 Tax rate) / Sales
(2) Sales / operating assets





Reminder:

Income tax 35,6 % 33,1 % 29,8 %





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Appendix







1) Breakdown by Product of 1998 Sales

2) Changes in the Company Stock Price since the IPO (initial public offering)

3) Accounting Reports

4) Breakdown of Operating Costs






















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Appendix 1: Breakdown by Product of 1998 Sales







% cumulated % Number of Goods Sold
Product n 1
Product n 2
Product n 3
Product n 4
Product n 5
Product n 6
Product n 7
Product n 8
Product n 9
Product n 10
18 %
17 %
15 %
10 %
7 %
5 %
2 %
1 %
1 %
1 %
18 %
35 %
50 %
60 %
67 %
72 %
74 %
75 %
76 %
77 %
295 000
287 000
250 000
167 000
117 000
83 000
33 000
17 000
16 000
15 000






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Appendix 2: Changes in the Company Stock Price since the IPO (initial public offering)










J A S O N D J F M A M J J A S O
0
20
40
60
80
100
120
140
160
180
200
J A S O N D J F M A M J J A S O
0
20
40
60
80
100
120
140
160
180
200
Source: DATASTREAM
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Appendix 3 : Accounting Reports







Thousands of Euros
Income Statement 1996 1997 1998
Sales

Cost of goods sold
7 545

3 247
9 995

4 480
17 738

9 637
Gross Margin

Distribution and marketing expenses
Administrative expenses
4 298

798
1 627
5 515

961
2 319
8 101

2 427
2 913
Operating Income

Financial income
Financial expenses
1 873

39
1
2 235

24
33
2 761

27
87
Income before Exceptional Items

Exceptional income
Income taxes
1 911

-
679
2 226

74
712
2 701

-
804
Net Income

Dividends
1 232

440
1 440

496
1 897

496
Net Income Available to Common
Stockholders
792 944 1 401







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Balance Sheet

ASSETS 1996 1997 1998
Intangibles
Net plant and equipment
0
816
0
1 738
193
2 215
Net fixed assets 816 1 738 2 408
Inventories at manufacturing stage
Finished goods inventories
539
430
2 009
603
4 283
852
Total inventories 969 2 612 5 135
Accounts receivable
Other receivables
Short-term investments
Cash and equivalents
919
50
1 000
95
1 306
351
2 000
50
5 567
567
-
5
Total assets 3 849 8 057 13 682


LIABILITIES AND EQUITY 1996 1997 1998
Capital
Issuance premium
Reserves
Retained earnings
1 000
500
181
832
1 200
2 275
1 573
440
1 202
2 322
2 815
600
Total stockholders equity 2 513 5 488 6 939
Accounts payable
Other payables
Short term debt
Long term debt
Leasing
557
779
-
-
-
603
1 422
44
500
-
2 327
1 604
2 247
500
65
Total liabilities 1 336 2 569 6 743
Total liabilities and equity 3 849 8 057 13 682
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Appendix (Thousands of Euros)




1. Sale of Assets
1996 1997 1998

Assets sale price - 113 -
Assets net book value - 187 -

2. Dividends 1996 1997 1998

Dividends paid 400 440 496

3. Depreciation 1996 1997 1998

Depreciation 207 519 653





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Appendix 4: Breakdown of Operating Costs





1996 1997 1998
Thousands of Euros
Fixed Costs Variable Costs Fixed Costs Variable Costs Fixed Costs Variable Costs
Cost of goods sold

Distribution and
marketing expenses
Administrative expenses

2 500

500

1 500

747

298

127

3 380

550

2 151

1 100

411

168

7 536

1 212

2 613

2 100

1 215

300

TOTAL 4 500 1 172 6 081 1 679 11 361 3 615