Arundel

Arundel Partners: The Sequel Project

Investment Analysis and Opportunity Review

EXECUTIVE SUMMARY

Background

The proposed business venture, Arundel Partners, is an investment group which would purchase the sequels rights associated with all films produced by 1 or more selected U.S. movie production studios for a specified period of time, or a specified number of films. As your investment analysts, our goal is to assess the value of the sequel rights to allow a determination of the value of the overall investment as well as a reasonable price-per-film for the sequel rights.

Arundel Partners plans to pay to obtain a guarantee to the ownership of sequel rights for a set of films prior to production. It is assumed that only a small percentage of the films produced by a studio will be sequel candidates, based on the profitability of the initial film release. It is also recognized that the profitability of a sequel is typically lower than the initial release. This estimated profit will determine the proposed contract offer by Arundel Partners to the selected studio.

Sequence of Events

**Note: The diagram in Figure 1.1 outlines the timeline as it applies to the Arundel investment described.

Prior to proposal, Arundel will need to determine which studio they feel offers the best potential success, and propose the contract prior to knowledge of films to be produced during the contract period. Arundel will then own the sequels rights as defined in the contract. History suggests that a studio would entertain an offer around $2 million per film for the rights to the sequels of each move it produces that year.

FIGURE 1: SUMMARY OF EVENTS BY YEAR

Arundel's ownership rights begin on day 1 (year 0) of the contract. The lifeline of a film, as shown in the timeline above (please see Figure 1), is: 1 year in production; release to theaters and on video over the next calendar year; and, Pay TV in year 2 and Network TV in the 3rd calendar year. A sequel is typically released to theaters 3 years after the orignal film's initial release. Sequel rights also expire 3 years from the films initial release. Note that Arundel must declare, based on the profitability of the first release, whether or not it will produce the sequel, prior to the expiration of the rights at year 4.

RECOMMENDATION

Based on our valuation of the investment, as outlined below in the Analysis portion of the report, we have determined a per-movie-value of $8.9 million when considering purchasing the rights to the entire portfolio of 99 movies analyzed in the sample data. Based on production of 10 sequels, the per-movie-value of the portfolio would be $52.25 million. Our calculations based on the hypothetical portfolio is that Arundel Partners should make this investment as long as the present value of the expected cash flows from the sequel revenues exceeds the cost of production plus the cost of the investment. Depending on what value a studio will accept as payment per sequel, there appears to be significant profitability in the investment.

ANALYSIS

As with all options there is more potential profit if the value of the underlying asset is very volatile. Purchasing sequel rights prior to release of the films makes this a very volatile investment. The proponents of this venture believe that Arundel Partners can make money buying sequel rights because the investment is structured as an option. They are not required to produce every sequel, but can determine which they will choose to produce based on the success of the initial release of the film. In some sense, much like real options, this is the extension of financial option theory to options on non-financial assets.

The strategy of buying a portfolio of rights rather than negotiating film-by-film gives Arundel advantage in that a studio could not negotiate higher rates of sequel rights based on the success of an individual film. Purchasing prior to the release of the initial film (t=0) gives Arundel the possibility they will obtain the rights to the next great Terminator 2, without the initial release success increasing the risk of losing the rights to the sequel or paying increased prices based on the original studio having production interests or demanding more money for the rights.

Our initial analysis determined, based on data from past years movie releases (1989) and the hypothetical sequel profitability based on data cost data associated with sequel production, the estimated the Net Present Value (NPV) of the cash flows from the sequel movies, if produced, accounting for revenues (inflows) and negative costs (outflows). The calculation yields a negative average NPV of the portfolio at -$2.405 million. However, this data is not complete. We have to remember that the business plan does not include producing a sequel for every first film released, only those that are profitable on their initial release. In the situation where a first film was not profitable, Arundel would not incur the costs of producing a sequel limiting potential loss and therefore would also not recognize any revenues from that film. In order to account for this stipulation, we must approach this investment as a real option.

Decision Tree Models

To investigate further, we constructed a binomial decision tree to determine the per-movie-value of the entire portfolio of 99 films today. Arundel's profit comes if a film's market value rises above the sum of the strike price and the amount paid for the sequel rights option. On a per film basis the binomial decision tree model below (please see Figure 2) based on the entire portfolio of 99 films shows a per-movie value of $8.90 million for the sequel rights to the entire portfolio of 99 movies released in 1989 by the six major studios. It is then assumed then that Arundel will only invest in production of the sequel if the first film is profitable enough to predict profitability of a sequel. (See Appendix A - Binomial Decision Tree, 99 Film Portfolio.)

FIGURE 2: SAMPLE DECISION TREE "PROCESS"

Assuming that only 10 of the 99 films would be produced in any given year, we can calculate a per-movie-value for the portfolio of 99 films in the same manner. In selecting which 10 sequels would be made based on the given set of data, we considered basing our decisions