LEGO Group a Strategic and Valuation Analysis

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

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 Porter’s Value chain .......................................................................................................................................................... 8 3.2.2 Porter’s 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 “Consumer companies from Mattel Inc to AutoNation Inc. are beating analysts’ sales estimates by the broadest margin in Standard & Poor’s 500 Index as shoppers help spur growth in the U.S. economy” (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 ‘current estimated market value’ are often not up-to-date, nor reflecting the latest market developments. With the American company Mattel often attributed as the world’ 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 Mckinsey’ ‘measuring and managing the value of companies’ 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: “Determining the overall firm value, for the Danish toy manufacturer LEGO, through a discounted cash flow analysis, with projections from a strategic and financial performances.”

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 ‘Only the best is good enough’; a motto which is still in use today. Deriving their company name from the Danish words ‘Leg godt’ loosely translating into ‘play well’ and coincidentally ‘I create’ in Latin. Following years of hardship, with many setbacks through most of the 1930’s and early 40’s, 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 Denmark’s 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 ‘Duplo’ to ‘Explorer’, 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

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CEO, Jørgen 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. “observations and measurements are the essence of scientific endeavor”, are the true way to acquire new knowledge (Eriksson & Kovalainen, 2008, p 18). Published texts, such as annual reports and announcements are studied as ‘artifacts’ (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 “’a bounded system’ that can be defined in terms of time and place” (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) “establishing 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 theorists”. 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 Porter’s Value chain To evaluate the LEGO group’s internal environment we have chosen to use Michael E. Porter’s value chain concept. The theory suggest a way to evaluate a company’s 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 company’s 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 company’s 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. Page 8 of 84

3.2.2 Porter’s five forces To analyze the external environment there will be formed an analysis of the competitive situation by using Michael E. Porter’s 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 today’s 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 Porter’s 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 haven’t become obsolete because in every competitive industry you will see the forces from Porter’s 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 it’s combined with the PEST framework. Page 9 of 84

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 group’s 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 Porter’s value chain, which analyses the internal environment, whilst the opportunities and threats are assessed through Porter’s 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 approach’s 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 company’s 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 analyst’s 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 ‘art form’ or ‘skill’ 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 ‘cleansing’ of non-financial and financial items arises, so as to arrive at the correct returns that only relates to the company’s 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 ‘Measuring and Managing the Value of Companies’ 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 it’s 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). LEGO’s 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 LEGO’s 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 ‘make or buy’ 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 – 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 “Analysis tab” 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 ‘LEGO friends’ with this particular audience in mind, proving to be a major success (Trangbæk, 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 ‘Bagend’ 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 ‘only the best is good enough’ 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 Page 17 of 84

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 ‘VIP’ 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 ‘substitute LEGO’ 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 ‘obvious’ flaws in their competitors products, and who would never consider mixing their LEGO bricks with ‘non-pure’ LEGO. Therefore the catering and service of these communities should not be neglected, even though it comprises an axillary activity, with no ‘apparent’ 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 “Through 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 company’s strong reputation” (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 – 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. Page 20 of 84

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 ‘augmented reality’ 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 company’s 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 Page 21 of 84

each other with several loans and financial support, with these activities being labeled ‘transaction to related parties’ 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 group’s 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 group’s 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 Page 24 of 84

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 Page 25 of 84

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 children’s 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 company’s theme licenses are important. However, a new entrant will be successful if it is able to draw the children’s 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 kid’s 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 world’s 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 Mattel’s 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 group’s 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 ‘cheaper LEGO’ (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 ‘’Threat of new competition’’ 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 Page 27 of 84

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

𝑛

𝐶𝑅𝑛 = ∑ 𝑆𝑖 𝑖=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 HerfindahlHirschman index is: Equation 2: Herfindahl-Hirschman

𝑁

𝐻𝐻 = ∑ 𝑆𝑖2 𝑖=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, Jørgen 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 group’s 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 group’s 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 ‘’desk jobs’’ 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. Page 30 of 84

4.3.2 Economic There are several economic factors, which affect the LEGO group. Change in different economic parameters in the LEGO group’s 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.

Graph 1: GDP growth 7% 6% 5% 4% 3% 2% 1% 0% 2011 World

2012 Advanced Economies

2013

2014 Developing economies

Source: IMF, 2013

As mentioned the LEGO group’s 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 group’s 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.

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There are several threats concerning the economy. The EURO area, which is one of the LEGO group’s 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 group’s 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 world’s 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

North America Europe Central and South America Asia Pacific Sub-Saharan Africa Middel East and North Africa World

Number of People (Millions Consumption and global share) 338 18% 26% 664 36% 38% 181 10% 7% 525 28% 23% 32 2% 1% 105 6% 4% 1845 100% 99% 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 group’s target group. This is confirmed by

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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.

Graph 2: Historical Currency Pairs 140 130 120 110 100 90 80 70 60

DKK/EUR

DKK/USD

DKK/GBP

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 group’s 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.

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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 34 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 selfsustaining level, resulting in previous generations having fewer offspring’s. 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 LEGO’s 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, companies’ 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. Page 35 of 84

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 valuechain, 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 36 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 - High brand equity - Loyal customers - Exclusive Licenses - Market experience - Solid distribution network - Financial liberty Opportunities - Economic growth in core markets - Increasing global middle class - Further acquisition of market share - Continued franchises collaboration - Blue ocean markets in Asia

Weaknesses - Expensive products - Narrow product portfolio - Low presence in Asia Threats - 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.

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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

𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 = 𝑂𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑤𝑜𝑟𝑘𝑖𝑛𝑔 𝑐𝑎𝑝𝑖𝑡𝑎𝑙 + 𝑁𝑒𝑡 𝑃𝑟𝑜𝑝𝑒𝑟𝑡𝑦 𝑝𝑙𝑎𝑛𝑡 𝑎𝑛𝑑 𝑒𝑞𝑢𝑖𝑝𝑚𝑒𝑛𝑡 + 𝐶𝑎𝑝𝑖𝑡𝑎𝑙𝑖𝑧𝑒𝑑 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑙𝑒𝑎𝑠𝑒𝑠 + 𝑁𝑒𝑡 𝑜𝑝𝑒𝑟𝑎𝑡𝑖𝑛𝑔 𝑛𝑜𝑛 𝑐𝑢𝑟𝑟𝑒𝑛𝑡 𝑎𝑠𝑠𝑒𝑡𝑠 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 cash Trade account receivables Prepayments Inventories Tax receivables

Operating current liabilities Accounts payable Current tax liabilities

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

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associates and non-current liabilities are left out because they are considered as nonoperating. 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 corporation’s 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. ROIC’s formula is: Equation 4: Return on invested capital

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𝑅𝑂𝐼𝐶 =

𝑁𝑂𝑃𝐿𝐴𝑇 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙

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.

Graph 3: ROIC 80% 70%

68%

60%

65% 50%

50%

63% 54%

48% 40%

35%

30%

34%

41%

NOPLAT

33%

20%

0%

Invested Capital

26% 17%

15%

10%

ROIC

8% -2% 2008

2009

2010

2011

2012

-10% Source: Own calculations, ‘’Analysis’’ 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.

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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.

Graph 4: Line item effect on Invested Capital Operating Working Capital

Net PPE

Capitalized Operating Leases

Net-operating non-current assets

0% 12,09%

12%

2,77%

1,51% 2,38% -3,85% 2008

14,46%

4,46% 2009

-6,80%

0% 22,97%

-0,89%

21%

13% 5%

2010

2011

-1,18%

-7%

2012

-1%

-2,33% Source: Own calculation, ‘’Adjusted balance’’ 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

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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

Trade account receivables/OR Inventories/PC Accounts payable/PC NET PP&E/OR Net operating non-current assets/OR Tax receivables/OR Tax liabilities/OR

2008 19,13% 27,49% 10,88% 13,29% 1,10% 1,36% 0,87%

2009 18,25% 30,49% 11,46% 16,55% 1,99% 0,95% 0,81%

2010 21,64% 30,07% 9,48% 16,04% 1,16% 0,07% 1,85%

2011 20,53% 27,92% 8,60% 18,13% 1,01% 1,30% 0,52%

2012 Average 21,15% 20,14% 25,23% 28,24% 9,02% 9,89% 19,51% 16,70% 0,89% 1,23% 0,09% 0,76% 0,41% 0,89%

Source: Own calculations, ‘’Analysis’’ 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 group’s 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 group’s revenue is organic since they do not try to grow through mergers and acquisitions but by Page 44 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.

Graph 6: Distribution of revenue 25000

NOPLAT

Million DKK

20000

Operating cash taxes

15000

Other operating expenses

10000

Administrative expenses

5000

Selling and distribution expenses

0 2007 2008 2009 2010 2011 2012

Production cost

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 group’s 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.

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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

ProductionCost/OR Selling and distribution expense/OR Administrative/OR Other operating expenses/OR

2008 33,22% 31,17% 6,77% 7,80%

2009 29,70% 30,89% 7,33% 6,34%

2010 27,56% 28,89% 5,81% 5,79%

2011 29,46% 29,12% 5,89% 5,27%

2012 Average 28,87% 29,76% 26,28% 29,27% 5,67% 6,30% 5,21% 6,08%

Source: Own calculation, ‘’Analysis’’ 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%.

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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 group’s 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. Mattel’s asset turnover in 2012 was 1.1 and Hasbro’s 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. Mattel’s inventory turnover was five in 2012 and Hasbro’s was 6.2. This tells us that the LEGO group’s 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 group’s 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.

Graph 7: Year to year growth 40,0% 30,0% 20,0% 10,0% 0,0% 2008

2009

2010

2011

2012

-10,0% -20,0% The LEGO group

Average competitor growth

Source: Own calculation, ‘’Competitors’’ 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 group’s 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 group’s 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). Page 48 of 84

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 world’s 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 ’’Consumers discretionary’’ 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 Disney’s 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

Revenue growth

2013 8%

2014 8%

2015 6%

2016 6%

2017 5%

2018 5%

2019 4%

Source: Own calculations, ‘’forecast’’ 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.

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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

Production Cost Selling and distribution expense Administrative expense Other operating expense Tax rate

2013 29% 26% 5,50% 5% 25%

2014 29% 26% 5,50% 5% 24,5%

2015 29% 26% 5,50% 5% 23,5%

2016 29% 25% 5,5% 5% 22%

2017 29% 25% 5,5% 5% 22%

2018 29% 25% 5,50% 5% 22%

Source: Own calculation, ‘’Forecast’’ 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.

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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 don’t 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 group’s 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

Trade account receivables/OR Inventories/PC Accounts payable/PC NET PP&E/OR Net-operating non-current assets Tax receivables/OR Tax liabilities/OR

2013 21,00% 28,00% 9,00% 20,00% 1,00% 0,01% 0,50%

2014 21,00% 28,00% 9,00% 21,00% 1,00% 0,01% 0,50%

2015 21,00% 28,00% 9,00% 22,00% 1,00% 0,01% 0,50%

2016 21,00% 28,00% 9,00% 23,00% 1,00% 0,01% 0,50%

2017 21,00% 28,00% 9,00% 24,00% 1,00% 0,01% 0,50%

2018 21,00% 28,00% 9,00% 25,00% 1,00% 0,01% 0,50%

2019 21,00% 28,00% 9,00% 26,00% 1,00% 0,01% 0,50%

Source: Own calculation, ‘’forecast’’ 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 group’s depreciation rates exactly, which is why an average is the best proxy to use for the free cash flow analysis.

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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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Graph 8: Debt-Equity ratio over time 100% 90% 80% 70% 60% 50% 40% 30% 20% 10% 0%

28%

72%

2007

32%

68%

2008

42%

58%

2009 Debt

50%

54%

60%

50%

46%

40%

2010

2011

2012

Equity

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 company’s debt rating can instead be used to evaluate a pseudo or synthetic cost of debt.

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This pseudo cost of debt (𝑘𝑑 ) is estimated by adding the risk free rate (𝑟𝑓 ) plus the company spread (𝑐𝑠 ), which is based on the company’s riskiness. Therefore the total cost of debt before tax, can be estimated by the following equation: Equation 5: Cost of debt

𝑟𝑓 + 𝑐𝑠 = 𝑘𝑑 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 ‘triple A’ 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 ‘triple A’ status is substantiated, given its coverage ratio (roughly 400) is substantially greater than the 8.5 coverage ratio usually associated with ‘triple A’ 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 countries’ 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 ‘other side of the coin’, return to equity holders, can be achieved in a variety of methods. Such methods include the capital asset pricing model (CAPM), Farma French threefactor model and the arbitrage pricing theory model (APT) (Koller et al., 2010). Although Page 57 of 84

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 stock’s 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

Ε(𝑅𝑖 ) = 𝑟𝑓 + 𝛽𝑖 [Ε(R M ) − 𝑟𝑓 ] Source: Koller et. al., 2010

CAPM is calculated by adding a market risk premium ([Ε(R M ) − 𝑟𝑓 ]) to the risk free rate (𝑟𝑓 ) defined earlier. This market risk premium is multiplied by the volatility of company, usually its share return, relative to the market (𝛽𝑖 ), 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 𝑇

1 1 + 𝑅𝑚 (𝑡) 𝐴𝑟𝑖𝑡ℎ𝑚𝑒𝑡𝑖𝑐 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 = ∑ −1 𝑇 1 + 𝑟𝑓 (𝑡) 𝑡=1

Source: Koller et al., 2010, p 243

Equation 8: Geometric average 1+𝑅 (𝑡)

1/𝑇

Geometric Average = (∏𝑇𝑡=1 1+𝑟𝑚(𝑡) ) 𝑓

−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 – 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 (Fernández, 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 company’s correlation to the market; with ‘the market’ 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 company’s stock return (𝑅𝑖 ) against the market return (βR m ) as follows: Equation 9: Market RP

𝑅𝑖 = α + βR m + 𝜀 Source: Koller et. al. 2010

The beta represents the slope of the company’s 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 beta’s

Top competitors

Beta(s)

Mattel Hasbro BANDAI NAMCO Takara Tomy Co Ltd The Walt-Disney Co Average

0.98 0.95 0.75 0.93 1.21 0.9644

Source: Bloomberg and own calculations, ‘LEGO.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 company’s economic asset stated in the following equation: Equation 10: Weighted average risk of economic assets 𝑉𝑢 𝑉𝑢 +𝑉𝑡𝑥𝑎

𝛽𝑢 +

𝑉𝑡𝑥𝑎 𝑉𝑢 +𝑉𝑡𝑥𝑎

𝐷

𝐸

𝛽𝑡𝑥𝑎 = 𝐷+𝐸 𝛽𝑑 + 𝐷+𝐸 𝛽𝑒

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

𝐷 𝛽𝑒 = 𝛽𝑢 (1 + ) 𝐸

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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.

Bandai Takara WaltUnlevered Calculation Mattel Hasbro Namco Tomy 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

𝑊𝐴𝐶𝐶 =

𝐷 𝐸 𝑘𝑑 (1 − 𝑇𝑚 ) + 𝑘𝑒 𝑉 𝑉

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

𝐶𝑜𝑛𝑡𝑖𝑛𝑢𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒7 =

𝑔 𝑁𝑂𝑃𝐿𝐴𝑇𝐶𝑉 (1 − 𝑅𝑂𝑁𝐼𝐶 ) 𝑊𝐴𝐶𝐶 − 𝐺

Source: Koller et al., 2010 Equation 14: Present value of continuing value

𝐶𝑜𝑛𝑡𝑖𝑛𝑢𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒0 =

𝐶𝑉7 (1 + 𝑊𝐴𝐶𝐶)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 group’s 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 Namco’s 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.

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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

Company Mattel Hasbro Walt Disney Bandai Namco Average The LEGO group

P/E ratio 2013 17,80 16,04 17,91 15,06 16,70 21,38

Source: Bloomberg and own calculations, ‘’Beta’’ 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 WACC’s-

Source: Own calculation, ‘’Sensitivity analysis’’ in spreadsheet

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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, ‘’Sensitivity analysis’’ 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.

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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, ‘’Sensitivity analysis’’ 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.

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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.

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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 world’ largest toy manufacturer.

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7. Literature list 7.1 Books -

Ackert, L. F. (2010). Behavioural finance. (1st ed.). South-western.

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Barrows, E., & Neely, A. (2011). Managing performance in turbulent times. Hoboken: Wiley.

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Bender, J. (2010). Lego: A love story. John Wiley & Sons.

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Buelens, M. (2011). Organisational behaviour. (4th ed.). McGraw-Hill.

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Koller, T., Goedhart, M., & Wessels, D. (2010). Valuation - measuring and managing the value of companies. (5th ed.). McKinsey & Company.

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Kotler, P., Keller, K. L., Brady, M., Goodman, M., & Hansen, T. (2009). Marketing management. (European ed.). Pearson Education Limited.

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Kumar, V. B., & Gopinathan, S. (2009). Organisational behaviour and mass media. Mumbai: Global Media.

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Lipczynski, J., Wilson, J. O. S., & Goddard, J. (2009).Industrial organization - competition, strategy, policy. (3rd ed.). Prentice Hall.

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Lipkowitz, D. (2012). The lego book. Dorling Kindersley.

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O'Brien, J. A., & Marakas, G. M. (2009). Management information systems. (9th ed.). McGraw-Hill

-

Whittington, R., Scholes, K., & Johnson, G. (2011).Exploring strategy. (9th ed.). Pearson Education Limited.

7.2 Articles and interviews -

Adams, B. (2011, November 10). The most profitable movie franchises of all time. The Blaze. Retrieved from http://www.theblaze.com/stories/2011/11/10/the-mostprofitable-movie-franchises-of-all-time/

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Bomsdorf, C., & Hansegard, J. (2013, Marts 7). Lego weighs tie-up with 'the simpsons'. The Wall Street Journal. Retrieved from

Page 70 of 84

-

Burritt, C. (2013, April 23). Mattel to autonation show consumers drive s&p 500 sales. Bloomberg. Retrieved from http://www.bloomberg.com/news/2013-0423/mattel-to-autonation-show-consumers-drive-s-p-500-sales.html

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Clark, E. (2007, August 15). Mattel's real toy story: slave labour in sweatshops. London Evening Standard. Retrieved from http://www.standard.co.uk/news/mattels-real-toystory-slave-labour-in-sweatshops-6606274.html

-

Delingpole, J. (2009, December 18). When lego lost its head - and how this toy story got its happy ending.Daily Mail. Retrieved from http://www.dailymail.co.uk/home/moslive/article-1234465/When-Lego-lost-head-toy-story-got-happy-ending.html

-

Gara, T. (2012, November 29). Highlights from the gender-neutral swedish toys “r” us catalog. The Wall Street Journal. Retrieved from http://blogs.wsj.com/corporateintelligence/2012/11/29/highlights-from-the-gender-neutral-swedish-toys-r-uscatalogue/

-

Hansegard, J. (2013, February 21). Lego shrugs off toy-market blues. The Wall Street Journal. Retrieved from http://online.wsj.com/article/SB10001424127887323549204578317603729616028. html?KEYWORDS=lego mega brands

-

Heathcote, E., & Roux, C. (2012, October 26). Things ain’t what they used to be .. Financial Times. Retrieved from http://www.ft.com/intl/cms/s/2/b2a9fa26-19f311e2-a179-00144feabdc0.html

-

Knudstorp, J. V. (2013, February 21). Interview by Deidre Bolton []. Lego ceo knudstorp on performance, growth outlook., Retrieved from http://www.bloomberg.com/video/lego-ceo-knudstorp-on-performance-growthoutlook-LzsCco8ORgGkHR_3ujJ~2w.html

-

Kristensen, M. (2013, January 9). Lego vil investere milliarder i udenlandsk produktion. Mandag Morgen. Retrieved from https://www.mm.dk/lego-vil-investeremilliarder-i-udenlandsk-produktion?utm_source=apsis-anp3&utm_medium=email&utm_content=unspecified&utm_campaign=unspecified

-

Matzen, E. (2013, April 12). Srsf foreslår lavere selskabsskat fra 2014 i forligstilbud. Reuters. Retrieved from http://apps.infomedia.dk.ez.statsbiblioteket.dk:2048/Ms3E/ShowArticle.aspx?output Format=Full&Duid=e3beef0d).

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Miller, F., & Gray, E. (2012, January 15). Lego friends petition: Parents, women and girls ask toy companies to stop gender-based marketing. The Huffington Post. Retrieved from http://www.huffingtonpost.com/2012/01/15/lego-friends-girls-gender-toymarketing_n_1206293.html

Page 71 of 84

-

Pezzini, M. (2012). An emerging middle class. OECD Yearbook 2012, Retrieved from http://www.oecdobserver.org/news/fullstory.php/aid/3681/An_emerging_middle_cl ass.html

-

Riising, T. (2013, February 21). Niels lunde: Sådan bygger lego sin succes. Børsen. Retrieved from http://borsen.dk/nyheder/investor/artikel/1/252483/niels_lunde_saadan_bygger_leg o_sin_succes.html

-

Ritzau. (2013, March 18). Lego bygger fabrik i kina.Børsen. Retrieved from http://borsen.dk/nyheder/virksomheder/artikel/1/254220/lego_bygger_fabrik_i_kin a.html?hl=TEVHTztMZWdv

-

Sherman, L. (2009, May 3). In depth: Barbie by the numbers. Forbes. Retrieved from http://www.forbes.com/2009/03/05/barbie-design-manufacturingbusiness_numbers_slide_3.html

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Wienberg, C. (2013, February 21). Lego profit soars 35% as toy bricks for girls drive sales growth.Bloomberg. Retrieved from http://www.bloomberg.com/news/2013-0221/lego-profit-soars-35-as-toy-bricks-for-girls-drive-sales-growth.html

-

Metcalf, T., & LaFranco, R. (2013, March 13). Lego builds new billionaires as toymaker topples mattel.Bloomberg. Retrieved from http://www.bloomberg.com/news/201303-13/lego-builds-new-billionaires-as-toymaker-topples-mattel.html

7.3 Websites -

Barbie Media. (n.d.). History. Retrieved from http://www.barbiemedia.com/aboutbarbie/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

-

Community Team Blog. (2012). [Web log message]. Retrieved from http://ceeteamblog.com/about/

-

Cuusoo (LEGO). (n.d.). Cuusoo. Retrieved from http://lego.cuusoo.com

-

Damodaran, A. (n.d.). What is corporate finance?. Retrieved from http://people.stern.nyu.edu/adamodar/ TOPICS->Valuation ''What is it''

Page 72 of 84

-

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

-

Damodaran, A. (n.d.). Estimating discount rates. Retrieved from http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/dcfrates.pdf

-

Damodaran, A. (2013, January 5). Annual returns on stock, t.bonds and t.bills: 1928 current. Retrieved from http://people.stern.nyu.edu/adamodar/New_Home_Page/datafile/histretSP.html

-

Danmarks statistik. (2013). Valutakurser efter valuta, kurstype og opgørelsesmetode (dagsobservationer). Retrieved from http://www.statistikbanken.dk/DNVALD

-

Design Council. (n.d.). Idea generation at lego. Retrieved from http://www.designcouncil.org.uk/case-studies/lego/idea-generation-at-lego/

-

Enjoy the VIP treatment (LEGO). (2013). Retrieved from http://shop.lego.com/enUS/VIP/index.jsp;jsessionid=LIlBrgYNIazB3Mk3Ov1gbw**.lego-ps-3-3

-

European Central Bank. (2013). Interest rate statistics (2004 eu member states & accbs). Retrieved from http://sdw.ecb.europa.eu/browseTable.do?sk=IRS.M.BG.L.L40.CI.0000.BGN.N.Z&sk=IR S.M.CZ.L.L40.CI.0000.CZK.N.Z&sk=IRS.M.DK.L.L40.CI.0000.DKK.N.Z&sk=IRS.M.LV.L.L40 .CI.0000.LVL.N.Z&sk=IRS.M.LT.L.L40.CI.0000.LTL.N.Z&sk=IRS.M.HU.L.L40.CI.0000.HUF .N.Z&sk=IRS.M.PL.L.L40.CI.0000.PLN.N.Z&sk=IRS.M.RO.L.L40.CI.0000.RON.N.Z&sk=IRS .M.SE.L.L40.CI.0000.SEK.N.Z&sk=IRS.M.GB.L.L40.CI.0000.GBP.N.Z&REF_AREA=124&no de=SEARCHRESULTS&sfl2=4&DATASET=0&SERIES_KEY=229.IRS.M.DK.L.L40.CI.0000. DKK.N.Z

-

Eurostats. (2013). Gdp and main components - volumes. Retrieved from http://epp.eurostat.ec.europa.eu/portal/page/portal/national_accounts/data/databas e

-

Finansministeriet. (2013, April 24). Aftale om vækstplan. Retrieved from http://www.fm.dk/nyheder/pressemeddelelser/2013/04/vaekstaftale/~/media/File s/Nyheder/Pressemeddelelser/2013/04/vækstplan/aftale om en vækstplan.pdf

-

FRED. (2013). Graph: 10-year treasury constant maturity rate. Retrieved from http://research.stlouisfed.org/fred2/graph/?id=DGS10

-

Games (LEGO). (n.d.). Games. Retrieved from http://www.lego.com/games/

-

Hasbro (Google finance). (2013). Retrieved from http://www.google.com/finance?cid=270458

Page 73 of 84

-

Hasbro. (2013, April 22). Hasbro reports growth for the first quarter 2013. Retrieved from http://investor.hasbro.com/releasedetail.cfm?ReleaseID=758021

-

IMF. (2013, January 23). World economic outlook update - gradual upturn in global growth during 2013. Retrieved from http://www.imf.org/external/pubs/ft/weo/2013/update/01/

-

Investopedia. (2013). Price-earnings ratio - p/e ratio. Retrieved from http://www.investopedia.com/terms/p/price-earningsratio.asp

-

Jensen, M. V. S. (2012, January 9). Product quality and safety. Retrieved from http://aboutus.lego.com/en/lego-group/product-quality-and-safety/

-

Knudstorp, J. V. (Performer) (2013). Jørgen vig knudstorp, chief executive officer of the lego group [Web]. Retrieved from http://www.thenewsmarket.com/j248rgen-vigknudstorp-chief-executive-officer-of-the-lego-group/a/6d179a34-4d52-455e-930727294d4edd9d?cl=d5e43685-6c68-4514-bd44-74d3913d6872

-

LEGO (About us). (2013). About the lego group. Retrieved from http://aboutus.lego.com/da-dk/default.aspx

-

LEGO education. (n.d.). Products. Retrieved from http://education.lego.com/enus/products/

-

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

-

Mattel (Google finance). (2013). Retrieved from http://www.google.com/finance?q=NASDAQ:MAT&ei=9PZ0UYj6DuGJwAP6Cg

-

Mattel. (2013, April 17). Mattel reports first quarter 2013 financial results and declares quarterly dividend. Retrieved from http://news.mattel.com/News/Mattel-ReportsFirst-Quarter-2013-Financial-Results-and-Declares-Quarterly-Dividend-150.aspx

-

Mega Bloks. (2012, March 29). [Web log message]. Retrieved from http://blog.megabloks.com/posts/tag/mattel/

-

Merlin Entertainment Group. (2013). What we do. Retrieved from http://www.merlinentertainments.biz/en/company/do.aspx

-

Metaio. (n.d.). Lego digital box augmented reality kiosk. Retrieved from http://www.metaio.com/kiosk/lego/

-

MIT media lab. (n.d.). Mitchel resnick. Retrieved from http://www.media.mit.edu/people/mres

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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 – 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/binpublic/060_www_fidelity_com/documents/Sectors_2013_Consumer_Discretionary2.p df

-

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/Hvader-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/newsroom/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-qualityand-safety/

-

Yohn, D. L. (2012, April 26). Brand experience brief: Lego. Retrieved from http://www.futurelab.net/blogs/marketing-strategyinnovation/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/STRD85KGS6?OpenDocument&Site=igf&cty=en_us

-

Daujotas, G. (2013, January 09). Future markets for toys: Demographic outlook. Euromonitor International

-

Fernández, 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/societyat-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/newsroom/media-assets-library/documents/

-

Annual Report (2011). Retrieved from http://aboutus.lego.com/en-us/newsroom/media-assets-library/documents/

-

Annual Report (2010). Retrieved from http://aboutus.lego.com/en-us/newsroom/media-assets-library/documents/

-

Annual Report (2009). Retrieved from http://aboutus.lego.com/en-us/newsroom/media-assets-library/documents/

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-

Annual Report (2008). Retrieved from http://aboutus.lego.com/en-us/newsroom/media-assets-library/documents/

-

Company Profile (2012). Retrieved from http://aboutus.lego.com/en-us/newsroom/media-assets-library/documents/

-

Progress Report (2012). Retrieved from http://aboutus.lego.com/en-us/newsroom/media-assets-library/documents/

-

Progress Report (2011). Retrieved from http://aboutus.lego.com/en-us/newsroom/media-assets-library/documents/

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8. Appendix Appendix 8.1: The LEGO group historical balance sheet Assets Non-current Assets Development Projects Software Licences, patents and other rights Intangible assets

4 34

2008 90 13 2 105

2009 116 33 83 232

2010 78 26 81 185

2011 12 102 76 190

2012 37 104 68 209

543 431 126 54 1154

549 500 139 78 1266

699 766 246 219 1930

863 983 384 338 2568

1140 1239 502 514 3395

1688 1615 746 517 4566

Deferred tax asssets Investments in associates Other non-current assets

281 3 284

132 3 135

94 3 97

180 3 183

114 3 117

131 3 134

Total non-current assets

1472

1506

2259

2936

3702

4909

Current assets: Inventories Trade receivables Other receivables Prepayments Current tax receivables Receivables from related parties Cash at banks Non-current assets classified as held for sales Total current assets

2007 946 1796 681

1001 42 4537

2008 870 1822 439 0 130 600 1129 0 4990

2009 1056 2128 604 0 111 0 1630 0 5529

2010 1327 3321 618 0 12 1956 802 0 8036

2011 1541 3845 603 462 244 1950 557 0 9202

2012 1705 4950 630 226 22 3442 468 0 11443

Total assets

6009

6496

7788

10972

12904

16352

Buildings and installations Plant and machinery Other fixtures and fittings, tools and equipment Fixed assets under construction Property, Plant and equipment

2007 30

71

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Equity and Liabilities Equity Share captial Reserve for hedge accouting Reserve for currency translation Retained earnings LEGO A/S' share of equity

2007 20 22 -319 1948 1671

2008 20 49 -302 2291 2058

2009 20 49 -281 3488 3276

2010 20 -114 -138 5684 5452

2011 20 -252 -140 7321 6949

2012 20 39 -117 9888 9830

Non-controlling interests Total equity

8 1679

8 2066

15 3291

21 5473

26 6975

34 9864

Liabilities Non-current liabilities Sobordinate loan capital Borrowings Derferred tax liabilities Pension obligations Provisions Other long-term debt Total non-current liabilities

2007 1100 237 128 63 93 79 1700

2008 500 839 98 50 63 72 1622

2009 0 832 82 56 20 71 1061

2010 0 826 21 52 75 92 1066

2011 0 818 50 55 72 63 1058

2012 0 210 21 54 71 72 428

Current Liabilities Borrowings Trade payables Current tax liabilities Provisions Other short-term debt Total current liabilities

2007 77 778 121 174 1480 2630

2008 4 1036 83 138 1547 2808

2009 5 1336 94 100 1901 3436

2010 6 1518 297 3 2609 4433

2011 7 1611 97 103 3053 4871

2012 608 2112 96 64 3180 6060

Total liabilities

4330

4430

4497

5499

5929

6488

Total Equity and Liabilities

6009

6496

7788

10972

12904

16352

Page 79 of 84

Appendix 8.2: Income statement Revenue Production costs Gross profit

2007 8027 -2812 5215

2008 9526 -3165 6361

2009 11661 -3463 8198

2010 16014 -4413 11601

2011 18731 -5519 13212

2012 23405 -6758 16647

Other operating income Sales and distribution expenses Administrative expenses Other operating expenses Special items Impairment of non-current assets Restructuring expenses and other special items Operating profit

224 -2794 -575 -599

0 -2969 -645 -743

0 -3602 -855 -739 -100

0 -4627 -931 -928 -142

0 -5455 -1104 -987

0 -6150 -1326 -1219

24 -46 1449

-20 116 2100

2902

4973

5666

7952

Profit/Loss from associates after tax Financial income Financial expenses Profit before income tax

-1 123 -157 1414

41 -289 1852

131 -146 2887

21 -105 4889

34 -158 5542

19 -449 7522

Tax on profit for the year Net profit for the year

-386 1028

-500 1352

-683 2204

-1171 3718

-1382 4160

-1909 5613

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Appendix 8.3: Reformulated Balance sheet

Total Funds invested Operating cash Trade account receivables Prepayments Inventories Tax receivables Operating current assets Accounts payable Current tax liabilities Deferred revenue Other accrued expenses Operating current liabilities Operating working capital Net property and equipment Capitalized operating leases Net-operating non-current assets Invested capital

1036 133% 83 69% 0 0 1119 124%

1336 172% 94 78% 0 0 1430 159%

1518 195% 297 245% 0 0 1815 202%

1611 207% 97 80% 0 0 1708 190%

2112 271% 96 79% 0 0 2208 246%

2007 2008 2009 2010 2011 2012 160,54 100% 190,52 119% 233,22 145% 320,28 200% 374,62 233% 468,1 292% 1796 100% 1822 101% 2128 118% 3466 193% 3845 214% 4950 276% 462 226 946 100% 870 92% 1056 112% 1327 140% 1541 163% 1705 180% 71 100% 130 183% 111 156% 12 17% 244 344% 22 31% 2973,54 100% 3012,52 101% 3528,22 119% 5125,28 172% 6466,62 217% 7371,1 248% 778 100% 121 100% 0 0 899 100%

2074,54 100% 1893,52 91% 2098,22 101% 3310,28 160% 4758,62 229% 5163,1 249% 1154 100% 1266 110% 1930 167% 2568 223% 3395 294% 4566 396% 1433,0218 100% 1323,988 92% 1012,461 71% 950,1558 66% 482,866 34% 420,5607 29% 34 100% 105 309% 232 682% 185 544% 190 559% 209 615% 4695,5618 100% 4588,508 98% 5272,681 112% 7013,436 149% 8826,486 188% 10358,66 221%

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Appendix 8.4: Reformulated income statement

Revenue Other operating income Operating revenue (OR) -Production cost (PC) -Selling and distribution expenses -Administrative expenses -Other operating expenses -Total operating costs EBITA

2007 8027 100% 224 100% 8251 100% 2812 100% 2794 100% 575 100% 599 100% 6780 100% 1471 100%

2008 9526 119% 0 0% 9526 115% 3165 113% 2969 106% 645 112% 743 124% 7522 111% 2004 136%

2009 11661 145% 0 0% 11661 141% 3463 123% 3602 129% 855 149% 739 123% 8659 128% 3002 204%

2010 16014 200% 0 0% 16014 194% 4413 157% 4627 166% 931 162% 928 155% 10899 161% 5115 348%

2011 18731 233% 0 0% 18731 227% 5519 196% 5455 195% 1104 192% 987 165% 13065 193% 5666 385%

27 29% 7979 510%

2012 23405 292% 0 0% 23405 284% 6758 240% 6150 220% 1326 231% 1219 204% 15453 228% 7952 541%

-1909 495% 23,93% 97%

31 34% 5697 364%

-1382 358% 24,26% 98%

61 66% 5176 331%

-1171 303% 22,62% 92%

1909 495% 6070 516%

65 71% 3067 196%

-683 177% -500 130% 23,93% 97% 22,27% 90%

1382 358% 4315 367%

85 92% 2089 134%

-386 100% 24,70% 100%

1171 303% 4005 340% 500 130% 1589 135%

683 177% 2384 203%

92 100% 1563 100%

Operating cash taxes Reported taxes Marginal tax-rate

386 100% 1177 100%

Add: Operating lease interest Adjusted EBITA

Operating cash taxes NOPLAT

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Appendix 8.5: Equation calculations Equation 1: N-firm concentration ratio Company market share Mattel Hasbro LEGO Group BANDAI NAMCO group Takara Tomy Co Ltd Spin Master Ltd MGA Entertainment Inc Hallmark Cards Inc The Walt-Disney Co Simba-Dickie Group GmbH & Co KG

2008 12,75% 8,67% 3,67% 2,76% 2,45% 1,01% 1,58% 1,25% 0,81%

2009 12,10% 8,72% 4,36% 2,88% 2,40% 1,25% 1,43% 1,45% 0,94%

2010 12,42% 8,46% 5,06% 2,95% 2,50% 1,52% 1,51% 1,44% 1,26%

2011 12,29% 8,46% 5,64% 3,15% 2,75% 1,49% 1,44% 1,37% 1,35%

1,01%

1,02%

1,04%

1,08%

𝑛

𝐶𝑅𝑛 = ∑ 𝑆𝑖 = 12,29% + 8,46% … . +1,37% = 36,59% 𝑖=1

Equation 2: HH-index 𝑁

𝐻𝐻 = ∑ 𝑆𝑖2 = 12,29%2 + 8,46%2 … … + 1,08%2 = 28% 𝑖=1

Equation 4: ROIC 𝑅𝑂𝐼𝐶 =

𝑁𝑂𝑃𝐿𝐴𝑇 6070 = = 63% 𝐼𝑛𝑣𝑒𝑠𝑡𝑒𝑑 𝐶𝑎𝑝𝑖𝑡𝑎𝑙 10358,66

Equation 5: Cost of debt 𝑟𝑓 + 𝑐𝑠 = 𝑘𝑑 = 3,52% + 0,4% = 3,92%

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Equation 6: Cost of equity Ε(𝑅𝑖 ) = 𝑟𝑓 + 𝛽𝑖 [Ε(R M ) − 𝑟𝑓 ] = 3,52% + 1,1 ∗ (5% − 3,52%) = 9,02% Equation 7: Arithmetic average 𝐴𝑟𝑖𝑡ℎ𝑚𝑒𝑡𝑖𝑐 𝐴𝑣𝑒𝑟𝑎𝑔𝑒 = =

1 𝑇

∑𝑇𝑡=1

1+𝑅𝑚 (𝑡) 1+𝑟𝑓 (𝑡)

−1

1 1 + (−8.8%) 1 1 + 1.8% ∗( ) − 1 + ⋯……. ∗ ( ) − 1 = 4.46% 51 1 + 3.95% 51 1 + (−0.61%)

Equation 11: Equity beta 𝐷

𝛽𝑒 = 𝛽𝑢 (1 + 𝐸 ) = ( E.g. Mattle 2012) 0.98=unlevered beta*(1+0.11) => 0.98/1.11=Unlevered Beta = 0.88

Equation 12: WACC 𝑊𝐴𝐶𝐶 =

𝐷 𝐸 𝑘𝑑 (1 − 𝑇𝑚 ) + 𝑘𝑒 = 40% ∗ 3.92% ∗ (1 − 0.25) + 60% ∗ 9.02% = 6.61% 𝑉 𝑉

Equation 13: Continuing value in period 7

𝐶𝑜𝑛𝑡𝑖𝑛𝑢𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒7 =

𝑔 𝑁𝑂𝑃𝐿𝐴𝑇𝐶𝑉 (1 − 𝑅𝑂𝑁𝐼𝐶 ) 𝑊𝐴𝐶𝐶 − 𝐺

=

2.15% 9975.12 ∗ (1 − 6.61%) 6.61% − 2.15%

= 149905.09

Equation 14: Present value of continuing value 𝐶𝑜𝑛𝑡𝑖𝑛𝑢𝑖𝑛𝑔 𝑉𝑎𝑙𝑢𝑒0 =

𝐶𝑉7 149905.09 = = 95589.77 (1 + 𝑊𝐴𝐶𝐶)7 1,568

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