Valuation of LEGO Group

Transcription

1 Valuation of LEGO Group Copenhagen Business School MSc Finance and Strategic Management June 2013 Author: Morten Vang-Pedersen Supervisor: Peter Staudt Number of pages: 76 Number of characters:

2 Author Statement 2

3 Executive Summary The purpose of this thesis has been to estimate a fair value of the LEGO Group as of December 31 st 2012, with the perspective of an investor or prospective buyer. The valuation is based upon strategic and financial analysis, as these allowed for the necessary forecasts to be estimated. The strategic analysis applied different models in regards to three levels of strategic analysis. The PEST model was applied for the macro environment analysis, Porters for the industry analysis and the VRIO framework for the internal analysis. LEGO s primary revenue is made in Western Europe and North America, but while LEGO does not experience significant growth on the Western European, it has experienced growth of more than 20% in 2012 alone on the North American market. LEGO s growth in emerging markets was significant, but as the total sales in the regions were of a lesser degree, the impact was big. In general the analysis portrayed a bright future for LEGO, due to a strong brand, an optimized operating model and plenty of opportunity for growth The financial analysis showed LEGO has had strong sales growth, decreasing costs and thereby increasing profit margins, effectively showcasing the complete turnaround since LEGO s ROIC and ROE were found to be much higher than its peers, as both Mattel s and Hasbro s financial were dissected. These two chapters findings were applied to forecast future performance for LEGO, as both the income statement and the balance sheet were budgeted for the forecast period. The forecasts show continued sales growth, although at a decreasing rate, while costs are expected to increase gradually. The DCF and EVA models were applied to estimate the fair value of the LEGO Group, resulting in a value of ,5 million DKK. The value is substantial as it is far higher than the enterprise value, based upon shares and share price, of market leader Mattel. A sensitivity analysis and multiples comparisons analysis were conducted in order to critically asses the result of the valuation models. LEGO s value was found to be sensitive to changes in WACC, in particular the cost of equity, which influences LEGO s WACC by 85,32% due to its capital structure. The multiples comparisons showed that LEGO was valued very highly by the thesis, but this has to be adjusted for the peers bad match in sales growth with LEGO, as their sales growth is much lower. The thesis estimates that the found value of ,5 million DKK is a representative assessment of LEGO s value as of the 31 st of December

4 Table of Contents Author Statement... 2 Executive Summary Introduction Problem Discussion Research Question Structure of the Project Methodology Delimitation Presentation of LEGO Group History of Lego LEGO s Recent Financial Performance CSR: Corporate Governance: Ownership Board Composition Management Products: Market situation Strategic Analysis Growth Opportunity Overlook American Market European Market Asian Market Macro Analysis PEST Micro Analysis Porters Five Forces Internal Analysis Tangible Resources Intangible resources

5 3.4.3 Organizational Capabilities SWOT Strengths: Weaknesses Opportunities Threats Financial Analysis Peer Group Applied Accounting Policies Reformulation the Financial Statements Statement of shareholders Equity Balance Sheet Income Statement Profitability Analysis Return on Equity Return from Financing Activities ROIC Risk analysis Operating Risk Financial Risk Part Conclusion Budgeting and Forecasting Forecast Period Income Statement Forecast Sales Growth Costs Tax Rate Unusual Items NOPAT Balance Sheet Forecast Net Working Capital Forecast

6 5.3.2 Net Non-Current Operating Assets forecast Forecasted Return on Invested Capital Forecasted Free Cash Flow Part Conclusion Valuation Valuation Models Discounted Cash Flow Economic Value Added Valuation assumptions Weighted Average Cost of Capital Capital Asset Pricing Model (CAPM) Cost of debt Cost of Capitalized Operating Leases Capital Structure WACC Terminal Period Discounted Cash Flow Valuation EVA Valuation Sensitivity Analysis Risk premium for the Terminal period and Terminal Growth Cost of Debt and Cost of Capitalized Operating Leases Market Risk Premium and Terminal Growth Beta Value and Terminal Growth Summary of sensitivity analysis Multiples Comparison EV/Sales EV/EBITDA EV/EBIT P/E Valuation of LEGO Based on Peer Ratios Summary of Multiples Comparisons

7 6.9 Valuation Part Conclusion Conclusion Perspectives Literature list: Appendices Appendix Appendix Appendix Appendix Appendix Appendix Appendix Appendix Appendix

8 1. Introduction 1.1 Problem Discussion The world s economy has experienced dramatic changes the past 5 years. The economic turmoil has resulted in strained economies for countries around the world, threatening with a total collapse of large financial institutions. This has provided companies with severe challenges, as consumer spending has declined i. It stands to reason that in such conditions consumers might substitute expensive products with cheaper alternatives, compromising with. Despite the circumstances, several companies have been experiencing growth and success the past 5 years, causing them to be of interest as a case study. Through the course of my education at Copenhagen Business School, strategic analysis and financial analysis have been an integral part of the curriculum. Further I was introduced to the concept of firm valuation, which applies these tools to gauge the value of a company. I find it of particular interest to gauge the value of a company, which has defied the circumstances and prospered in times of economic turmoil, since this process will allow me to obtain an understanding of how the company accomplished that feat. I have found LEGO to be of particular interest, as the company was struggling mightily in the early 2000 s but has been able to turn it around and now is one of the top competitors in global traditional toys and games market. As LEGO is an unlisted company, it entails some challenges due to the decreased accessibility of information on the company. The valuation therefore necessitates a very thorough and careful process, in order to achieve a fair value of LEGO. It is assumed that enough information is accessible to compute a credible valuation of the company. LEGO competes on the global traditional toys and games industry, with its primary focus on construction toys. Below is the development of the different geographical markets within the industry. 8

9 USD Millions Figure 1.1 Traditional Toys and Games market sizes and growth rates ,0 0, ,0 0,25 Asia Pacific , , , , , , ,0 0, ,2 0,15 0,1 0,05 0-0,05-0,1-0,15-0,2 Eastern Europe World North America Western Europe World North America Western Europe Asia Pacific Eastern Europe Source: Own creation, Euromonitor As depicted in figure 1.1 the traditional toys and games market globally grew at an average of 5,2% for the illustrated period. The markets in North America and Western Europe have not experienced much growth in the period, not even prior to the financial crisis, and are considered stagnant. LEGO operate primarily on these two markets, it is however expanding in regions such as Asia and Eastern Europe ii. The global traditional toys and games market s growth is primarily driven by emerging markets growth, in large part the Asian market. The global traditional toys and games market suffered a setback due to the financial crisis in 2008, but especially the Western European market was affected negatively as it dropped by 8,04% iii. The Eastern European market has experienced tremendous growth, but was also severely affected by the financial crisis. It has since returned to a growth higher than 15% annually, making it a prime target for toy manufacturers. LEGO produces the iconic brick-based construction toys in a time where children give up toys for video games and online activities iv. LEGO has been able to establish themselves as the 3 rd largest company in the market with a market share of 5.6 % in 2011 v, despite being on the brink of going out of business in 2004 vi. LEGO is considered a high end toy product, as the price and quality are both very high vii. Seeing that the financial crisis has severely decreased consumer spending viii and the fact that its primary markets are the stagnant North American and Western European markets, one might think that LEGO had been experiencing 9

10 difficulty for the last several years. Quite to the contrary LEGO has experienced organic growth and an increasingly larger profit. LEGO presents an interesting case, as it has been able to overcome diversity, economic distress and turn itself into a successful company. Further the company is not listed and an estimate of the company s value is therefore not accessible, making LEGO very interesting to valuate utilizing the relevant theory. 1.2 Research Question The main purpose of this thesis is to gauge the fair market value of the LEGO Group from the point of view of a potential investor. Whereas a sale of LEGO as a whole is unlikely, it is always a possibility. Further it LEGO could go public in the future making a valuation most relevant. What is the current theoretical fair market value of the LEGO Group? Supporting the main problem statement is these sub-questions. These will be analyzed and discussed throughout the thesis. What strategic aspects are of interest to LEGO, and how do these influence the valuation of the firm? Can LEGO continue to grow at its current pace or will it hit a cap in the different markets? Has LEGO been able to build a sustainable business model, considering the challenges it faces? How sensitive is LEGO to market risk, substitutes etc.? What is the fair value of the company using the DCF and the EVA model? 1.3 Structure of the Project This thesis has been separated into eight chapters. Each chapter will be described shortly following the figure, which depicts the structure of the project. 10

11 Figure 1.2 Chapter 1 Introduction Chapter 2 Presentation of LEGO Group Chapter 3 Strategic Analysis Chapter 4 Financial Analysis Chapter 5 Budget and Forecasting Chapter 6 Valuation Chapter 7 Conclusion Chapter 8 Perspectives Chapter 2 Following the preliminary chapter the company will be presented. The presentation will both be quantitative and qualitative, thereby creating an understanding instrumental to the valuation. Chapter 3 A strategic analysis will be performed on LEGO and its context, also applying knowledge gained in the former chapter. The main goal here is to determine LEGO s potential for future value creation. The potential for growth in the different markets will be analyzed. The micro-environment will be analyzed with the Porters Five Forces model, displaying the competitive situation in the industry, LEGO s macro-environment will be analyzed with the PEST-model, the VRIO framework will be applied to supply an internal analysis and the chapter will be concluded with the SWOT-model. Chapter 4 The goal of this chapter is to reveal the company s true performance. The financial statements will be dissected, hereby making them applicable for analytical purposes. The dissected values will be the base of 11

12 the profitability analysis. This analysis strives to reveal deficiencies and gauge what has been the key driver of the company s performance in the analyzed period. The chapter also provides an overview of key figures, the financial state up till today and historical performance. Chapter 5 In this chapter the future performance of LEGO will be projected for the forecast period of ten years, providing a forecasted income statement, balance sheet and free cash flows. Chapter 6 First the WACC level will be decided through thorough analysis. The thesis will then apply two different valuation models to gauge the value of the LEGO Group, the DCF model and the EVA model. Lastly a sensitivity analysis and a multiples comparisons analysis will be conducted. Chapter 7 This chapter will summarize the thesis and highlight the main objects and results. Chapter 8 As the thesis has been written over a long period of time, it was found necessary to make a constraint date, after which new information was disregarded. Current developments after the cut-off date have however still been followed, and this chapter will use the new information to put some perspectives on the results found in the thesis. 1.4 Methodology This section will illuminate methodical considerations in the thesis. The basis for my data collection will be depicted and the data s validity for the thesis will be evaluated. The thesis is written from an external point of view, the view of a prospective investor. Therefore, only external available information has been applied to conduct the valuation. This choice stands to reason, as it is assumed that a prospective investor would typically only have access to secondary data. While it can be assumed that most of the data collected is correct and objective, primarily due to the nature of selected sources, the thesis will at all times take a critical view. Various models, theories and frameworks have been applied to obtain a complete overview of LEGO and the industry in which LEGO competes, thereby allowing a thorough analysis. Both quantitative and qualitative are applied in order to answer the research question satisfyingly. The thesis applies models based on the frameworks found in Valuation: Measuring and Managing the Value of Companies by Koller, Goedhart & Wessels (2010), Contemporary Strategy Analysis by Grant (2010), 12

13 Financial Statement Analysis Plensborg & Petersen 2006, Financial Statement Analysis and Security Valuation by Penman s (2010) and Regnskabsanalyse og værdiansættelse by Sørensen & Elling s (2005). The thesis will be an intensive analysis of an individual unit focusing on the developmental factors in relation to context. Therefore thesis will follow one of the three main approaches of an analysis (Yin, 2009), which is the case study approach. 1.5 Delimitation Throughout the work process it has been necessary to assume certain delimitations, hereby achieving a manageable amount of information and analysis. To answer to problem statement most accurately this thesis has focused its attention on the most important factors. A considerable limitation in the thesis is the limitation of secondary information on the company, which is primarily caused by LEGO A/S not being a public company. As the scope of the thesis is to gauge the value from an investor s point of view the thesis has chosen not to try and gain insider knowledge through confidential interviews. LEGO Group A/S consists of many subsidiaries ix, often in different markets with different sets of parameters being of importance. Therefore the thesis has chosen to look upon LEGO A/S as one entity, this also stands to reason as the subsidiaries does not account for a major part of LEGO A/S total value and further will not be a primary driver for future value. The aim of the thesis is to do a valuation of LEGO A/S as of 31 st December 2012 therefore all information from beyond that date is excluded from the thesis. There are several different models and theories, which can be applied in the process of a valuation, and it is acknowledged that other models might have been appropriate for the thesis, but due to the limited size of the thesis, the models found to be best applicable have been applied. The chosen models have certain limitations but are widely used and accepted as valuation tools. The thesis will not use time and space on exploring and analyzing the models, instead using them as tools to gain the necessary insight and information needed for the valuation of LEGO A/S. Further the thesis will mainly refer to LEGO Group as LEGO, but when deemed appropriate the full name will be used. 2. Presentation of LEGO Group In order to obtain a credible and satisfactory estimate of the value of LEGO, a thorough understanding and evaluation of all key aspects is needed, as it serves as the foundation of the predictions and expectations, which comprises a vital part of the valuation process. Therefore an ample analysis and understanding of the 13

14 company is crucial as well. The next section will present LEGO s history, the current state of LEGO and delve into certain aspects of LEGO and its surroundings, critical for the later valuation. 2.1 History of Lego In 1932 Ole Kirk Kristiansen (OKK) founded the Danish toy company LEGO in Billund, Denmark x. The company name was created by combining the first to letters of each of the Danish words LEG and GODT. OKK, unknowingly, chose a company name, which in Latin means I assemble xi, which is quite a coincidence considering the product LEGO s end product. OKK s motto was The best is not good enough, which he incorporated into LEGO s values. To this day the motto is still at the core of LEGO s values. The core message of the motto is that LEGO will never stop trying to improve its products, working environments etc. LEGO started off producing toys made of wood, but started experimenting with plastic toys in In 1949 it launched its first plastic building blocks, which encouraged children to use their imagination when playing and go exploring in their own universe xii. A year later OKK s son Godtfred Kirk Kristiansen (GKK) took over the business and 5 years later LEGO launched LEGO system in playing. The concept underlined the importance of children learning through playing. GKK continued to expand LEGO s product portfolio throughout the 1960 s, as he introduced LEGO trains with small motors and launched LEGO DUPLO and thereby started adapting LEGO s products to different age levels. The increase in business activity in the Billund area, primarily due to LEGO, resulted in the Billund airport opening in A few years later in 1968 LEGO opened its first theme park, LEGOLAND in Billund, Denmark. In the 1970 s LEGO introduced the LEGO figures, which resembles very small dolls, further expanding its product portfolio. This new aspect of the LEGO product portfolio created new opportunities to market and sell its product, as it now combined its product with the opportunities of role-playing and personality. Later in 1978 GKK s son Kjeld Kirk Kristiansen (KKK) further systemized and optimized the concept of learning through playing by creating new product programs, which put an emphasis on stimulating the child s creativity and imagination. A year later, 1979, KKK was appointed CEO, and thereby took over from his dad, GKK. KKK continued the aforementioned systemization and worked hard on optimizing it. KKK and GKK were often in disagreement on how LEGO should be run and what the goals were for the company. Through the 1980 s LEGO started collaborating with MIT on subjects such as learning processes and technology, which gave LEGO an opportunity to be cutting edge in its industry and the ability to introduce new products used for educational purposes. 14

15 The 1990 s marked a decade in which LEGO introduced numerous new products resulting in a wide spanned product portfolio. Additionally LEGO opened a new theme park in the UK in Through the aforementioned collaboration with MIT, LEGO introduced a system called LEGO MINDSTORMS, which provided children the opportunity to create and program intelligent LEGO models. In 1993 KKK had to leave his position at LEGO due to health issues. He returned in 1994 with renewed energy and a new strategy called Compass Management. The idea was to motivate and stimulate the employees of the organization to become self-thinking and responsible. xiii There was, however, a growing sense within LEGO, that the company had some serious issues. Sales were not growing and had stagnated around 1995 xiv. It became clear that KKK s initiative, Compass management, had failed, the employees had not changed their behavior and something had to be done. When LEGO published its first annual report in 1997, the public became aware that LEGO was experiencing some problems with significant drops in profits and stagnation in sales. In 1998, trying to counter the impending crisis, KKK hired Poul Plougman (PP) as his CFO. The plan was to cut down on expenses and create a lean company; the plan was called LEGO fitness. The same year LEGO made a deal with Lucasfilm Ltd, providing LEGO with the rights to market a new LEGO series with a Star Wars theme, which would later be a success. The financial distress did not stop LEGO from opening a new theme park in 1999 in California, USA, as KKK was a strong believer in the parks. However, LEGO s financial struggles continued, as in 1998 it had a deficit for the first time since 1945, stressing the declining state the company was in marked a year of optimism; it seemed that a savings round of 1 billion DKK provided by LEGO fitness and a round of firings along with the success of the Star Wars line had changed the fortunes of LEGO. The result was a profit of 274 million and everybody seemed to believe PP had been able to turn around the company. In 2000 LEGO s woes returned and it had a company record deficit at 863 million DKK. PP had become COO and no longer focused on financial control and analysis, he now tried to become as close as possible to KKK, trying to gain more influence on the strategy of the company. A significant change of directors was made, as KKK took a step back in operations and made all directors refer directly to PP. The directors were unhappy and tried to reason with KKK, but to no end. Therefore several of them chose to leave LEGO, one even did it on the day of the announcement. PP had become more and more powerful, while KKK was stepping into the background, believing PP to be the right person to orchestrate the turnaround of LEGO. The financial struggle did not keep LEGO from introducing new products, as it struggled to find ways out of its struggle. In 2001 LEGO BIONICLE was introduced, which purpose was to mix action toys with construction toys, and in the hopes of getting a share of the commercial success of the Harry Potter brand, a Harry Potter line was launched. 15

16 DKK Millions Figure 2.1: LEGO Profit and Sales Year Source: Own creation, Euromonitor LEGO experienced some financial progress in 2001 and 2002 with profits of 366 and 326 respectively, which could be credited to PP, but rather the reason was LEGO s ability to ride along on the Harry Potter success. Star Wars had saved the financial performance in 1999, and Harry Potter did in This was a clear indication that LEGO was becoming dependent on licensing. LEGO s distress was apparent in The company incurred a major deficit of 935 million DKK in 2003 along with a heavy decline in sales of 26 %, indicated by figure 2.1. Clearly the action taken by PP to steer out the crisis had failed. In the end of 2003 KKK began preparing to take LEGO in a new direction, and in the start of 2004 PP was fired, and Jørgen Vig Knudstorp (JVK) and Jesper Ovesen (JO), who had been hired as CFO in November 2003, now became the defacto leaders of the company. It was, however, only the top leadership of the company that knew this, while everyone else thought JVK and JO were in supporting roles of KKK, which significantly weakened their authority within the company. JVK became the official number 2 in June 2004, when KKK promoted him to COO, but it was not until the 31 st of August 2004 that KKK stepped down officially and JVK was appointed CEO by the board. This marked the first time LEGO would not have a CEO, who originated from the Kirk Kristiansen family. KKK continued working on the board, where he was joined by his son, Thomas Kirk Kristiansen, in 2007, and where both are still active to this day. JVK was a surprise hire to industry observers, as many thought of JVK as a rookie xv. KKK had hired JVK due to his intimate knowledge of him and the compliance of their values and view of the company s future. JVK was now faced with a challenge as LEGO s future looked dark. Debt was high, liquidity was low and now Danske Bank refused to loan LEGO any more money. JVK s plan was in three stages: Manage for cash ( ), Manage for value ( ) and Manage for growth (2009+) xvi. 16

17 JO worked out a restructuring deal regarding the debt, which included Nordea, SEB, Nykredit and SEB, further LEGO had to loan 1 billion DKK from KKK s personal savings. Then LEGO sold off the LEGOLAND parks in 2005 for 375 million, while also acquiring a 22% equity stake in the new theme park operator, Merlin Entertainment. A lot of decisions were made regarding different product lines as JVK strived to streamline LEGO and find the core of the business. Industry leader, Hasbro, had started outsourcing manufacturing a long time ago and JVK felt that it was time for LEGO to go the same route. The manufacturing costs of LEGO had exploded xvii and Bali Padda was not able to explain it as forecasts and sales orders varied so much. LEGO chose Flextronics due to its experience in molding. It was by far the hardest decision during JVK s leadership, as JVK s plan included letting 80% of the staff on the factory in Billund go over the next three years. JVK further wanted LEGO to focus more on satisfying retailers and making them profitable, as he believed this would benefit LEGO and create more revenue. Many of the leaders within LEGO disagreed and were afraid that LEGO would forget the consumers marked a year with 505 million DKK in profits xviii and sales of million DKK. This was very satisfying and could be credited to larger savings than expected and increased sales of the modified core products. Further asset sales contributed to almost half of the year s profits before tax. In 2006 the progress continued as profits increased by 183 % and sales by almost 11 %. Not all was well, however, as LEGO cancelled its contract with Flextronics between 2007 and The relationship had proved troublesome as Flextronics had problems living up to the standards set by LEGO xix. JVK admitted it had been a grave mistake not to consider manufacturing a core competence. Hundreds of millions of dollars were now invested to rebuild LEGO s own manufacturing capabilities. It, however, relied on Chinese contractors to manufacture electronics and decorations. Emphasizing LEGO s competence of manufacturing is that LEGO has three people operating 64 machines, compared to factories in China where often there a three people per machine xx. JVK started reinforcing the LEGO culture, which had always been centered on good working relationships, collaboration and trust. JVK also wanted to change the innovative approach in LEGO which entailed many changes. JVK did not change the staff of designers; rather he employed a more disciplined work process for them. The designers were introduced to a more critical and analytical approach to consumer data, they began to use market research insights and became engaged with children and parents, and were even sent to live with consumers from time to time. This work process has been widely successful for LEGO. Organizationally, the innovative steps were employed in 4 groups xxi : 1) Product and marketing development, 17

18 which have around 100 designers. The goal is to keep the core product portfolio fresh and vibrant, e.g. by licensing new brands. Its acceptance rate of ideas is approximately 80 %. 2) The Concept Lab which is a smaller team, who comes up with ideas for new products. The lab has a very low acceptance rate, as it had 72 ideas turned down before it had 1 accepted. 3) Community, Education and Direct: This group is primarily responsible for digital innovations. The group has around 2000 employees as it also manages and supports digital experiences for schools, consumers, LEGO stores and online store. This group often works together with the other groups. 4) The New Business Group is a group of 10 designers with freedom to experiment with small ideas with limited sales potential. Production planning was optimized and scenario planning was introduced to adjust for ups and downs in demand. Lastly, LEGO was finally able to develop systems to gauge the manufacturing costs by specific product and customer profitability. As stated JVK wanted an emphasis on retailer satisfaction and he continued down that road. LEGO has been able to achieve excellence in key account management, as it tailors its value proposition for the specific customer. Some wants price leadership, others exclusivity etc. LEGO has further improved the service level through its optimization of the manufacturing process. It has increased the availability of products to retailers and tried to avoid having too many products sold out. LEGO has been able to increase retailer margin from 19% in 2004 to 30% in 2009, which are most likely a reason for the increase in shelf space for LEGO in a typical store from about 3 meters to almost 10 meters. If LEGO takes care of the retailers, the retailers take care of LEGO. JVK attributes much of the success of LEGO to the optimization of its complex operating model system of factories, distribution centers, packaging, inventory and shipping. And it s a necessity that the model is punctual, because as he states If you don t meet the 7 am cross docking window at Wal-Mart, they tell you to come back the next day. LEGO s model had to be able to fit most or all of its retailers wishes and demands, thereby enhancing the relationship, which in turn benefits LEGO greatly. 2.2 LEGO s Recent Financial Performance LEGO s recent financial performance correlate with the success of JVK s planned stages, as 2004 was the turning point. The data is the raw data from the annual reports, as the revised data will be explored in financial analysis chapter. 18

19 DKK Millions , , , , , , , , , ,00 0,00 Figure 2.2: LEGO Group Sales and Operating margin Year 30,00% 20,00% 10,00% 0,00% -10,00% -20,00% -30,00% -40,00% Sales Operating margin Source: Own creation, Euromonitor As depicted in figure 2.2 the operating margin increased greatly from -28,80% in 2004 to 16,54% in 2006 and up to 23,22% in 2010, which it has been around since. The figure also clearly illustrates how LEGO s sales have developed, increasing steadily from 2004 to 2008, and increasing significantly from 2008 to LEGO s sales are expected to continue to grow, though LEGO is adamant about the growth not happening too fast, as organic growth is vital to continue having an optimized operating xxii. 2.3 CSR: LEGO signed the UN s Global Compact in 2003 xxiii and strives to be corporate socially responsible according to its website. It should therefore seldom in a situation where it needs to correct behavior, process etc. due to legislation since LEGO strive to be cutting edge in regards to almost all aspects of the company. The Danish consumer agency scored LEGO negatively in accordance to CSR xxiv, primarily due to its unwillingness to cooperate and let the agency visit factories. When it comes to suppliers breaking the law on e.g. work hours in China, LEGO, however, has continuously demanded they live up to regulations and stopped relationships with several suppliers. LEGO is very unhappy with its rating from the consumer agency and claim it did not have time and resources for this particular study, while also claiming to invest a lot of resources in CSR. 19

20 2.4 Corporate Governance: LEGO A/S is a family owned business, and it strives to combine the strengths of being family owned with good corporate governance for listed companies. LEGO realizes the weaknesses of being family owned, e.g. handover risk, and are diligently preparing and implementing plans to mitigate these risks Ownership LEGO A/S is owned by third and fourth generation of the founding family Kirk Kristiansen; Kjeld Kirk Kristiansen and his three children xxv. The ownership is handled through KIRKBI Invest, which is an investment company, run by Kjeld Kirk Kristiansen, owning 75%, and the LEGO foundation, who owns 25%. The ownership structure for LEGO A/S has both benefits and issues as KKK effectively has the power. Therefore the identity of the owner is equally as important as the relationship between owner and manager xxvi. As mentioned KKK handpicked his CEO and apparently have a good relationship with him. After mismanaging the company for years it seems KKK has found the right man to run his company Board Composition LEGO A/S has the typical European two-tier board xxvii. The board consists of the 7 members from the supervisory board and 4 members from the executive board. Of the 7 members, 3 are considered dependent as two have ownership xxviii, KKK and his son TKK, and the last due to being in the management of the parent firm, KIRKIBI Management Three of the four managers have been part of LEGO A/S for a long time, only the new CFO has not, as he started in September Since JVK took over as CEO conditions have stabled, and it can be assumed that these conditions will continue for the near future. There has been some replacing of managers during KVK s tenure, as he has tried to optimize the group. 2.5 Products: LEGO A/S is the third largest manufacturer of toys & games in the world in regards to revenue xxix. It has built up its product portfolio to a wide span of products to all ages, children from 2 years and up to the adults who still like to play once in a while xxx. Its portfolio includes toys, games, videogames, movies, accessories as bags, clothes etc. Its core business is toys, evolving around the brick, and games and therefore LEGO most often work with external partners on its other products through different strategic partnerships or contracts. xxxi LEGO has a wide array of products and they will shortly be outlined in this section xxxii. 20

21 DUPLO is a product for pre-school children, which translates to ages 2-6. The bricks are twice as large as regular LEGO for both safety and handiness reasons. The product has been a part of the portfolio for many years and can be bought as loose bricks or themed packs. LEGO promotes the product as a way to stimulate and evolve children s senses and skills. Bricks and more is buckets or boxes with bricks and other parts. There are no instructions as to how the pieces should be put together, only the imagination sets the boundary. Bricks and more primarily appeals to customers who love to build in a free flow from the imagination. Themed LEGO sets are boxes with operating instructions to create a pre-determined theme. This could be ships, cars, castles, houses etc. Children can then play with the built model or alter it as they wish. In line with the themed LEGO sets, LEGO has a line of licensed products, which are themed sets. These are among others, Star Wars, Lord of the Rings, Cars. LEGO has had great success with these products, especially its former Harry Potter line. LEGO Mindstorms NXT is a product where children can design their own robots, built of LEGO bricks. The robot can be voice controlled or controlled by a smart-phone. The possibilities are endless, as there are wide array of different bricks, motors and sensors to combine. LEGO Videogames are LEGO themed videogames licensed from other worlds children know. Among others there are "Pirates of the Caribbean", Batman and Harry Potter games. LEGO recently launched LEGO Games, which are board games combined with building with LEGO bricks. The new launch has been a success so far and LEGO expect it to continue. LEGO Technic is a building system which differs from the original LEGO bricks. Children can build a miniature Formula 1 car, motorcycles, cranes and big trucks with lots of working functionalities. This series is definitely more complex and add gears, axles, pins and beams to the equation. LEGO friends is a brand new concept introduced in The sets appeal primarily to girls and LEGO has successfully marketed the product to girls. LEGO made a big marketing push, spending almost 50 million dollars xxxiii, because as JVK said: We want to reach the other 50 percent of the world s children. Further LEGO has been experiencing with online games. In 2010 LEGO Universe, a MMO game, was launched. It was however shut down in 2012 since it was not profitable. LEGO currently has an array of small online videogames xxxiv, which are related to its product lines. 21

22 2.6 Market situation The global market of toys and games amounted to US$ 154 billion in 2011 xxxv, where traditional toys and games accounted for US$ 82 billion. The tradition toys and games market grew by 7,9% in 2011 compared to 2010, the growth originating from emerging markets, as the North American market declined by 1,3% and the Western European growing by 6,5% to get close to the 2008 level. Eastern Europe and Latin America were the fastest growing regions in traditional toys and games xxxvi, followed closely by Asia Pacific, driven primarily by India and China. By 2013 Asia is expected to overtake North American as the world biggest market for traditional toys and games. LEGO is firmly focused on developed markets, in particular the North American and the Western European. The two regions accounted for 72% of LEGO sales in 2011 xxxvii. LEGO maintains a very strong position in the Germany, Scandinavia and the UK. The North American market is LEGO's second largest regional market, but is the market with most growth in recent years xxxviii. LEGO has actually doubled its sales in the market since 2008, as a result of the change in how it cooperates with retailers and opening LEGO stores. In emerging markets LEGO is especially present in the Easter European market, where it was the market leader of traditional toys and game. Asia and pacific are viewed more as opportunity markets and the opportunity within these will be explored later. Table 2.1: Traditional Toys and Games market leaders in percent Rank Company Mattel Inc 12,8 12,3 12,5 12,5 2 Hasbro Inc 8,6 8,8 8,4 8,2 3 LEGO Group 3,7 4,4 5 5,6 4 BANDAI NAMCO Group 2,4 2,7 2,8 3,1 5 Takara Tomy Co Ltd 2 2,2 2,3 2,7 6 Spin Master Ltd 1 1,3 1,5 1,5 7 MGA Entertainment Inc 1,6 1,4 1,5 1,4 8 Hallmark Cards Inc 1,2 1,5 1,5 1,4 9 VTech Holdings Ltd 1,1 1,1 1,1 1,1 10 Simba-Dickie Group GmbH & Co KG ,1 11 Walt Disney Co, The 0,7 0,8 1, LeapFrog Enterprises Inc 0,9 0,9 0, Giochi Preziosi SpA 0,8 0,8 0,8 0,7 14 Geobra Brandstätter GmbH & Co KG 0,7 0,7 0,7 0,7 15 Ravensburger AG 0,6 0,6 0,6 0,6 16 JAKKS Pacific Inc 0,9 1 0,8 0,6 17 Mega Brands Inc 0,4 0,4 0,5 0,5 Source: Own Creation, Euromonitor 22

23 LEGO's market share of 5.64% in the traditional toys and games market in 2011, ranks behind only Mattel and Hasbro xxxix, as shown in table 2.1. Mattel is an American toy manufacturer. Its product portfolio is very wide, and includes Fisher-Price, Barbie dolls, board games xl etc. Mattel announced in early 2012 that it will be launching a new line of construction toys in co-operation with Mega Brands xli, specifically Barbie construction dolls, as they seek to challenge LEGO for the girls construction toys market. Hasbro is also an American multinational toy and games manufacturer. Hasbro, too, has a wide product portfolio, spanning from games like Monopoly and Trivial Pursuit to toys like my little pony and Transformers. Hasbro have launched a new product called Kre-O xlii, a construction toy themed upon the movie Transformers. The toy is primarily big construction dolls of the transformers and is compatible, with LEGO s products. The product is a direct competitor to certain lines of LEGO's product portfolio. These two American multinational companies pose a threat to LEGO in the long run, as they look to grab market shares of LEGO's construction toys market. Mega Brands is company, which produces plastic bricks like LEGO. Its concept is practically the same as LEGO's, as its blocks match LEGO s. It could be considered a copy product, but is not like the generic lesser competitors who basically copies LEGO's products. LEGO has continually sued Mega Brands xliii, and might have slowed MEGA BRANDS progress, but has still lost in court. MEGA BRANDS has not been able to catch up to LEGO, but it is number two on the market in construction toys. Mega Brands sorely lack the brand LEGO has, and perhaps the know-how for an optimal production process. Mega Brands does, however, pose a threat as its team-up with Mattel, provides capital, a known brand and more know-how of large-scale operations. 23

24 Figure 2.3 : LEGO Share in Construction Toys in 2011 China Taiwan South Korea Spain Turkey Japan Mexico Poland Brazil Germany UK USA Netherlands Russia Sweden Source: Own creation, Euromonitor Figure 2.3 depicts LEGO s strong position in the construction toys segment in different markets. It remains to be seen whether LEGO can keep these percentages up with the incoming competition in its segment. Licensing is an agreement between a licensor and licensee. They agree to give the licensee permission to use the licensor's material. In the toy industry it can be characterized as intellectual property or brands. Known brands such as Star Wars, Harry Potter etc. are licensed out to the competitors, who in turn pay royalties to the licensor. The toys and games industry is one of the most licensed industries xliv. The reason is that licensing has become very important in driving sales and launching new products in the industry. The competitors utilize the already known brand, and market their product heavily reaching out to children through heavy marketing campaigns. Licensing differs in its importance on the different markets, generally licensing drives growth primarily on the North American, Western European and different countries in Asia, including South Korea, Singapore, Indonesia and Thailand xlv. 3. Strategic Analysis The previous chapter described important aspects of LEGO, its development over the y ears and the context in which it operates in. This information will be utilized in this chapter to perform a thorough strategic analysis, and subsequently in the thesis, as the information is influential in regards many aspects of the valuation. 24

25 The strategic analysis is separated into five sections in order to create a complete understanding of the different aspects in LEGO strategic context. The analysis will start by exploring the growth opportunities for LEGO in the different markets. Subsequently the PEST framework will be applied, shedding light on four key macro-environmental factors, which are out of direct control for LEGO, but directly affect LEGO and its opportunities. In order to analyze the current competitive situation in the industry the Porters Five Forces framework will be utilized, while to conduct an internal analysis of the company, the VRIO framework will be applied taking a resource-based view. Lastly a SWOT analysis is applied, as the framework sums up the strategic findings and evaluates which strengths, weaknesses, opportunities and threats are of importance for future performance for LEGO. 3.1 Growth Opportunity This section will explore the outlook for LEGO in different markets, highlighting the opportunity for growth. The situation will be shortly outlined before a more in-depth exploration of the markets will take place, while analyzing LEGO s opportunity within the markets. As LEGO does not disclose geographical sales numbers, much data relies on second hand sources and in other cases, data has not been available Overlook The American market has been the largest market for many years, but slow growth on the market means that both Europe and Asia will overtake it in a few years. The American market had a value of 21,2 billion USD in 2011 xlvi, while Europe and Asia had values of 21,1 billion USD and 19,2 billion USD respectively. The American market has had a compound annual growth rate (CAGR) of -0,2% xlvii from 2007 to 2011, showing a negative growth in the period, primarily due to the financial crisis. The European and Asian market both had positive growth in the period, with CAGR s of 2,2% and 6,5% respectively. As these two markets are expected to grow at approximately same rate the next 5 years, 2,1% for Europe and 7,5% for Asia, and the American market is expected to grow by only 0,1%, it becomes obvious that both markets will overtake the American market and that Asia will soon be the biggest market for traditional toys and games. Europe, meanwhile, will be the second biggest market, driven especially by the growth in Eastern Europe American Market LEGO has had significant success in the last 8 years in the American market, as it has posted double-digit sales growth for eight consecutive years xlviii. LEGO s growth in the market is not driven by the markets growth, evidenced by the market s decline in the period. Rather the growth is achieved by outperforming or stealing market shares from its competitors. Thus the market still presents LEGO with a substantial growth opportunity. The opportunity is however capped, as the market is stagnant and due to the fact that it must be presumed that at a point in time LEGO will reach a saturation level in the market for its product. Due to the 25

26 diverse nature of the industry, LEGO s product, the changing demands of children and a dozen of other factors it is not possible for LEGO to gain control of the industry with its current setup. In the first half of 2012 LEGO had sales growth of 23% xlix, indicating that a saturation level for LEGO s products is not imminent. In % l of LEGO s sales on the American market were to boys, which rate can be assumed to be similar in other markets, therefore LEGO has begun to try and develop products to the girls. The new LEGO FRIENDS product for girls is showing promise and constitutes a significant growth opportunity. Therefore the market presents LEGO with a notable growth opportunity and LEGO could continue to steal market shares, as its competitors scramble to enter the construction toys segment to defend their market shares European Market The European market is a core market for LEGO, and in 2011 LEGO had sales growth of 10% li. LEGO has been present in the market for many years and has, in markets such as Germany and UK, reached a saturation level for its product, making growth through its traditional products difficult. Therefore its growth is driven by other factors. The growth can be attributed to the success of LEGO FRIENDS for girls in the entire market and growth in Eastern Europe. Russia is LEGO s fourth largest country-market measured on sales after the markets in America, Germany and Great Britain lii, and clearly the largest market in the Eastern Europe segment. Therefore growth in this market will be an instrumental driver for total growth in this region. In 2011, the Russian traditional toys and games market grew around 12% and LEGO had around 1 billion DKK in sales in the market. For the last 2-3 years LEGO has had sales growth around 35% liii in Russia. LEGO has spent several years and many resources gaining acceptance and establishing themselves in the Russian market, which can be troublesome due to the political climate liv, and is now positioned to take full advantage of the growing market. LEGO s potential for growth in Europe primarily consists of its opportunities in Eastern Europe and the potential for the LEGO Friends product. LEGO has invested heavily in new plants in Eastern Europe and it would be logical if LEGO were to open plants even closer to or in Russia in the near future to handle the increasing demand Asian Market The Asian traditional toys and games market has had riveting growth compared to Europe and America. Sales in Japan accounted for 34,8 % in 2011 while China accounted for 32,9% lv and India for 11,3%. Of these 3 major countries LEGO is most popular in Japan lvi with a market share of 46% in the construction toys segment, and while only possessing 5% in China. 26

27 LEGO has had 50% sales growth in the first six months of 2012 in Asia and more than 100% a month in China. lvii While the growth in especially China seems staggering, LEGO does not expect China to be as good a growth opportunity as Russia, as LEGO projects the potential of the Chinese market to be half of Russia primarily due to culture differences lviii. Half of Russia, however, constitutes a significant growth opportunity, as LEGO projects the potential of Russia to be around 6-8billion DKK lix. LEGO has made the decision to build a plant in China, which will begin construction in 2014 and will supply around 70-80% of the demand in the Asian region in 2017 lx. Having a factory closer to the end market will significantly lower costs of transportation etc. As China develops a larger middle class, there is a possibility for a significant increase in demand for LEGO s products. In several Asian countries, parents view toys as an obstruction to their children s school studies, constituting a significant culture difference lxi. Therefore LEGO brands its products heavily as innovative and intellectual products, from which children can enhance and train certain skills. In Japan and South Korea LEGO is popular, its popularity increased by the toys ability to make children learn while playing. It is assessed that LEGO can achieve decent growth, but not major, as it has already been in the market for many years. The market in Asia will be world s biggest sooner rather than later, and therefore has major growth potential. LEGO will have to adapt to the cultural values and brand its product in specific ways, to be able to tap deeply into the vast potential of the market. 3.2 Macro Analysis This analysis will explore the factors on the macro-environmental levels, which affect the traditional toys and games industry, and in particular LEGO. These factors are influential elements, which cannot directly be changed by competitors in the industry. The focus will tend to focus more on the North American and the Western European market as these constitute the main part of LEGO s sales, but emerging markets are of note as these constitute growth opportunities lxii. This analysis will be simplistic version, focusing on the key factors, as the complete macro-environment is vast PEST The PEST analysis will be in 4 parts, as there are 4 factors; Political, Economic, Social and Technological. Each part will contain analysis in regards to the societal factors which influence the toys and games industry Political: The political environment has a big influence on a company s short- and long-term strategic and operational decisions. Further it directly influences the earning opportunities for competitors through changes in corporate taxes, tariffs, labor laws, environmental laws, education systems etc lxiii. 27