Case Study on Youku and Tudou’s Business Combination

In March 2012, Youku Inc - Case Study on Youku and Tudou’s Business Combination introduction. (NYSE:YOKU) (“Youku”) and the Company announced that they had signed a definitive agreement for Tudou to combine with Youku in a 100% stock-for-stock transaction. After the merger, the new company Youku Tudou Inc will keep the Youku and Tudou brands, continuing to occupy the 1st and 2nd positions in the online video industry. Youku and Tudou together will achieve synergy in numerous aspects, including video copyrights price, bandwidth servers cost, back-stage data consolidation, search, media library, and advertisement publishing. Both Youku and Tudou expect to benefit from the operating synergy and financial synergy. The faster they achieve synergies, the quicker they can break even. Case abstract:

This case led us to discuss the impact of Youku and Tudou’s business combination on Tudou’s historical and future financial statements.

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Case Questions:
What is the impact of the merger on Tudou’s historical financial statements? As a result of the merger, Tudou’s financial figures had to be adjusted in accordance to Youku’s accounting policy. This involved reclassifying some accounts, revaluing items and removing certain items. Income statement adjustment

In the profit-loss statement, there were several significant changes. Firstly, business tax was reclassified. It was taken out of net revenues and added to the cost of revenues. This had no net effect on profit. Secondly, Youku’s policies identified heretofore unrecognized intangible assets. The amortization expense for this was added to cost of revenues, product development expenses and general and administrative expenses. This had a negative net effect on profit. Thirdly, share-based compensation expense of assumed Tudou options had to be adjusted as Tudou’s shares would no longer exist. This had a net positive effect on profit. Fourthly, certain sales and marketing expenses were reclassified into product development expenses. This had no effect on profit. Fifthly, amortization expense for purchased licensed contents and productions costs were also deducted. As a result, the adjustments would result in Tudou reducing its losses. Balance sheet adjustment

In the balance sheet, there were also considerable adjustments. Firstly, cash and cash equivalents were reduced as a result of the possible merger transaction costs. Secondly, the value of capitalized content production costs was increased and content production costs were reclassified into non-current assets. This had no effect on the value of current assets, but had a positive effect on non-current assets. Thirdly, purchased software licenses were reclassified into fixed assets and this had a positive effect on non-current assets.

Fourthly, a reserve against unrecoverable receivables was made and this reduced non-current assets. Finally, a decrease in accruals reduced current liabilities. An increase in deferred tax liability will increase long-term liabilities. Thus, the merger will reduce Tudou’s current assets, increase its non-current assets, reduce its current liabilities and increase its long-term liabilities. In sum, the merger had a positive effect on Tudou’s profitability. It also expanded its assets by newly recognizing intangible assets. On the other hand, it also resulted in a considerable increase in liabilities in the form of deferred tax liability.

How should Ryan explain the impact of the merger in the third quarter earnings release? Under the terms of the Merger Agreement, Youku’s shares prior to the effective time of the Merger will be cancelled in exchange for the right to receive 7.177 Youku Class A shares, and each Tudou ADS will be surrendered in exchange for the right to receive 1.595 Youku ADS, which will result in Youku shareholders and ADS holders owning approximately 71.5% of the combined entity upon completion of the Merger and Tudou shareholders and AHDS holders owning approximately 28.5%. Against this backdrop, Ryan will have to address the following three issues first:

1.The actual net tangible and intangible assets and liabilities of Tudou that exists as of the date of completion of the Merger.

2.Necessary changes to adjust Tudou’s
accounting policies in accordance with Youku’s accounting policies.

3.The actual purchase price to be paid by Youku to complete the Merger. Once the above three issues were thoroughly explains, Ryan can move on to talk about the impacts on the financial statements accordingly.

First of all, due to the acquisition method of accounting, Youku will assume the assets acquired from and liabilities assumed of Tudou based upon their fair values mentioned above. Therefore; we will see a large spike in total assets, total liability, and total shareholder’s equity on the balance sheet. It’s worth noting that: 1)The significant increase in Goodwill on the balance sheet reflects the excess of the purchase price to be paid by Youku over the fair value of Tudou’s identifiable assets to be acquired and liabilities to be assumed in the merger. 2)The increase in shareholder’s equity reflects the issuance of approximately 830 million of Youku shares at the effective time of the Merger. Ryan can then try to clarify the changes brought to the income statement because of the merger.

Although the revenue has almost doubled after the merger, the cost of revenues also increased which led to a higher net loss per share accordingly. It is, however, pertinent for Ryan to close the session informing the investors that better results are to be expected by further integrating the operation of Youku and Tudou to take advantage of the synergies existed between the two firms. Take content cost as an example, the merging of Youku and Tudou accelerates the process of copyright price’s falling back to reason.

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