boston chicken case. case overview rapidly growing restaurant chain is one of the hottest names on...

Boston Chicken Case

Case Overview

Rapidly growing restaurant chain is one of the hottest names on Wall Street

Sales and earnings show consistent growth But a small number of detractors argue that the

strategy is flawed and the accounting numbers are misleading

Overview of Business

Over 1,000 stores by the end of 1996, with plans to open another 300 by the end of 1997.

Pioneer of the ‘Home Meal Replacement’ concept. Hearty, home-style cooking with fast-food convenience.

Uses an ‘Area Developer’ network to facilitate rapid expansion strategy. Over 80% of stores are under franchise contracts with ADs.

Provides bulk of financing for ADs so that they can focus on operational issues.

Strategy appears to be working, with EPS up from $0.06 in 1993 to $1.01 in 1996.

What is the Key Line of Business?

The balance sheet suggests that most of the assets are tied up in the financing business

The income statement suggests that most of the revenues and earnings are generated by the franchise business

The restaurant operating business is the least important

Summary of Business Strategy (1)

Key Success Factors Associated with Financing Business

Good access to customers Potentially valuable conversion option Comparative advantage in managing collateral in case of

default


Key Risks Associated with Financing Business Credit Risk

Concentrated with a small number of ADs who are all in the same line of business

Poor interest rate spread Low leverage Regulatory and legal risks


Key Success Factors Associated with Franchise Business

Premium franchise fees and royalties AD network promotes rapid and systematic penetration of

target markets ‘Boston Market’ brand name ADs have ready access to additional capital at low cost


Key Risks Associated with Franchise Business Initial franchise fees dry up as growth slows ADs could go broke and would then be unable to continue

to pay royalty and franchise fee payments


Key Success Factors Associated with Restaurant Business

Fist mover advantage in ‘Home Meal Replacement’ concept

‘Boston Market’ brand name


Key Risks Associated with Restaurant Business

Competition– KFC starts selling rotisserie chicken, fluffy mash potato etc.– Supermarkets start selling rotisserie chicken

Home Meal Replacement concept is not viable

Overall Evaluation of Boston Chicken’s Business Strategy

Financing business is lackluster, but has important synergies for franchising business. Credit risk is a big concern here.

Franchise business looks great, so long as franchisees can keep paying bills.

Restaurant business looks horrible and is making substantial losses and sucking up huge amounts of cash (refer to AD losses on p. 6).

Overall Evaluation of Boston Chicken’s Business Strategy (cont.)

BUT: ADs can only pay Boston Chicken so long as Boston

Chicken lends cash to ADs. Boston Chicken can only lend cash to ADs as long as it raises cash from capital markets. It can only raise cash from capital markets if its financial performance looks healthy.

How long can this go on if we can’t make money selling chicken?

Why does accounting make financial performance of Boston Chicken look healthy?

Quality Issues with Boston Chicken’s Earnings

Two issues:

The poor performance of the franchised stores is not reflected in Boston Chicken’s earnings. This is an important issue, because Boston Chicken is bankrolling these stores.

A large portion of 1996 earnings came from the $38,163 ‘Gain on issuance of subsidiary’s stock’.

Earnings Restatement

There are two ways to account for the poor performance of the franchised stores:

A ‘pro forma’ consolidation of the franchised stores’ operating results. From an economic perspective, Boston Chicken bears the risks and rewards of ownership of these stores. Note that because they provide financing in the form of debt, consolidation is not required by GAAP.

A provision for bad debts on the notes receivable. Since the franchised stores are losing money with no evidence of a turnaround, a generous allowance would seem appropriate – say 10% of new originations. This would be consistent with GAAP, but the absence of prior defaults gives Boston Chicken and the auditors leeway to book no provision for bad debts.

Boston Chicken Restatement

BOSTON CHICKEN INC1996 Income Statement (restated) As Pro Forma Pro FormaFigures in thousands unless noted Reported Consolidation Provision

------------ ------------ ------------Revenue:Royalties and franchise related fees............ 115,510 0 115,510Company stores.................................. 83,950 83,950 83,950Interest income................................. 65,048 0 65,048Area Developer Revenues 975,022Total revenue................................ 264,508 1,058,972 264,508Costs and Expenses:Cost of products sold........................... 31,160 31,160 31,160Salaries and benefits........................... 42,172 42,172 42,172General and administrative...................... 99,847 99,847 246,554Provision for relocation........................ 0 0 0Area Developer Costs and Expenses 991,561Total costs and expenses..................... 173,179 1,164,740 319,886Income From Operations............................ 91,329 -105,768 -55,378Interest expense, net........................... -14,446 -14,446 -14,446Gain on issuances of subsidiary's stock......... 38,163 38,163 38,163Other income, net............................... 137 137 137Total other income (expense)................. 23,854 23,854 23,854Income Before Income Taxes and Minority Interest..........................115,183 -81,914 -31,524Income Taxes...................................... 42,990 0 0Minority Interest in (Earnings) of Subsidiary..................................-5,235 5,940 2,286Net Income........................................ 66,958 -75,974 -29,238Net Income Per Share $1.01 -$1.14 -$0.44Shares Outstanding............................… 66,501 66,501 66,501

Pro Forma Consolidation Computations

Restated Revenue = Reported Revenue + Revenue of Boston Market Financed Area

Developers + Revenue of ENBC Financed Area Developers – Revenue Received by Boston Chicken from Area Developers

= 264,508 + 865,082 + 109,940 – 115,510 – 65,048= 1,058,972Restated Costs and Expenses = Reported Costs and Expenses + Expenses of Boston Market

Financed Area Developers + Expenses of ENBC Financed Area Developers – Expenses Paid by Area Developers to Boston Chicken

= 173,179 + (865,082+156,505) + (109,940+40,592) –115,510 – 65,048

= 1,164,740

Pro Forma Consolidation Computations (continued)

Restated Income Taxes

Income taxes are set to zero, as Boston Chicken is making pre-tax losses, and it is not reasonably certain that they will be able to offset the losses against future income.

Restated Minority Interest

This is recomputed by assuming that the minority stockholders have the same proportionate interest in pre-tax income

as reported % interest = -5,235/(115,183-42,990) = -7.25%

restated minority interest = -7.25% of -81,914 = 5,940

Pro Forma Provision Computations

• Setting the Provision for Bad Debts at 10% of notes receivable issued during the period, we have:

Provision = 10% of 1,467,065* = 146,707 *This amount is found in the investing section of the statement of cash flows

• Including the provision in General and Administrative Expense:

Restated G&A Expense = Reported G&A Expense + Provision

= 99,847 + 146,707 = 246,554• Taxes and Minority Interest use same approach as in pro forma

consolidation computations

Future Events That Will Cause Problems to Surface

Capital markets recognize problems with business strategy and refuse to provide additional capital on favorable terms

Area developers will be forced to default if they receive no new loans from Boston Chicken

OR Boston Chicken will have to covert the area developer loans to

equity and begin to consolidate their losses

Auditors recognize poor performance of area developers is likely to continue and require a provision to be charged against notes receivable

Extracts From Boston Chicken’s 1997 Annual Report (MD&A section)

RESULTS OF OPERATIONS Fiscal Year 1997 Compared to Fiscal Year 1996 General and Administrative. Included in general and administrative expenses for 1997 were special charges of $120.0 million primarily for asset write-downs and provisions associated with the Company's strategic redirection and the moratorium on new store development. Also included in general and administrative expenses for 1997 were special charges of $15.5 million incurred by ENBC primarily in connection with its transition to a company-owned system. Included in general and administrative expenses for 1996 were special charges of $38.0 million for asset write-downs and a provision to purchase certain store equipment from Boston Market area developers. Absent these items, general and administrative expenses increased $95.2 million or 154% for 1997 compared to 1996. The increases in general and administrative expenses, exclusive of the special charges, included $61.5 million associated with operating a larger Company store base and $23.0 million of greater depreciation and amortization expense resulting primarily from the acquisition of Company stores and ENBC's conversion to a company-owned system.


RESULTS OF OPERATIONS Fiscal Year 1997 Compared to Fiscal Year 1996 Provision for Loan Losses. The Company established a $128.0 million provision for potential loan losses in 1997 after a determination that portions of its loans to certain of its area developers may not be recoverable. The provision for potential loan losses was based upon a number of factors that management deemed relevant, including the use of loan proceeds, the form and amount of consideration proposed in the acquisition of BCEF and Market Partners, and evaluations regarding the cost and availability of capital and the value of the collateral securing the loans. There can be no assurance that the Company's loan recoverability analysis will not result in the Company establishing additional provisions for potential loan losses in subsequent quarters.


RESULTS OF OPERATIONS Fiscal Year 1997 Compared to Fiscal Year 1996 Losses of Boston Chicken, Inc.'s Area Developers. Since October 1997, the Company has recognized, in a single line item on its statement of operations, the net losses of the area developers in which BCEF and Market Partners have preferred equity interests. Such losses, which aggregated $49.4 million, include $42.0 million of special charges and non-cash charges taken by these area developers, which primarily relate to store closures. Such amount represents the net losses (reduced by the amount of royalties, franchise and related fees and interest not recognized by the Company) of the area developers commencing from the date the Company announced its intent to acquire BCEF and Market Partners in October 1997. The Company will continue to recognize the area developer net losses in a single line item on its statement of operations until it has acquired a majority equity interest in such area developers through conversion of its convertible loans to such area developers or other acquisition by the Company of such area developers. Upon acquisition of a majority equity interest in an area developer, the Company will then consolidate such area developer's results of operations in its financial statements.

Key Takeaways

Make sure you understand the nature of the business strategy. Some business are not what they first seem.

Do not assume that rapid sales growth reflects a viable business strategy. It is easy to grow when you are selling something for less than it cost.

If a business seems to be doing very well in a highly competitive environment, make sure that you understand the source of its competitive advantage and its sustainability.

boston chicken case. case overview rapidly growing restaurant chain is one of the hottest names on...

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