Boston Chicken Case

1. Boston Chicken Case

2. 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

3. 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.

4. 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

5. 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

6. Summary of Business Strategy (2) • 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

7. Summary of Business Strategy (3) • 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

8. Summary of Business Strategy (4) • 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

9. Summary of Business Strategy (5) • Key Success Factors Associated with Restaurant Business • Fist mover advantage in ‘Home Meal Replacement’ concept • ‘Boston Market’ brand name

10. Summary of Business Strategy (6) • 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

11. 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).

12. 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?

13. 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’.

14. 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.

15. Boston Chicken Restatement

16. 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 = 1,058,972 Restated 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

17. 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

18. 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

19. 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

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

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

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

23. 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.