Business Analysis using financial statement

Boston Chicken, Inc.

Case Analysis

Boston Chicken, Inc.Objectives

• To illustrate analysis of assets—how to value the loans to the area developers.

Boston Chicken reported the loans at face value, with no allowance for bad debts. How to appreciate the loans.

• Comprehensive security analysis—covering strategy analysis, accounting analysis and financial analysis.

Boston Chicken, Inc.Overview

• Boston Chicken developed a new segment of the fast food restaurant business, home-cooked food

• The company sought to grow rapidly by signing franchise agreements with large area developer.

• The company provided sizable loans to help developers finance new restaurant.

• These loans was financed through public stock and convertible debt issues made by Boston Chicken.

Analysis of Boston Chicken’s Strategy

• Created a new segment in the highly competitive fast-food restaurant industry—take-out home-cooked food.

Engaged in three businesses—operating restaurant, selling franchises, and financing area developers

• Major competitors Existing take-out chains such as KFC: few barriers to entry,

but has a different concept. New take-out competitors: potential barriers for entry Supermarkets: be unlikely to compete• Boston Chicken’s success depends on its ability to expand

rapidly and develop its brand name.

Boston Chicken, Inc.Critical Success Factors

• Rapid growth into new geographic markets.

The company used franchising to leverage its idea. Under these agreements, it sells the right to build and operate restaurants to area developers and uses the developers’ financing, management talent and local information as a way of growing the business

• Management of existing and new store operations

Incomes come from royalties on system-wide franchise sales and from its own store operations. Boston chicken’s success depends on both businesses. (I/S)

Boston Chicken, Inc.Critical Success Factors

A number of recent operational changes:• Long term agreements with supplies-

locking in food price• Flagship stores• Adding menu items to increase sales at off--

peak times• Store improvement-in store computer

feedback and drive –thru lanes.

Boston Chicken, Inc.Risks

• Losing control of the business operations as a result of its focus on rapid growth.

Excess focus on growth could lead to reduced quality of operations, increased food wastage, and lower profitability of franchise operations

• The growth strategy also puts a heavy strain on cash management, since funds are required

for growth.

Boston Chicken, Inc.Key success and risk factors reflected

in the financial statements• Revenues are recognized for franchise fees and

development fees when the store opens.• Revenues from royalties are recognized when the

store generates sales Pre-opening costs are amortized over one year.(notes 2)

• Financing costs on notes receivable to franchisees are shown as earned. However, the company makes no allowance for defaults on these notes. (B/C and notes 8c)

Boston Chicken, Inc.Analysis of notes receivable to

franchisees• The notes are structured to give the parent

the option to convert the loan into equity in the franchisee at a 12-15% premium over the equity price at formation of the franchise(how do you think this option)

• We can estimate the income statement effect of changing the assumption for franchisee defaults.

Boston Chicken, Inc. Analysis of notes receivable to franchisees(cont.)

1% allowance 3% allowance 5% allowance

Net income before tax $20,450 $20,450 $20,450Bad debt expense on $202,500 notes receivable 2,025 6,075 10,125Adjusted net income before tax $18,425 $14,375 $10,325Percent Change -10% -30% -50%

•The company shares both the upside and downside risk for financed franchise restaurants according to agreement of franchise.

•The company avoided consolidating the financed developer operations in its financial statements.

Boston Chicken, Inc.Analysis of notes receivable to franchisees(cont.)

• The company effectively has control over the financed area developers through its option to purchase—recommend consolidating.

• How consolidation would change the financial statements of Boston Chicken?

(1) The royalty, franchise fee and interest income would be eliminated.

(2) The company would show its share of the sales revenue and cost from the stores.

(3) The notes receivable would be eliminated and the company would report its share of the assets and liabilities of the franchisees

Boston Chicken, Inc.Are Franchisees Profitable

• Whether franchisees are profitable or not is a key factor for accessing the value of the notes receivable.

• We can estimates the profitability of store for franchisees by the two ways.

(1) Use data for the company-owned stores (2) Use data of franchise profitability

provided by the company.

Boston Chicken, Inc. Use data for the company-owned stores

($ in thousand)

Company operated store revenue $40,916(P4-32)

Average number of owned stores 39.5[(38+41/2) P4-27]

Revenue per average store $1,036

Gross margins(100%-15,876/40,916) 61.2%

Less royalty and promotion fees 10.8%(5%+2%+3.75%)

Residual 50.4%

From this residual margin franchisees have to deduct wages and salaries, administrative costs, depreciation, interest, and taxes.

Boston Chicken, Inc.Use data on franchise profitability provided by the company.

The average system sales per week for the third quarter of 1995 were 23,388 and EBITDA margins were 15%-16%.($ in thousand)(P4-24)

Annual sales per store $1216(23,388*52)EBITDA 194.6(0.16*1,216)Depreciation(see below) (117.0)Interest (59.3)[11,632/(314+78)/2]Net profit before tax 18.3Depreciation is calculated as follows:1993 Boston Chicken capital expenditure $49,151(P4-33)Number of new owned stores 28(P4-27)Cost per store $1,755Expected life 15 yearsAnnual depreciation per store $117

Boston Chicken, Inc.What additional data would you request from management

• The analyses indicate that the franchisees are profitable at this level of sales($1,216).

• Some franchisees appear to be having cash flow problem. Footnote 7 points out Boston Chicken had been forced to make advances to franchisees to fund local and national advertising.(P4-37)

Boston Chicken, Inc. What additional data would you request from management

• The analyses are based on limited information and average data is incomplete, since it only takes one franchisee to fail, and Boston Chicken will incur a large loss in Notes receivable.

• Some additional information Same store sales Distribution of same store sales Late payments by franchisees. Security provided by developers such as any other

assets outside the franchise corporation.

Boston Chicken, Inc.How is Boston Chicken Performing

• Summary ratios for 1993-1994

Ratios 1994 1993

ROE(Ending equity) 6.2% 1.7%

=profit before tax/sales 21.3% 3.9%

*(1-average tax rate) 79.1% 100%

=after-tax profit margin 16.8% 3.9%

*sales/assets(end) 0.23 0.39

*asset/equity(end) 1.64 1.16

Boston Chicken, Inc. How is Boston Chicken Performing(cont.)

• Profit margins indicate the company’s performance for 1994 has improves markedly

• Increase in leverage from the introduction of convertible debentures during 1994.(Notes 4 P4-36)

• Decline in turnover, due to the increase in Notes Receivable.(P4-38 notes 8)

Boston Chicken, Inc.Future Prospects

• There are wide differences in opinion in the market about the company’s future prospects. This is reflected in the strong growth forecasts made by some analysts(as high as 45%), and the large short position in the company’s stock. This raise questions of how the market is valuing the company

• Analyst forecasts of future EPS are $0.63 in 1995 and $0.90 in 1996, with 45% growth until 2001.

• But some analysts thought that the quality of earnings is very low since all of Boston Chicken’s income comes from fees, royalties and interest payment from franchisees, most of whom were financed by the franchisers.(P4-24)

• Short interest positions in the stock were at an all-time high of 10 million shares, more than 20% of the shares outstanding and double the short interest position at the beginning of 1995.

Boston Chicken, Inc.Subsequent Events

• Boston Chicken continued to report increasing revenues and earnings in the fourth quarter of 1995 and throughout 1996

• At the end of 1996, the company provided information about loss $128 m

• From May to July 1997 B.C.’ share price plummeted 50%

• In October 1998 B.C. filed for bankruptcy• In December 1999 McDonalds agreed to acquire

B.C. for $173.5 m.