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
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
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
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
Summary of Business Strategy (5)

 Key Success Factors Associated with

Restaurant Business
 Fist mover advantage in ‘Home Meal Replacement’
concept
 ‘Boston Market’ brand name
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
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 INC
1996 Income Statement (restated) As Pro Forma Pro Forma
Figures in thousands unless noted Reported Consolidation Provision
------------ ------------ ------------
Revenue:
Royalties and franchise related fees............ 115,510 0 115,510
Company stores.................................. 83,950 83,950 83,950
Interest income................................. 65,048 0 65,048
Area Developer Revenues 975,022
Total revenue................................ 264,508 1,058,972 264,508
Costs and Expenses:
Cost of products sold........................... 31,160 31,160 31,160
Salaries and benefits........................... 42,172 42,172 42,172
General and administrative...................... 99,847 99,847 246,554
Provision for relocation........................ 0 0 0
Area Developer Costs and Expenses 991,561
Total costs and expenses..................... 173,179 1,164,740 319,886
Income From Operations............................ 91,329 -105,768 -55,378
Interest expense, net........................... -14,446 -14,446 -14,446
Gain on issuances of subsidiary's stock......... 38,163 38,163 38,163
Other income, net............................... 137 137 137
Total other income (expense)................. 23,854 23,854 23,854
Income Before Income Taxes and Minority Interest..........................
115,183 -81,914 -31,524
Income Taxes...................................... 42,990 0 0
Minority Interest in (Earnings) of Subsidiary..................................
-5,235 5,940 2,286
Net Income........................................ 66,958 -75,974 -29,238
Net Income Per Share $1.01 -$1.14 -$0.44
Shares 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
= 1,058,972
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
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.
Extracts From Boston Chicken’s
1997 Annual Report (MD&A section)

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