FINANCIAL STATEMENT

ANALYSIS & VALUATION

Third Edition

Peter D. Mary Lea Gregory A. Xiao-Jun

Easton McAnally Sommers Zhang
 Harvard Case:
Boston Chicken, Inc.
Boston Chicken Case Purposes
1. Provide you with an opportunity to dig into many of the information sources
provided by firms.
• Management Discussion & Analysis
10-K SEC
• Financial Statements Filing
• Notes to the Financial Statements
• Report of Independent Auditor (Arthur Andersen, LLP)
• Analyst Report (Lehman Brothers)
Information
• Short Seller Report (Axiom Capital Management) Intermediaries
• Business Press Article (Washington Post)

2. Provide you with an opportunity to conduct strategy analysis and earnings

quality analysis.
Overview: Boston Chicken, Inc.
• Rapidly growing restaurant chain

• One of the hottest names on Wall Street

• Sales and earnings show consistent growth

• Market offerings:
• 1993 IPO: offering price $10, price soared to $26.50 before settling around $18 - raised $19 million
• 1994 SEO: raised $105 million
• 1994 Debentures: raised $125.7 million
• “As capital requirements increase, the Company will seek additional funds from future public or
private offerings of debt or equity securities.” (p 10)
Question 1

• Briefly outline Boston Chicken’s business strategy. Identify Boston Chicken’s

key competitors and identify their competitive advantage. Assess the
potential for entrants and substitutes.
1a. Broad elements of business strategy

• Pioneer of the ‘Home Meal Replacement’ concept. Hearty,

home-style cooking with fast-food convenience.
Macro-economic factor:
• Value “From 1970 to 1993, the proportion
• Meals < $5 per person of dual-earnings couples increased
from 39% to 61% of all married
couples.”
• Convenience Source: Blau, Berber, and Winkler 1998, The Economics
of Women, Men and Work.
• Take-out or on-site dining
1a. Specific elements of business strategy
• Grab “Stomach-share”: Use a network of 22 ‘Area Developers’ to facilitate rapid
expansion strategy into 60 large U.S. markets
• 34 stores in 1991
• 534 stores in 1994
• 750 stores in 1995
• On average, ~ 1 new store being opened every 2 days

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

• Strategy appears to be working - EPS is growing, and is expected to continue to

grow in the future
1b. Key competitors

• Pizza

• KFC

• Supermarkets
1b. Competitive advantage

• Per Washington Post:

“There is nothing particularly new about rotisserie chicken – those birds have been
turning succulently in delicatessen windows for generations. But Boston Chicken is not
really about poultry – it is about developing a market-winning formula for picking real
estate, designing stores, organizing a franchise operation and analyzing data. These are
Boston Chicken’s innovations – trade secrets that can be every bit as valuable as a new
drug or computer chip design.”

• Key question: Is this a durable advantage?

1c. Potential entrants & substitutes

• Potential entrants
• Existing players:
• Few barriers here - KFC quickly added rotisserie chicken to its 5,100 restaurants
(comp to BC’s 534 restaurants) and quickly became the market leader
• New players:
• Barriers are higher given BC’s rapid expansion strategy

• Substitutes
• Clear threat from supermarkets
Question 2

• Describe the critical success factors and risks associated with Boston
Chicken’s business strategy.
2. Critical success factors and risks
• Success factors:
• Quality of ADs
• Rapid growth into new markets – growth achieved through the use of franchise agreements
• Management of existing and new store operations to ensure that stores are profitable -
requires balancing of quality and costs

• Risks:
• Losing control of business operations due to rapid expansion and franchising strategy
• Access to capital for growth
Question 3
• In Boston Chicken’s 1994 balance sheet (see page 11), total Notes Receivable
(current and long-term) exceed $200 million. Explain how these Notes
Receivable arise.

• Answer: From page 19, “The Company currently offers partial financing to certain area
developers for use in expansion of their operations. Certain of these financing
arrangements permit the Company to obtain an equity interest in the developer at a
predetermined price after a moratorium (generally two years).”
Question 4
• Does Boston Chicken’s accounting assume that any of the Notes Receivable
will ultimately be uncollectible?
• Answer: No. From page 20, “The allowance for credit losses is maintained at a level
that in management’s judgment is adequate to provide for estimated possible loan
losses. The amount of the allowance is based on management’s review of each area
developer’s financial condition, store performance, store opening schedules, and
other factors, as well as prevailing economic conditions. Based upon this review and
analysis, no allowance was required as of December 26, 1993 and December 25,
1994.”
• Do you believe the assumptions embedded in the accounting for Notes
Receivable are reasonable?
Question 5
• Recompute after-tax net income for 1994 assuming that 1% of these Notes
Receivable will ultimately be uncollectible. Perform the same computation
assuming a 3 and 5% allowance for bad debts.
Question 5
Assumed Uncollectible
Reported 1% 3% 5%
NI Before Tax 20,450 20,450 20,450 20,450
BDE - 2,013 6,038 10,063
NI Before Tax 20,450 18,437 14,412 10,387
Taxes 4,277 3,853 3,012 2,171
NI After Tax 16,173 14,584 11,400 8,216
Question 6

• What is Boston Chicken’s line of business? That is, if you had to assign
them to an industry, which industry would you choose?
Possible Answer 1
• They are a restaurant….

1992 1993 1994

Royalties and franchise-related fees 2,627 12,681 55,235
Company-operated stores 5,656 29,849 40,916
Total revenue 8,283 42,530 96,151

% Royalties and franchise-related fees 32% 30% 57%

% Company-operated stores 68% 70% 43%
Possible Answer 2
• They are a franchisor….

1992 1993 1994

Royalties and franchise-related fees 2,627 12,681 55,235
Company-operated stores 5,656 29,849 40,916
Total revenue 8,283 42,530 96,151

% Royalties and franchise-related fees 32% 30% 57%

% Company-operated stores 68% 70% 43%
Possible Answer 3
• They are a bank….
Company-operated 19 38 41
Financed area developers 3 78 314
Non-financed area developers and other 61 101 179

Percent franshished stores that are financed 5% 44% 64%

Possible Answer 3
• They are a bank….
1994 1993
Assets
Current assets
Cash $25,304 4,537
Accounts receivable, net 6,540 2,076
Due from affiliates 6,462 3,126
Notes receivable 16,906 1,512
Prepaid expenses & other current assets 2,282 1,843
48% of assets Deferred income taxes 1,835
are tied up in Total current assets 59,329 13,094

N/R Property & equipment, net 163,314 51,331

Notes receivable 185,594 44,204
Deferred financing costs 8,346 358
Other assets 10,399 1,077
Total assets 426,982 110,064
So what is Boston Chicken’s line of business?

• It’s a bank!: The balance sheet suggests that most of the assets are tied up in the financing
business.

• It’s a franchiser!: The income statement suggests that most of the revenues and earnings
are generated by the franchise business.

• It’s a restaurant?: …they do sell chicken.

• They are kind of like a bank that tells its customers what to do, lends them the money, and
then becomes a major supplier.

• Key Question: How is Boston Chicken not like a bank?

Question 7
• Estimate the after-tax net income per year for a franchised store. Note: this
is a very challenging computation – the discussion on page 5 provides a
good place to start.
Question 7
Lower Bound Upper Bound From pg 5
Average weekly sales per store 23,388 23,388
EBITDA margins 15% 16%
Annual EBITDA 182,426 194,588 *
Less: Depreciation expense (134,000) (101,000) **
Less: Interest expense (59,300) (59,300) ***
Income before taxes (10,874) 34,288
Taxes 3,806 (12,001) Assume 35%
Net income (7,068) 22,287
* Annual EBITDA = $23,388 * 52 * EBITDA margin
** Depreciation expense estimated as average amount invested in each new company-operated store over the past
two years, depreciated over 15 years for lower bound estimate and 20 years for upper bound estimate.
• 1993: 28 new company-operated stores, $49,151 invested = 49,151/ 28 = $1,755
• 1994: 49 new company-operated stores, $163,622 – 52,300 invested in corp HQ = 111,322 / 49 = $2,272
• Average = $2,014; Lower bound = $2,014/15 = $134; Upper bound = $2,014/20 = $101
*** Interest expense estimated by dividing $11,632 interest from area developers by average # of area developer
stores (196) = 11,632/196 = $59.3
Important Questions
• What is the point of the preceding exercise?
• What do the results tell us about BC’s reported numbers?
Tangents
• Restaurants on Dickson Street
• Margins and Turns – BC
• Margins and Turns - Chipotle
Question 8
• What do sophisticated market participants (i.e., analysts and short sellers)
think about Boston Chicken’s prospects and current market valuation?
Question 8
• Lehman Brothers:
• Strong buy
• EPS will grow 45% from 1997 to 2001

• Short interest is high and rising

Question 8: Clear message from the analysts: Buy!
100

1 Analyst
90

80

70

60

50

6 Analysts
40

30

20

10

4
-9 4

-9 4

-9 5
c- 9

r -9
Ju n

Sep

Ju n
Ma
De

% of Analysts saying "Buy" % of Analysts saying "Hold" Sell Percentage

Key question: Why do you think analysts like BC so much?

Question 8: Clear message from smart money: “Short the chicken!”
Short Interest Ratio
# of shares sold short / total shares outstanding
16%

14%

12%

10%

8%

6%

4%

2%

0%
-9 4 -9 4 94 -9 4 -9 4 -9 4 95 -9 5 -9 5
Mar Apr Ju n - Aug Sep Nov J an - Feb Apr

Average short interest ratio for U.S. common equities

So what has happened to Boston Chicken since 1995?

• Area developers losing money:

• $51.3 M in 1994
• $148.3 M in 1995
• $156.5 M in 1996

• Filed for Bankruptcy (Ch. 11) in 1998

• McDonalds acquired the whole thing for $173.5 million in December 1999 (deal
closed in May 2000)
• Only senior secured creditors got anything

• Sold by McDonalds to Sun Capital Partners in 2007

 Stock Price
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Ma Jun Se De Ma Ma Au No Fe Ma Au No Fe Ma Au No Fe Ma
 Analyst Recommendations
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90
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Sep

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% of Analysts saying "Buy" % of Analysts saying "Hold" Sell Percentage

Short Interest Ratio

35%

30%

25%

20%

15%

10%

5%

0%
-94 94 -95 95 -96 96 97 98 Jul-9
8 99
Mar Sep- Apr Oct- May Dec- Jun- Jan- Feb-
A Chicken Autopsy

This one-time highflyer will go down as one of the decade’s great

disasters in which the accounting, while perfectly kosher, helped
perpetuate a charade of profits that masked the real business
fundamentals. In other words, it’s a tale of why studying a company’s
public filings with a skeptical and astute eye toward economic reality is
always a good idea.

Source: www.fool.com (November 7, 1998)

Key Takeaways
• Make sure you understand the business strategy. Some businesses are not what
they first seem.
• If a business seems to be doing very well in a highly competitive environment,
make sure that you understand the source of its profitability.
• Is the competitive advantage sustainable?
• 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 costs.
• Read the notes to the financial statements carefully and challenge assumptions
that appear to be unreasonable.
• Be cautious when firms repeatedly dip into the capital markets to raise money.