Introduction
Boston Chicken is a traditional American success story and a stellar representation of the new economy. Founded in 1989 by Scott Beck, the idea was to franchise restaurants that featured home style rotisserie-cooked chicken at affordable prices. While the actual food offerings were nothing new, the market winning formula for picking real estate, designing stores, organizing franchise operations and analyzing data was nothing short of a breakthrough. Due to an innovative competitive advantage, Boston Chicken sustained a growth rate that drew both lucrative and discerning attention. This report looks to analyze what key factors led to such rapid growth, Boston Chicken’s accounting policies, as well as a comprehensive valuation of the firm that concludes with a recommendation for further action.
Critical Success Factors
Boston Chicken was a hybrid restaurant that offered affordable, home-style meals with the convenience of fast food. The company can attribute their stellar success to several success factors including their: growth rate, communications infrastructure, diversified product offerings, and operational efficiency.
Beginning with growth, by the end of 1994, only 5 years after launch, Boston Chicken was comprised of over 500 stores, a stark comparison to their 34 stores at the end of 1991. The company had experienced an annual growth rate of nearly 500%, which correlates to a new store being built every other day. Such stellar growth translated into significant market share capture rates, and solidified the chain’s products into the minds of hungry American consumers.
Boston Chicken can attribute a large portion of their success to their communications and technological infrastructure. Their computer software support network was able to translate counter sales into usable knowledge for product re-ordering, preparation timetables, product offering recommendations, and employee utilization. With the addition of touch-activated computer terminals, the company was able to communicate directly with their customers; nearly instantaneously, the company could recognize how customers perceived a restaurants atmosphere, product offering, and staff. Therefore, the company was able to tailor individual restaurants within a matter of weeks based on real-time customer input.
Boston Chicken also grew fast because they had a diverse product offering. Besides offering chicken and fresh vegetable sides such as mashed potatoes and corn, in 1994 and 1995, the company added vegetable pot pies, Caesar salad, and cinnamon rotisserie-roasted turkey, ham, and meat loaf to their menu. This diversification enabled them to mitigate the effects of seasonal market downturns, especially in the fall; the company was now able to generate income by offering prepared turkey and ham to families during the Thanksgiving and Christmas season, which was generally the firm’s slowest time of the year. Additionally, the company entered the bagel industry, which according to Michael Moe of Lehman Brothers was “one of the hottest growth areas in America.”
Lastly, Boston Chicken’s cornerstone for success was their overall operational efficiency. In addition to the speed of their growth, the company was able to efficiently grow as well. In order to add such a large number of new locations, the firm employed 180 real estate and construction professionals that handled locating, building, and standardization tasks, thus taking pressure off of corporate for such responsibilities. Boston Chicken had the capacity to open 325 stores per year if demand required. Instead of franchising just a few locations at a time, new franchisees were expected to open a minimum of 50 new stores. Because of these large growth commitments, the company only dealt with 22 regional franchise partners, instead of hundreds as their competition did. The company had a diverse range of income, as it collected startup franchise fees, opening fees, annual royalties, advertising contributions, and interest earned from providing lines of credit to assist franchisees. Lastly, the company did not always rely on new stores, but rather capturing additional market share in existing markets. The company added things such as drive through windows, which two thirds of customers indicated being the defining reason for their visit to the restaurant. The company ended up converting 70% of its stores to being drive through capable.
Risks
The company faced multiple risks. The $200B restaurant industry was extremely competitive, and consumers had many substitute offerings other than Boston Chicken. Kentucky Fried Chicken (KFC) started competing directly with Boston Chicken when it started offering its own version of rotisserie chicken. The well-established KFC, with over 5,000 stores, quickly overshadowed Boston Market and became the world’s largest rotisserie chicken retailer. Aside from direct chicken competition, Boston Chicken’s founder Scott Beck said “our number one competitor is pizza,” thus representing both direct and indirect forms of competition.
Another area of concern for the company was the rapid rate at which it was growing. In order to sustain such a rapid rate, the company would have to be earning an average of $23,000 in sales per store per week to just break-even, and this was not happening. Instead, according to Roger Lipton and Lipton Financial Services, the firm was earning only roughly $18,900 per store per week, representing a net loss for the franchisees and company as a whole. Mr. Lipton also noted that the quality of earnings is low, as it comes primarily from fees, royalties, and interest payments instead of from the sale of its products.
Accounting Policies
For the most part, the accounting policies in place by Boston Chicken were normal and are what one would expect to see from a company. However, there were two areas that seemed to be a little different that would make the finical statements less transparent to the reader. The first area is how they accounted for income taxes, specifically the deferred tax assets. As of December 25, 1994, Boston Chicken had cumulative Federal and State net tax operating loss carry forwards available to reduce future taxable income of approximately $30.5 million. The area of concern would be that Boston Chicken recognized the benefit of the deferred tax asset for financial reporting purposes, but not for income tax purposes. The notes also mention that there would be certain ownership changes that would result in annual limitation of the company’s utilization of those deferred tax assets. This could increase the appearance of the current financial statements because the deferred tax asset is being recognized now. Although, since it is not being reported from an income tax perspective, the benefit is actually not being utilized until a later date.
The only other accounting issue is related to its marketing and advertising funds. The company established a “National Advertising Fund” in which amounts are collected from the individual stores by an agreed upon 2% of its revenues. The problem is that Boston Chicken does not segregate these amounts from the other cash resources of the company; the National Advertising Fund itself is accounted for separately and not included in the financial statements of the company. Furthermore, Boston Chicken also establishes a Local Advertising Fund that supports local marketing and is collected on an agreed upon 3% to 3.75% of each stores’ revenues. The company then distributes the funds and accounts for all transactions, but, again, these amounts are not segregated from the other cash resources of the company. Both of these funds have had accumulated deficits at years end of 1993 and 1994, which were both funded by advances from the company and are reflected as, “due from affiliates.” Not segregating the cash to these accounts from other cash amounts could be confusing to the reader of the financial statements as it could seem as Boston Chicken has more available cash than it actually does.
Comprehensive Valuation
In order to perform a comprehensive valuation of Boston Chicken’s common stock, three valuation methods were implemented: discounted cash flows (DCF), abnormal earnings, and P/E multiples. Each of these three methods were weighted using a 40-40-20 triangulation approach.
Discounted Cash Flows
Using the DCF method of valuation, the common stock of Boston Chicken was estimated to have an intrinsic value of $17.02 assuming no growth, and a value of $31.79 assuming 5% terminal growth rate. Exhibit 1 illustrates the calculations required to arrive at these valuations. The first step in the DCF method requires the prediction of earnings per share (EPS). The random walk with hyperdrift (n=2) was used to forecast Boston Chicken’s earnings from the years 1995 to 1999, Exhibit 2 details the calculations of the drift term and EPS forecasts. Since Boston Chicken went public in 1993, it was assumed that there will be substantial growth for the next five years. As discussed by Palepu and Healy (2013), it is best to use a forecast horizon ranging from five to ten years when valuing a company; therefore, Boston Chicken’s earnings were forecasted up to 1999, at which point a terminal value was determined.
The number of shares outstanding was another critical input variable to the DCF method. The number of shares increased by about 31% between 1993 and 1994, so this is the growth rate that was used for the first year. After that, it was assumed that this rate would decrease to 15% because Boston Chicken’s growth will stabilize to a more moderate level.
Depreciation and amortization increased more than 200% between 1993 and 1994, mainly because of Boston Chicken’s “substantially higher fixed asset base reflecting the Company’s investment in its infrastructure.” This high growth in depreciation is unlikely to continue into the future because Boston Chicken has already grown so much and invested heavily in its infrastructure. Therefore, it is assumed that in the upcoming years, Boston Chicken’s depreciation will grow by 15% in the first year, 10% in the next, and 5% thereafter. Similarly, the change in capital expenditures was substantial between 1993 and 1994. Therefore, it was assumed that a constant 5% growth would be a reasonable assumption to use for all years in the forecast horizon.
The investment in working capital was calculated between years 1993 and 1994. The random walk model was implemented with this investment, so it remained constant throughout all of the years.
Utilizing all of these assumptions, free cash flows were generated for each year. These values were then discounted using a discount rate of 10.54%, Boston Chicken’s assumed cost of equity. This rate was calculated using the CAPM, including the thirty year Treasury bond rate of 6.04%, a market risk premium of 3%, and a beta of 1.5.
Abnormal Earnings
Implementing the abnormal earnings method of valuation, Boston Chicken’s common stock’s has an intrinsic value of $33.08 assuming no growth, and $51.98 assuming a 5% terminal growth rate. Exhibit 3 shows the calculations used to arrive at these values. For each year in the forecast horizon, the equity book value and cost of equity were used to determine Boston Chicken’s normal earnings. The cost of equity was calculated in the same manner as for the DCF method. Then the net earnings were calculated by multiplying Boston Chicken’s predicted EPS by its forecasted number of shares outstanding. The same assumption used in the DCF method regarding growth in the shares outstanding and EPS was applied in the abnormal earnings method as well; Exhibit 4 shows the calculations. The normal earnings was subtracted from the net earnings to arrive at Boston Chicken’s abnormal earnings.
The abnormal earnings for each year in the forecast horizon was then discounted using the cost of equity, 10.54%, to arrive at the predicted intrinsic value of the common stock for the year 1995.
P/E Multiples
Using P/E multiples, it was predicted that the intrinsic value of Boston Chicken’s common stock is $14. The P/E multiples of four competing firms were averaged in order to arrive at a proxy for Boston Chicken’s P/E multiple. Exhibit 5 lists the four competitors that were chosen, along with each one’s P/E multiple, and the average P/E multiple used in Boston Chicken’s valuation. The primary reason for choosing these competitors were because Boston Chicken’s main competitors are restaurants serving pizza and chicken. More recent P/E multiples were used in calculating the average because of the lack of access to historical P/E values for the competing firms. Yum! Brands, Inc.’s P/E ratio was found as of 2009, and the rest of the competing firms’ P/E ratios are current. The average P/E multiple used to value Boston Chicken’s stock was 23.6.
Exhibit 6 summarizes the estimations of the intrinsic value of Boston Chicken’s common stock using the DCF, abnormal earnings, and P/E multiples weighted 40%, 40%, and 20%, respectively. Assuming no terminal growth, the stock’s intrinsic value is estimated to be $22.84, and assuming a 5% terminal growth rate it is predicted to be $36.31. As of December 1, 1995, Boston Chicken’s common stock was valued at $33.75, which is not significantly different than the estimated value assuming 5% terminal growth. Therefore, it is recommended to hold the stock and reevaluate in a few years.
Sensitivity Analysis
In order to determine which variables the intrinsic value estimates are most sensitive, a sensitivity analysis was conducted. The sensitivity analysis was applied on the following variables: market risk premium, growth in shares outstanding, growth in depreciation and amortization, growth in capital expenditures, the terminal growth assumption, and the average P/E multiple.
According to Palepu and Healy, the “expected risk premium in the market in recent years has been between 3 and 5 percent.” Since a 3% market risk premium was used in the initial valuation, 5% was used in the sensitivity analysis in order to see what effect this variable has on the intrinsic value of Boston Chicken’s common stock. This resulted in an intrinsic value of $15.73 assuming no terminal growth, and $21.13 assuming a 5% terminal growth rate. These results are summarized in Exhibit 7.
The rate of growth in the number of shares outstanding was the next variable that was included in the sensitivity analysis. The growth rates used in the initial valuation was 31% for the first year and then 15% until the terminal value. The rates were increased and decreased for high and low scenarios, respectively, as shown in Exhibit 8. The intrinsic values ranged from $12.40 to $28.26 assuming no terminal growth, and from $18.34 and $45.74 assuming a 5% terminal growth rate.
The rate of growth in depreciation and amortization was the next variable included in the sensitivity analysis. The growth rates used in the initial valuation was 15% for the first year, 10% for the second year, and then 5% thereafter. The rates were changed to a constant 5% growth and a constant 15% growth for low and high scenarios, respectively, as shown in Exhibit 9. The intrinsic values ranged from $22.77 to $23.01 assuming no terminal growth, and from $36.20 and $36.60 assuming a 5% terminal growth rate.
The rate of growth in capital expenditures was the next variable that was included in the sensitivity analysis. The growth rate used in the initial valuation was a constant 5%. This rate was increased and decreased to 10% and 3% for high and low scenarios, respectively, as shown in Exhibit 10. The intrinsic values ranged from $20.80 to $23.56 assuming no terminal growth, and from $32.89 and $37.52 assuming a 5% terminal growth rate.
The rate of terminal growth was the next variable that was included in the sensitivity analysis. The growth rate used in the initial valuation was 5%. This rate was increased and decreased to 3% and 7% for low and high scenarios, respectively, as shown in Exhibit 11. The intrinsic values ranged from $28.78 to $52.35.
Finally, the sensitivity analysis was used to evaluate the average P/E multiple because, in the initial valuation, the recent P/E ratios were used instead of ratios from 1995. Therefore, the average P/E multiple used in the initial valuation was increased by 10% to 25.96, and decreased by 25% to 17.7, as shown in Exhibit 12. The intrinsic values ranged from $22.14 to $23.12.
The performed sensitivity analysis showed that all variables included in the valuations were significant except the growth in depreciation and amortization and the average P/E multiple. If Boston Chicken expects an increase in the growth of the number of shares outstanding to 31% in the first year and then 20% thereafter, or an increase in its terminal growth rate to 7%, its common stock’s intrinsic value would increase. Therefore, the recommendation would be changed from hold to buy. Otherwise, the changes in the other variables resulted in favor of a sell or hold recommendation.
Conclusion
Assuming that the initial assumptions are representative of Boston Chicken’s predicted future performance, it would be recommended to hold the stock. Boston Chicken is performing well now, although the future is highly uncertain and there are many other external factors, such as competition and the economy itself that might affect the value of the stock in the future. Also, the sensitivity analyses showed that a slight decrease in growth assumptions lead to a decline in the intrinsic value of Boston Chicken’s stock. Therefore, for the investors who are currently holding the Boston Chicken stock, it is recommended to sell.