Wednesday, October 7, 1998
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Bookstore chain Barnes & Noble (NYSE: BKS) booked a $1 5/16 gain to $24 7/8 after announcing that German media giant Bertelsmann AG has agreed to pay $200 million for a 50% stake in the bookseller's online subsidiary, barnesandnoble.com. Under the agreement, the companies will contribute $100 million each to the joint venture. As a result, the planned initial public offering of barnesandnoble.com has been put on the back burner "temporarily." The deal is a coup for Barnes & Noble, which has struggled to overtake Amazon.com (Nasdaq: AMZN) as THE place to buy books online. This new alliance with the world's largest book publisher, which also has shown its Internet savvy with its European partnerships with America Online (NYSE: AOL), may be just the launching pad Barnes & Noble needs to surpass Amazon in terms of marketshare and mindshare. Investors placed their bets against Amazon today, driving its shares down $14 7/8 to $93 7/16 (see today's Fool Plate Special on Amazon), and apparently against competitor Borders Group (NYSE: BGP), which fell $1 13/16 to $22 13/16.

Internet music retailer N2K Inc. (Nasdaq: NTKI) spun up $1, or 22.2%, to $5 1/2 as the company confirmed that it is in discussions with rival CDnow Inc. (Nasdaq: CDNW) regarding a "possible transaction" between the two companies, though "no agreement has been reached." The Wall Street Journal today reported that CDnow will acquire N2K, which operates online music store Music Boulevard, in a stock swap that would create the industry's largest music website, with more than a million customers, and take Internet book and music selling powerhouse Amazon.com (Nasdaq: AMZN) head on. According to "people with knowledge of the talks," the combined company would merge under the CDnow name and be run by Jason and Matthew Olim, 29-year-old twin brothers who started CDnow four years ago. N2K Chairman and music industry veteran Larry Rosen (who was interviewed in StockTalk in August) would likely stay on in a senior management role.

QUICK TAKES: AT&T (NYSE: T) picked up $1 3/8 to $58 3/8 as the nation's largest long-distance company has launched a new brand, Lucky Dog Telephone Co., which will allow it to compete against "dial-around" phone carriers, such as rival MCI WorldCom's (Nasdaq: WCOM) Telecom USA (you know, "Just dial 10-10-321 then the number"). MCI WorldCom fell $1 to $43 15/16... Electronic connectors maker AMP Inc. (NYSE: AMP) gained $1 1/8 to $37 7/8 as its efforts to block an unsolicited takeover bid by AlliedSignal (NYSE: ALD) may be foiled now that the House in its home state of Pennsylvania passed conflicting amendments on corporate takeovers, supporting both companies' arguments. AlliedSignal shed $9/16 to $34 11/16.

Circuit board assemblies manufacturer Jabil Circuit (NYSE: JBL) climbed $1 3/8 to $36 3/8 after reporting fiscal Q4 EPS of $0.35 (before charges), compared with $0.47 a year ago and analysts' expectations of $0.32. For more info, see our conference call synopsis... Cellular phone and telecommunications equipment company Motorola (NYSE: MOT) rang up another $1 15/16 to $43 3/4 in the wake of reporting fiscal Q3 EPS of $0.07 before charges, down from the $0.51 earned last year but $0.06 above analysts' downwardly revised mean estimate... Enterprise software company Oracle Corp. (Nasdaq: ORCL) regained $1 3/16 to $24 3/8 as the company called a Reuters report about potential price cuts "highly misleading" and said that there was no change in the market for database software, adding that it has used the same wording it used to describe the current business environment in its 10-Q for the past 11 years.

Stocks of Japanese companies traded higher today on the back of a 803.97 point, or 6.2%, surge in the Nikkei index on expectations that the government would approve guidelines for recapitalizing banks to help stimulate the country's troubled economy. Toyota Motor Corp. (Nasdaq: TOYOY) sped up $4 7/8 to $48 7/8, Bank of Tokyo-Mitsubishi (NYSE: MBK) added $1 1/4 to $8, Kyocera Corp. (NYSE: KYO) jumped $3 to $45 1/2, and Tokio Marine & Fire Insurance Co. (Nasdaq: TKIOY) was lifted $4 5/8 to $49... The nation's second-largest credit card issuer MBNA Corp. (NYSE: KRB) charged up $1 1/4 to $15 after reporting Q3 EPS of $0.27, up from $0.21 a year ago and in line with analysts' estimates. Managed loans grew by $3.5 billion to $56.3 billion from the previous quarter.

STMicroelectronics (NYSE: STM) advanced $13/16 to $39 1/4 as Lehman Brothers reiterated its "buy" rating on the semiconductor maker, citing sequential growth of 1.6% in the worldwide semiconductor market in August, the first increase since November 1997, and the company's relatively limited exposure to economically challenged Japan... Call center systems manufacturer Aspect Telecommunications Corp. (Nasdaq: ASPT) rose $2 1/2 to $15 3/8 as concern about Q3 results dissipated. The company's shares had plunged 43% this week on rumors of a disappointing quarter... Imperial Chemical Industries (NYSE: ICI) American depositary receipts added $3 7/16 to $36 1/2 as the U.K. chemicals giant said it expects Q3 earnings in its main specialty-chemical units bought from Unilever NV to be "similar" to a year ago.

Mortgage lender Thornburg Mortgage Asset Corp. (NYSEL: TMA) jumped $1 1/8 to $7 as it said that its business strategy of investing in high quality adjustable-rate mortgage securities is still "sound" despite the dark cloud hanging over mortgage lenders following the Chapter 11 bankruptcy filing of Criimi Mae Inc. (NYSE: CMM)... Telecommunications and cable TV test access and test extension products maker Tollgrade Communications (Nasdaq: TLGD) gained $1 3/16 to $13 5/8 after announcing a multi-year, product development, license, and authorized reseller agreement with Lucent Technologies (NYSE: LU).


Chipmaker Advanced Micro Devices (NYSE: AMD) slipped $2 5/8 to $15 3/4 despite reporting a surprise $0.01 per share profit for fiscal Q3, ahead of the $0.11 per share loss expected by the Street. While folks normally prefer upside earnings surprises to the downside variety, investors may be reacting to a continued lack of visibility and accurate guidance from AMD. The past few quarterly earnings estimate rituals from AMD's analyst community have resembled games of pin-the-tail-on-the-semiconductor-donkey, with forecasts all over the place. For fiscal Q4, the 21 analysts surveyed by IBES offered estimates ranging from a loss of $0.13 per share to a profit of $0.25 per share of Oct. 1. Those forecasts will likely be massaged following last night's report, which was examined in greater detail in this morning's Breakfast With the Fool.

Internet sports media company SportsLine USA (Nasdaq: SPLN) was sacked for $8 11/16 to $7 11/16 after pre-announcing a fiscal Q3 loss of $0.41 per share, which the company says is in line with analysts' estimates. However, revenues will come in at a lower-than-expected $7.4 million, with Q3 advertising revenues forecasted to be flat with last quarter's $4.1 million figure. That SportsLine was unable to boost ad sales during a period that contained some of the best professional baseball playoff races in recent memory, not to mention the media-friendly Mark McGwire/Sammy Sosa home run derby, is somewhat disconcerting. Similar falling ad worries are also battering radio broadcasting stocks, which had another bad day. Chancellor Media (Nasdaq: AMFM) slid $2 1/8 to $23 15/16, Jacor Communications (Nasdaq: JCOR) slipped $1 17/32 to $40 1/8, and Clear Channel Communications (NYSE: CCU) sank $3 15/16 to $37.

Credit card issuer Capital One Financial (NYSE: COF) was crunched for an $18 loss to $67 today on numerous issues of concern to investors. First, there's the issue of companies that securitize loans, which translates into concerns about quality of earnings, growth in earnings, and safety of the balance sheet. As we saw with Criimi Mae (NYSE: CMM) earlier this week, if a company gets into the wrong position with the balance sheet, a dead market for lower-quality asset backed securities can be crippling. Then there's the issue of the Justice Department taking on VISA and MasterCard. On balance, that's probably a benefit to Capital One, not a problem. With its earnings report coming up soon, investors will have a better idea of the current state of operations at Capital One, but this isn't the first time that investors have freaked out and dumped the company when Capital One had a much better handle on operations than the market believed was the case. Finally, general concerns on a recession and a "credit crunch" hit consumer lenders across the board today. After the market close, Capital One said it expects to meet earnings estimates of $3.90 per share for 1998 and that its "...credit card portfolio continues to generate excellent excess spreads in our securitization master trust."

Private mortgage insurers took it on the chin today after legislation passed the House that would allow Freddie Mac (NYSE: FRE) to "self-insure mortgages with down-payments of less than 20%," according to Bloomberg News. With that being the business of private mortgage insurers, companies in that industry were hit on the news, though this worry has been in the market for some time. MGIC Investment Corp. (NYSE: MTG) lost $3 5/8 to $27 13/16, CMAC Investment Corp. (NYSE: CMT) was slammed for a $8 15/16 loss to $28, and Triad Guarantee (Nasdaq: TGIC) fell $6 1/2 to $14 1/2. Freddie Mac also lost ground on the news, falling $2 13/16 to $45 5/16, on concern that this allows a credit quality issue to creep into the picture for the company -- but it's hard to tell if that's entirely the case today, as financials across the board were hit on recession and loan growth fears. Fannie Mae (NYSE: FNM) fell $4 7/8 to $57.

QUICK CUTS: Internet service provider MindSpring Enterprises (Nasdaq: MSPG) was bounced $4 1/8 to $29 3/8 after CFO Michael Misikoff said he will resign his post sometime later this year... Investment bank and brokerage firm Merrill Lynch (NYSE: MER) slid $4 3/16 to $37 3/4 on rumors that the company will fire between 2,000 to 3,500 non-broker employees in an effort to cut costs... Mutual fund manager T. Rowe Price Associates (Nasdaq: TROW) slipped $2 3/8 to $23 3/4 after Goldman Sachs lowered its rating to "market perform" from "recommended list"... Cereals and Gatorade maker Quaker Oats Co. (NYSE: OAT) was toasted $6 9/16 to $57 15/16 after falling 5% yesterday following downgrades from Donaldson, Lufkin & Jenrette and Goldman Sachs. Today, The Wall Street Journal stirred the oats a bit more by giving the analysts at the two brokerages some ink in its "Heard on the Street" column.

Supermarket operator Winn-Dixie Stores (NYSE: WIN) surrendered $4 7/8 to $30 7/16 after announcing fiscal Q1 EPS of $0.10, down from the $0.32 earned a year ago and below the Street's mean estimate of $0.29. The company said cost controls fell by the wayside following its promotional blitz during the quarter... Natural foods supermarket operator Whole Foods Market (Nasdaq: WFMI) spoiled $3 1/2 to $36 1/2 after Peter Roy said he will step down as the firm's president at the end of the year. Mid-Atlantic region President Chris Hitt will fill Roy's shoes... Morton's of Chicago and Bertolini's restaurant operator Morton's Restaurant Group (NYSE: MRG) was knocked down $6 11/16 to $13 following a downgrade to "neutral" from "buy" from Lehman Brothers, which feels the slowing U.S. economy will take a bite out of earnings at upscale restaurants.

Hotel and senior living communities operator Host Marriott Corp. (NYSE: HMT) fell $1 9/16 to $10 after agreeing to buy the 7% stake in Forum Retirement Partners, L.P. (AMEX: FRL) it does not already own for $5.75 per unit... Drugmaker Eli Lilly and Co. (NYSE: LLY) slipped $6 1/8 to $71 3/8 after the FDA denied the company's application to have its Zyprexa schizophrenia drug approved as an additional treatment for patients with bipolar disorder... Mortgage real estate investment trust IndyMac Mortgage Holdings (NYSE: NDE) dropped another $1 1/4 to $8 3/4 after BT Alex. Brown and PaineWebber lowered their ratings following the bankruptcy of fellow mortgage REIT Criimi Mae earlier this week.

Oil and gas pipeline and drilling platform constructor Global Industries Ltd. (Nasdaq: GLBL) sank $1 5/16 to $7 13/16 after saying lower activity levels and recent storms in the Gulf of Mexico will result in fiscal Q2 EPS about 40% below the $0.21 earned last year... Solid waste removal company Waste Management (NYSE: WMI) was trashed for a $8 3/16 loss to $39 as Deutsche Bank Securities cut the firm's fiscal 1999 earnings estimate to $3.05 per share from $3.10 per share and trimmed its price target to $61 per share from $71 per share... Canadian-based funeral home and cemeteries operator Loewen Group (NYSE: LWN) was buried $3 3/8 to $8 1/4 after saying its fiscal Q3 earnings will be "significantly below" the Street's mean estimate of $0.19 per share. The company offered no reason for the shortfall.

Metal halide lighting products maker Advanced Lighting Technologies (Nasdaq: ADLT) was burned $1 17/32 to $5 1/2 after saying its fiscal Q1 EPS will be about 30% to 40% below the $0.17 earned last year, missing the Street's mean estimate of $0.22... Insurance brokerage firm Aon Corp. (NYSE: AOC) dropped $4 5/16 to $57 9/16 after Warburg Dillon Read cut its rating to "buy" from "strong buy," citing falling interest rates and international economic turmoil.

An Investment Opinion
by Louis Corrigan

A Chicken Autopsy

Short-sellers got teary-eyed this week following word that old faithful Boston Chicken (Nasdaq: BOST) finally bit the Chapter 11 bankruptcy dust. Though hardly unexpected, Monday's announcement dropped the stock to $0.50 a share, down an astonishing 97% from its 52-week high near $16. Operator of the ubiquitous Boston Market restaurant chain as well as majority owner of Einstein/Noah Bagel (Nasdaq: ENBX), the Chicken has been plucked due to deteriorating store-level economics, management turmoil, and an outsized amount of debt due to an aggressive expansion plan that had once impressed Wall Street but perhaps never made financial sense. Indeed, 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.

From the beginning, Boston Chicken was a story stock with all the air of legitimacy. On the day of its initial public offering back in November 1993, this bird soared from a split-adjusted $10 to a high of $23. Investors salivated over the prospect of CEO Scott Beck, one of Wayne Huizenga's former lieutenants at Blockbuster Video, creating a fast-growing chain of restaurants focused on "healthy" home-style meals of rotisserie chicken and fresh-cooked vegetables for baby boomers too busy to do the kitchen thing. The food tasted good and Wall Street analysts were gaga over the concept, so individual investors had little trouble imagining the Chicken would become the McDonald's (NYSE: MCD) of the '90s. There was a lot of hope and hype built into the share price from the beginning, as the shares sported a price-to-sales ratio around 15 by the end of 1993. The stock eventually flew to an all-time high of $41 1/2 in December 1996 before entering its death-spiral descent.

The key to the story was the store-level operating profits, or lack thereof. The challenge for investors, though, was that Boston Chicken is a franchisor, and its public filings made it difficult for investors to understand the store-level economics. All they really had to go on was the weekly per-store average (WPSA) sales figure. Although the Chicken's accounting was accurate, it surely deceived many investors who took the company's reportedly growing earnings per share at face value.

The fact is, Boston Chicken was always more of a finance company than a restaurant operator. Many chains grow by way of individual franchisees who like the business concept and put up a substantial amount of their own money to open new stores. They pay the franchisor certain one-time development fees plus regular royalties on sales. However, it takes time to grow a chain using this strategy because it's often tough for potential franchisees to arrange financing, even with assistance from the franchisor. Since a business built on home-style chicken dinners doesn't offer any obvious moat to protect against competition, the Chicken hoped to create an artificial moat through simple ubiquity. To ensure rapid expansion, the company signed up a small number of financed area developers (FADs) who had to put up just 20% of development costs with the rest provided via loans from the Chicken itself.

Similar to the ill-fated expansion model employed by oil-change company Jiffy Lube in years past, this rapid-assault plan depended on the Chicken's ability to raise capital through the public equity and debt markets. In a sense, rapid store expansion would create a steady flow of revenues from one-time development fees, ever-increasing royalties, and crucially, ever-rising interest payments on the loans to the FADs. Rising revenues would translate into rising earnings per share and that would ensure continued accolades from Wall Street analysts, a booming stock, and additional opportunities to raise more money to finance more expansion.

For a while, everything worked as planned. Indeed, it's crucial for investors to realize that Wall Street brokerage houses desperately wanted things to work as planned because they stood to make millions from doing underwriting deals. Even in April 1997, as short-sellers pointed to major problems at both the Chicken and the Bagel, Merrill Lynch, Alex. Brown and Morgan Stanley underwrote a $287.5 million bond offering for Boston Chicken and later floated a $125 million convertible debt offering for Einstein. Even as the stocks dipped, the analysts still had nothing but bullish things to say.

The problem is that the Chicken's reported earnings were essentially a fiction. The FADs were losing massive amounts of money: $51.3 million in FY94, $148.3 million in FY95, and $156.5 million in FY96. And most of the firm's assets consisted of $700 million in loans to these FADs. Boston Chicken's reported profits included interest payments from the FADs on the money the Chicken had loaned to them. The company was basically recirculating money raised from public shareholders and debtholders and claiming it as profit while the underlying stores operated at a loss well off the public company's balance sheet. While an experienced investor should have been able to piece together this story from the public filings, it still amounted to something of an accounting sleight-of-hand trick since the reported earnings distracted investors from the real story.

That story was not just ugly, but increasingly so, partly because the growth strategy didn't initially require the kind of religious devotion to quality food and clean stores that made McDonald's part of the American way. Also, a company that is basically in the business of making loans to unprofitable franchisees ought to establish some kind of loan loss reserve for bad debt. Because the Chicken did not do this, it seemed destined to face eventual write-downs and the assumption of the FADs' assets unless the store-level economics solidified and reduced the operating losses.

But exactly the opposite happened. Grocery store chains and others attacked the growing home meal replacement market and undercut Boston Market on price. At the same time, the company lost focus by expanding its offerings to include ham, turkey, and meatloaf, and by skimping on quality. It even entered the cutthroat sandwich business and boosted its coupon discounting, a margin-destroying gamble. Though even experienced investors had trouble getting at the firm's store-level profitability, the weekly per-store average (WPSA) sales figure at least offered a useful proxy for tracking the store-level performance. It was steadily declining throughout 1997 so that the company even had to renegotiate its credit facility to allow for a lower WPSA. Though Merrill Lynch and Forbes columnist David Dreman still liked the stock when I wrote about it a year ago, the Chicken's guts were pretty clearly hanging out.

Since then, Boston Chicken has acquired most of the stores owned by its FADs, written down loans, ousted the founders, and brought in new CEO J. Michael Jenkins to turn the company around. As announced Monday, it has closed 178 of its 1143 restaurants, fired 500 of its 18,500 employees, and transferred 2,700 others. It's also arranged $70 million in Debtor-in-Possession financing from GE Capital and Bank of America, with half to be used to refinance some of the $283 million in senior debt set to come due October 17, while the rest will be used as working capital to pay salaries. The company also has about $625 million outstanding in subordinated debt. The hope is that through the bankruptcy, total outstanding debt can be reduced by two-thirds, with most converted to equity in a reorganized business. Current stockholders, though, will walk away with little or nothing.

Although the Boston Chicken saga merits its own book, some lessons seem obvious. Investors need to understand the financials behind a company's basic operating unit and to focus on the useful metrics for following those financials. Be leery of companies whose financial statements seem designed partly to obscure this underlying story. Consider management's industry-specific experience. Be cautious when companies must repeatedly go to the public markets to finance growth. Recognize that the research analysts who work for brokerage houses with investment banking operations may not be reliably objective sources since they are under intense pressure to remain upbeat enough for the firm to win a company's underwriting business. Understand that a tasty drumstick does not a great investment make. And when short-sellers hit the message boards with their skepticism, pay attention. It's never too late to cut your losses.

Related articles:
The Evening News 02/10/98: Boston Chicken Skinned
The Evening News 10/08/97: The Franchisor as Lender
The Evening News 10/15/97: Einstein's Genius in Question
The Evening News 10/22/97: Chicken Guts


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