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Wednesday, October 7, 1998

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