Business Strategy of Boston Chicken - Essay Example

Case Analysis: Boston Chicken, Inc. of the Affiliated Case Analysis: Boston Chicken, Inc. Introduction In 1989, Boston Chicken emerged as a new company in the $200 billion restaurant industry (“Boston Chicken, Inc.”, n.d, p.30). The Company used two trends of 1980s in developing a business strategy (Mourdoukoutas, 2013): women at work and health concern in food selection. For Boston Chicken, more women at work meant the family has less time for home cooking and health concern in food selection meant more chicken on the table. Boston Chicken offered replacement of home meal, which included home-style entrees of chicken, turkey, ham, meat loaf, variety of freshly prepared salads, vegetables, and other side dishes. This assignment conducts a case study of Boston Chicken, Inc. to understand the philosophy behind the Company’s operation during years from 1992 to 1994 only. This report presents findings of the Company’s business strategy with associated risks, analysis of operating and accounting policies. It also describes the Company mangemnt’s pitfalls, problems associated with the current and future business operations along with the recommendations on probable escape routes. Strategy and Risks Business Strategy The philosophy behind the emergence of Boston Chicken in the restaurant business was to be a leader in the home-meal replacement market. The company’s primary customer segment were the families looking for affordable alternative meals to cooking at home. Furthermore, the customers expected the replacement meal to be healthy with a variety of choices. The above-defined aspects served as principle factors in the selection of the company’s business strategy. The strategy adopted the following principles: (1) aggressive growth and expansion, (2) introduction of tasty of new varieties of food, (3) high operational efficiency with customer feedback. Innovation of Franchising Concept. Store expansion became the Company’s primary success factor. In 1992, the expansion rate was 144%, i.e. from 34 to 83 stores; in 1993, it was 161% , i.e. from 83 to 217 stores, and in 1994, the Company achieved 146 % expansion rate, i.e. from 217 to 534 stores. Thus, in between years from the beginning of 1992 and the end of 1994, the company opened a new store on average every two days. The goal of the expansion policy was to penetrate into the 60 largest U.S. metropolitan markets. The Company used franchising method for brand expansion (“Franchising Concept”, n.d.). However, company introduced a new approach in brand expansion. Instead of selling store franchises to a large number of small franchisees, it decided to use experience and success of regional area developers. These developers are independently owned companies in particular geographical areas. The Company established a network of 22 area developers that got mandate to open 50 to 100 new stores in the 60 largest U.S. metropolitan markets. The Company imposed two constraints in selecting the area developers; (1) 15 – 20 years relevent mangement experinec, (2) substantial financial resources. Tasty Food Selection. Baline Hurst, who headed the Boston Chicken’s computer operation pointed out, “If I can save half a percentage point on food costs, that’s a lot of money. But, if I can know almost instantaneously that customers don’t like the drink selection and I can have that changed within a week – that’s worth lot more money (“Boston Chicken”, n.d., p.32).” The above statement implies that the company was serious when it concerned food selection by customers. The Company’s goal was to keep pace with changing tastes of consumers. This approach coincided with the company’s strategy; offering appealing, fresh and affordable meals. Boston Chicken invested $8 to $10 million in computer software in order to keep pace with changing consumer tastes. The software served as communication infrastructure by recommending products to serve based on the history of customer preferences at a particular store. This approach also helped to improve inventory management and freshness of the products. Introduction of flagship stores demonstrated company’s commitment towards the fulfillment of customer satisfaction. These stores performed the initial stages of food preparation for satellite stores. The flagship store concept increased the quality and freshness of the side items because frequent deliveries were made to the satellite stores. In some stores, customer feedback was enabled about the quality of food and service through the touch activated computer terminals. Risks A review of the company’s business strategy raises the question why it adopted store expansion strategy to this magnitude. It is no doubt that the company found a unique niche that offered a home cooked meal replacement apart from food that is offered in fast food restaurants. The strategy of rapid expansion, perhaps a good short-term strategy; however, it may not be a good strategy for long-term sustainable business. At the beginning of 1992, the company had 34 stores; at the end of 1994 it became 534. The rapid expansion always leads to oversaturation contributing to a growth rate that a business cannot sustain. Mainly, an increase of this magnitude causes loss of control of the business operation reducing the quality, increasing food wastage and lowering profitability. It also puts a heavy strain on company’s cash management. By 1994, the Company financed various area developers for 314 stores. It is true that the company wanted to establish a chain like many other companies in the restaurant business. However, it requires time to grow a chain of this magnitude because it is tough for potential franchisees to arrange financing (Spinelli, Rosenberg, & Birley, 2004). Boston Chicken’s rush can only be explained that the company wanted to capitalize home-style chicken dinner business. The company wanted to avoid competition by creating an artificial dike through simple ubiquity. To ensure rapid expansion, Boston Chicken signed agreement with area developers who could come up with 20% development cost with the rest provided via loan from the company itself. Thus, Boston Chicken was slowly moving away from the restaurant business to the finance business. The Company continuously was increasing its own credit risk by allocating finances to so many area developers, Moreover, liquidity risk was also on the rise, which was arising from the gap between account receivables from developers and liability obligations. By the end of 1994, the company had 534 stores of which only 41 were Company-operated. The strategy to limit Company-operated stores increased dependency on area developers and concentration risk in revenue source. Analysis of Operating and Accounting Policies The above set forth review illustrates that the company operated in three areas: selling chicken, selling franchises to developers, and lending money to developers. It also indicates that lending money to area developers became the priority of the business. The Company envisioned that rapid growth of the Boston Chicken brand could be obtained via franchising through area developers. At the beginning of 1992, the company had 34 stores; it grew to 217 at the end of 1993, and at the end of 1994, it reached 534 stores. The rate at which the company grew during these years could not be considered as financially sustainable. Corporate management chooses to solve this issue by raising capital through the stock market. In November 1993, the company went public; issued 1.9 million shares. The Company observed tremendous success of their stock in the market. Initial offer of $10 per share immediately soared to $26.50; however, within months the price dropped to $48 (Goldman, 2008). In August 1994, the company issued second round of 2 million shares at the IPO $18, which was oversubscribed. The company decided to respond to it by issuing additional 4 million shares. These activities provided a strong financial arm; the company brought to the table $105 million new capital. A big portion of this fund was spent to finance the area developers. In 1993, outstanding loan was $51 million, which became $333 million in 1994. The above description confirms that the Company was moving away from the core business. However, the Company’s accounting policy failed to describe this retreat in the financial documents. If considered selling chicken, selling franchises and lending money all are the integral parts of one business, then lending money to developers are expenses. However, the Company’s income statement does not include this item, thus distorting the real value of EBIT. Reported net income in the income statement is highly questionable. The attached graph displays the Company’s net income; it shows that Boston Chicken generated 9.8 times higher net income in 1994 compared to 1992. It does not happen in the restaurant business. The Company was considering one-time franchising fee as revenue in the income statement giving a controversial concept of total revenue from the restaurant business operation. The company’s revenue structure constituted earnings from core business, $45,000 one-time franchise fee, 5% royalty from gross sale and 2% to 3.75% of sales for advertising. In 1994, the company received 314 x $45,000 = $14,130,000 one-time franchise fee, which constituted 25.58% of total revenue earned from franchise activities through the area developers. A sustainable business revenue cannot depend on one-time franchise fee in the restaurant business. Furthermore, study of average revenue earned from stores shows that the company made more money from own stores than franchise stores. The results are shown in the following table and graph. Years No. of company stores Revenue from company stores Average revenue from company stores No. of franchise stores Revenue from franchise stores Average revenue from franchise stores 1992 19 5,565,000 297,684 64 2,627,000 41,047 1993 38 29,899,000 785,500 179 12,681,000 70,844 1994 41 40,916,000 997,951 493 55,235,000 112,039 In 1994, royalties and franchise-related fees generated 57% of the total revenue; however, in 1992 and 1993, the same generated 30% - 32% of the total revenue. In 1994, the company opened 268 franchised stores compared to 106 stores in 1993 boosting revenue through one-time fee. It is obvious that not a single business can keep this pace of store expansion; hence, in the end, the total revenue will drop, and the business will depend on the performance of the franchised store. According to Roger Lipton of Lipton Financial Services, the Boston Chicken’s franchised store were making $18,900 per week implying that the stores were losing money. According to Lipton, the franchised stores needed to make $23,000 a week just to cover expenses (“Boston Chicken, Inc.”, n.d., p.33). The above discussion points out one-time fee beefed up the total revenue. The company used an aggressive rule in revenue recognition by accepting one-time fee as revenue. This approach showed a rapid growth in revenue in 1994, but sustainability of the restaurant business depends on food sales. Onetime franchising fee should be recorded as an unearned revenue and amortized over the franchising period (Leiwy, 2013). The company recognizes royalties and fees as revenue, which can be considered controversial because these fees, in fact, came from the given loans to the franchisees. Boston Chicken assumed that these loans could be converted into common stock, thus leaving option to consider these payments as deferred. In 1994, the Company reported $55.235 million revenue from the franchise operation, of what $17.421 million from royalty, $13.057 million from franchise fees, and $11.632 million as interest income from franchisees. In the context of above explanation, once $24.669 ($13.057 + $11.632) is taken off, the revenue from franchise operation becomes $30.565 million. The company considered franchise fee and area development as revenue at the time when franchise store opens. This may be the wrong approach; revenue should be considered in the accounting statements when it has been received. The same with the royalties; it is recognized when store generates revenue. The Companies account principle used the following assumptions (“Boston Chicken”, n.d.): 1. Company-operated stores revenue is recognized when food and beverage are sold; 2. Royalties are recognized when franchise store generates revenue; 3. Initial franchise fees and area development fees are recognized when the franchise stores open; 4. Amortization of deferred financing costs relates to financing period; 5. Loan can be converted to equity in the franchisee at a 12-15% premium. In 1994, the Company reported $426,982,000 as total assets; of which $59,329,000 current and $367,653,000 long-term. Out of long-term assets, $185,594,000 related to notes receivable; thus, 43.5% of company’s total assets constituted loan to the area developers. Perhaps, it should be considered as a risk. In company’s accounting policy, there was no allowance for bad debt. In 1993, outstanding loan amounted $51 million and in 1994, it reached $333 million. The fact leads to believe that Boston Chicken assumed that the company would receive 100 % of the notes in due time; it seems to be naïve and optimistic. Instead of taking this aggressive approach in operating and accounting policy, the Company should have considered a provision to protect the Company in case a developer defaulted on loan payment. However, the conservative approach would have made a significant impact on revenues declared by the company. Cash flow statement shows that the major part of cash was coming from financing activities. The attached table presents a fragment of the company’s cash flow of 1994. In 1992, the company generated $20,228,000 from financing activities and had $9,709,000 cash at the end of the year. In 1994, it generated $414,175,000 from financing activities but had $$25,304,000 cash at the end of the years. In the same year, company had to sale $62,342,000 worth of assets. Proceeds from the sale of assets 62,342 6,161 385 Proceeds from issue common stock 125,703 66,150 19,843 Proceeds from convertible subordinate notes 130,000 9,658 Borrowings under credit facility 96,130 32,275 Cash, end of the year $25,304 $4,537 $9,709 It is a clear indication that the business is not sustainable and in future company might need to borrow more money to maintain a positive cash flow. Boston Chicken is strongly advised to use conservative accounting policy instead of aggressive and store expansion strategy through self-operated stores instead of franchising stores. Management Pitfalls The Company observed that cost of products sold of seed stores is high because of higher food and paper cost, increased food for free tasting, lack of experience of working personnel, lack of store operating history to assist in forecasting daily food production needs. Higher cost of products sold ultimately affects revenue, gross profit and net profit. Why did the Company management adopt the strategy of expansion to the magnitude that Boston Chicken conducted in 1993 and 1994? In the end, it is going to hurt the Company’s net profit and cash flow not mentioning of mismanagement in operation. The company will be forced to sell assets or take a loan in order to maintain cash flow for proper operation of stores. One of the company’s business strategies states in order to enter into a new area, the Company intends to sell the Company-operated stores to the area developers. Furthermore, the Company opened stores in new areas as seed development, developed them, and eventually sold them to the area developers. The Company envisioned this approach as market consolidation. In 1994, the Company sold 54 Company-operated stores to its area developers of various states. The proceeds from these sales were used to seed new markets. The market consolidation approach was also used for acquisition of Boston Market stores at any cost. For example, in 1994, the Company issued 1,112,436 shares of common stocks to acquire 34 Boston Market stores. Later, the Company sold 26 of them to the area developers. The aggregate proceeds from the sale of the Company-operated stores and sale of stores that were acquired to consolidate markets were $62,342,000; however, without any material gain for the Company. It cannot be considered as a sound business strategy. Does the Company’s desperateness to enter into a new area, at any cost, have a logical basis? Why would a company spend money to seed a new market, develop stores and then sell to area developers? Is Boston Chicken in the real estate business or restaurant business to provide consumers with home-replacement meals? The Company is definately moving away from its core business. Current Performance The case study reveals that the Company’s current position is not strong, and the future is unpredictable. It is no doubt that the company has achieved success in a very short time; however, the success came from the Company’s short-term business strategy, and not long-term (Frigo & Anderson, 2009). The aforementioned review has shown that the current strategy is not based on adequate planning and solid foundations. The company raised money by issuing common stocks, which later loaned to the area developers with the hope that they would develop strong, profitable franchisees. The company should expect disasters when franchise performance does not materialize loan into investment gains. It will then reveal financial gaps in financial reporting that are left because of the use of aggressive accounting practice. In the previous paragraphs, it was mentioned that the majority of the growth relates to the financing activities, which are classified in financial statement as notes receivables. However, the Company did not account for any allowances for default notes. Unpaid debts will cause a deficit in the future cash flows forcing the Company for more bank loans. The fate of the entire corporation now depends on the franchises. It will not survive in the business unless franchisees generate higher profit than usually expected. Conclusion: Road to Survival Boston Chicken found a unique niche in the restaurant business, which is neither a traditional fast food nor a traditional restaurant business. The concept alternative to home-meals at an affordable price is bound to bring success. Instead of popularizing and promoting this concept, the Company got involved in the financing and real estate business (Goldman, 2008). Boston Chicken thought rapid expansion of the brand stores could capitalize the market and prevent penetration of competitors. By the end of 1994, the Company had 493 franchised stores and 41 Company-operated stores. The Company needs to stop any further expansion, increase sales revenue in the Company-operated stores and ensure that the franchised stores make significant returns to the owners and investors. The company needs to imply an accounting policy that shows the real growth and not the appearance of growth (“Aggressive vs. Conservative Accounting”, 2014). Store opening should not be considered as an increase in revenue rather the sales of food in these stores. Long-term sustainable growth will require funding both for the Company-operated and franchised stores. Finding sources of funds to run both Company-operated and franchised stores will be a challenge for the company management. The company needs to realize that the potential for future stores is decreasing due to market saturation; poor returns from the current stores would crash the Boston Chicken business. References Aggressive vs. Conservative Accounting. (2014). Retrieved from http://www.svtuition.org/2014/06/aggressive-accounting-vs-conservative.html Boston Chicken, Inc. (n.d.). Retrieved from https://brainmass.com/file/1454085/BostonChickCase.pdf Franchising Concept. (n.d.). Retrieved from https://www.tom-tailor.biz/downloads/fr/Franchise_fr.pdf Frigo L. Mark and Richard J. Anderson. (2009). Strategic risk assessment. Retrieved from https://driehaus.depaul.edu/about/centers-and-institutes/center-for-strategy-execution-and-valuation/research-and-publications/Documents/Strategic_Risk_Assessement_-_Strategic_F.pdf Goldman, B. (2008). The Boston chicken problem. http://www.mediate.com/articles/goldmanB2.cfm Leiwy, D. (2013). Principles of accounting. Retrieved from http://www.londoninternational.ac.uk/sites/default/files/programme_resources/lse/lse_pdf/subject_guides/ac1025_ch1-3.pdf Mourdoukoutas, P. (2013). Starbucks and McDonalds winning strategy. Retrieved from http://www.forbes.com/sites/panosmourdoukoutas/2013/04/25/starbucks-and-mcdonalds-winning-strategy/ Spinelli, Stephan, Robert Rosenberg, and Sue Birley. (2004). Franchising pathway to wealth creation. New Jersey: Prentice Hall. Read More