Jack L. Treynor, Financial Analysts Journal , November/December 1993.
Feathered Feast is a case about disclosure—about the relation between the reporting accountant and the outside user and about the framework within which these professionals perform mutually complementary roles. Like all cases, it confers little or no insight on those who merely read it. Rather, one has to live the case—to feel the frustration and anguish of the protagonist, Shepard Saunders.
In May 1993, Shepard Saunders, manager of the Amalgamated Iceman’s Pension Fund, was reviewing certain purchases that, in retrospect, had not worked out as successfully as he had
Feathered Feast, Inc. (FF) was at that time one of a number of rapidly growing fast-food chains specializing in fried chicken. FF was distinguished by the fact that, instead of selling franchises, it retained complete control of all FF retail outlets, owning them outright. Management argued that outright ownership gave them better control over the quality of the final product. But outright ownership, together with management’s effort to keep pace with its rapidly growing competition, had also led to a heavy demand for funds.
Despite FF’s rapid growth, its management had controlled costs very successfully, maintaining profit margins virtually constant until 1992. In order to conserve funds, management had subcontracted the warehousing, distribution and food-preparation functions. New funds were mainly used for the construction of new outlets, which were built on leased land.
Each outlet was basically a standardized, sheet-metal structure fabricated in the shape of a giant chicken, with integral refrigeration, deep-fry vats and warming ovens. Standing nearly 30-feet high, these structures served to excite the eating public’s interest in FF’s principal product, the Featherburger. They were, in fact, rapidly becoming a familiar sight along heavily traveled suburban arteries when fast-food retailing margins collapsed in 1992.
The shock and disappointment of FF shareholders was heightened by the fact that, until that time, FF’s profit performance had been spectacular (see Table 1 ). It was, in fact, the profit performance that had induced Shepard Saunders to “swing a little bit,” as the institutional salesman from the First Hoboken Corporation had put it, cashing in Treasury bills amounting to roughly 5% of the fund’s portfolio and devoting the proceeds to FF shares.
Table 1
1987 1988 1989 1990 1991 (est)
Net Income (After Taxes) $58 $64 $71 $78 $85
Net Income Plus Depreciation $100 $110 $121 $133 $146
Dividends $50 $55 $60 $67 $73
Capital Investment $0 $50 $55 $60 $67
Gross Plant $500 $550 $605 $665 $732
Dividends/Net Income 0.86 0.86 0.86 0.86 0.86
Table 2 ). The performance was all the more impressive because, as the First Hoboken research report had made clear, the quality of
Table 2
Basic Assumptions
5-Year Growth Rate 10%
Discount Rate 12%
Dividend Payout Detail
Depreciation (12 years, straight-line) 5/12 of gross
Earnings after Depreciation 7/12 of gross
Cash Investment 6/12 of gross
Cash Available for Dividends 6/12 of gross
Dividends/Earnings 6/7 of net
In view of this rapid yet steady growth, coupled with the demonstrably high quality of earnings, a discount rate (total return) of 12% was surely conservative. Feathered Feast had consistently succeeded in paying out over 85% of its earnings in dividends, and it had achieved this high dividend payout without borrowing to finance its rapid expansion. Using the famous Gordon-Shapiro formula to translate these assumptions about growth rate, discount rate and dividend payout rate into an estimate of the investment value of Feathered Feast (see Table 2 ), the salesman had argued that Feathered Feast was worth at least a price/earnings ratio of 43, in contrast to the ratio of 40, at which it was selling in December of 1991.
Shepard Saunders’s first inkling that all was not well with FF came when he read in The Wall Street Journal that FF was defaulting on some of the lease contracts for retail sites (these contracts had 12 years’ duration, with subsequent options to renew). Declining unit volume and cutthroat price cutting quickly transformed formerly profitable outlets into money losers. The prob
Although most of FF’s competition had encountered the same problem at about the same time, it was hard to understand how a company that sold at 40 times earnings one year could be broke the next. In his attempt to understand why Feathered Feast had been such a disappointment, Saunders developed the figures shown in Table 3 . He noted that, by 1992, Feathered Feast’s existing outlets, being scarcely able to cover out-of-pocket operating costs, were essentially worthless. That meant, he reasoned, that the outlets that came into operation at the beginning of 1987 had, at least in hindsight, a five-year economic life. In similar fashion, he reasoned that the outlets that went into operation in 1988 had a four-year economic life, and so forth. Using these new assumptions about the economic lives of units coming into operation in each of the years from 1987 through 1991, Saunders recalculated earnings after depreciation (see Table 3 ).
Table 3
1987 1988 1989 1990 1991 (est)
Gross Plant $500 $550 $605 $665 $732
New Investment $0 $50 $55 $60 $67
Restated Depreciation $100 $112 $131 $161 $228
Net Plant $400 $338 $262 $161 $0
Net Income (after taxes plus depreciation) $100 $110 $121 $133 $146
Depreciation $100 $112 $131 $161 $228
Net Income $0 (2) (10) (28) (82)
Table 3 rather than Table 1 represented the true earnings history for Feathered Feast, Saunders reasoned, then it had not been worth 43 times 1991 earnings (estimated) in December 1991. But it had not been until 1992 when fast-food margins collapsed, that it became clear that Table 3 was a better representation of the earnings history than Table 1 .
Perhaps Saunders was misusing historical earnings data. Perhaps he didn’t understand what the data meant. He decided to go to a well-recognized accountant, someone who had given a lot of thought to the objectives of financial statements and the conceptual framework for accounting. The obvious choice was the noted accounting theorist, Stamford Ridges. Saunders was delighted when Ridges granted him an interview. A transcript of Saunders’s questions and Ridges’s answers follows.
Saunders: Was I wrong to rely on the earnings history of Feathered Feast in estimating the value of its common stock?Ridges: Earnings for an enterprise for a period measured by accrual accounting are generally considered to be the most relevant indicator of relative success or failure of the earnings process of an enterprise in bringing in needed cash. Measures of periodic earnings are widely used by investors, creditors, security analysts and others.Saunders: Is it appropriate to extrapolate historical earnings trends into the future?Ridges: The most important single factor determining a stock’s value is now held to be the indicated future earning Saunders: My experience with Feathered Feast suggests that earnings, earnings trend and estimates of investment value based on these numbers can be very sensitive to the life of fixed assets.Ridges: Assets are not inherently tangible or physical. An asset is an economic quantum. It may be attached to or represented by some physical object, or it may not. One of the common mistakes we all tend to make is that of attributing too much significance to the molecular concept of property. A brick wall is nothing but mud on edge if its capacity to render economic service has disappeared; the molecules are still there, and the wall may be as solid as ever, but the value has gone.Saunders: So it’s the economic, rather than the physical, life that matters. How is the outside user to know whether reported earnings are true earnings and reported earnings trend true trend unless he knows the economic life of major assets?Ridges: The success or failure of a business enterprise’s efforts to earn more cash than it spends on resources can be known with certainty only when the enterprise is liquidated.Saunders: How, then, does the accountant arrive at the figures he reports?Ridges: In the purest, or ideal, form of accrual accounting, sometimes called direct valuation, each noncash asset represents expected future cash receipts and each liability represents expected future cash outlays.Saunders: Wouldn’t I be better off if I focused on financial data that were untainted by the subjectivity of an accountant’s expectations?Ridges: The standard of verifiability is a necessary attribute of accounting information, allowing persons who have neither access to the underlying records nor the competence to audit them to rely on those records.Saunders: If I wanted to base my analysis on numbers relatively free from the influence of an accountant’s expectations regarding the future, what numbers might I use?Ridges: The fundamental concern of investors and creditors with an enterprise’s cash flows might suggest that financial statements that report cash receipts and cash disbursements of an enterprise during a period would provide the most useful information for investor and creditor analyses. That information is readily available, can be reported on a timely basis at minimum cost, and is essentially factual because it involves a minimum of judgment and assumption.Saunders: Would you mind telling me again why outside users like myself are supposed to pay so much attention to earnings?Ridges: The relation between cash flows to an enterprise and the market price of its securities, especially that of common stock, is complex, and there are significant gaps in the knowledge of how the market determines the prices of individual securities. Moreover, the prices of individual securities are affected by numerous other factors that affect market prices in general. Nevertheless, the expected cash inflows to the enterprise are the ultimate source of value for its securities, and major changes in expectations about these cash inflows immediately affect market prices significantly.Intrinsic value is the value that the security ought to have and will have when other investors have the same insight and knowledge as the analyst. Because the intrinsic value
Saunders: So that’s why you accountants place heavy emphasis on reported earnings.Ridges: Decisions about what information should be included in financial statements and what information should be excluded or summarized should depend primarily on what is relevant to investors’ and creditors’ decisions.
Sensing that he had gone about as far as he could go with Ridges, Saunders thanked him and brought the interview to a close. Although he found Ridges’s answers enigmatic and mildly confusing, he had the feeling that they held the key to his problems with Feathered Feast. In a few days, Saunders would be meeting with the trustees of the Amalgamated Iceman’s Pension Fund to explain its investment performance since 1991. They had selected him to manage the portfolio largely because of his reputation for emphasizing tangible earning assets, rather than “stories.” He was sure the trustees would ask him to defend the Feathered Feast decision and to explain the subsequent investment disappointment. Should he show them Tables 1 and ? Or should he show them Table 3 ? Saunders was uncertain exactly what to say.
