Vous êtes sur la page 1sur 4

BA 219 – Group 6

Case 1: Fotomat Corporation


Cañete | Chan | Macabaning | Maga

Point of View
In analyzing the case, we will take the point of view of a potential investor using the disclosed
information from Fotomat Corporation’s (“Fotomat”, the “Company”) prospectus and
consolidated financials.

Problem Statement
What is Fotomat’s normalized earnings before tax (“EBT”)?

Analysis
Fotomat, a company engaged in sales of film and photographic equipment & supplies and its
related services, went to public on 30 April 1969 after over two (2) years from its incorporation.
Fotomat’s distribution channels include both company-owned and franchised outlets.

Pre-IPO, Fotomat reported exponential growth from $23.6 thousand to $1.89 million in net
earnings2. Our analysis will look into the Company’s quality of earnings and assess how it
accumulates revenue and adjust for any one-time, non-recurring, non-core or one-off income.

Revenue recognition policies. To assess Fotomat’s quality of earnings, its revenue recognition
policy should be revisited. On the initial franchise fee, income recognition is made upon
execution of franchise agreement. This is generally acceptable since the agreement is
enforceable at the date of signing with both franchisor and franchisee expected to deliver their
obligations from then on. Sales of products or services sold through the two distribution
channels mentioned above are assumed recognized upon delivery of goods or service, which is
also acceptable. Issues, however, will arise when the franchisor repurchases its franchise rights.

Upon repurchase, the franchisor takes back its license to sell from the franchisee. Since
franchisor grants a right to sell for a fee, repurchasing this right needs a corresponding reversal
of the fee earned in order to normalize earnings. If this income reversal is not made, earnings
and revenue appears to be overstated in the period when initial fee was recognized.

In FY 1969, Fotomat repurchased franchise rights, with initial fees recognized in year of
repurchase and prior years. No reversals were made from this repurchase, hence, overstating
its earnings. Exhibit 1 in the following page shows about 5% overstatement in franchise fee:

2
Based on Fotomat’s Audited Consolidated Financial Statements as of 31-Jan-1969
Exhibit 1 - Overstatement in Initial Franchise Fees
In USD FY 1968 FY 1969 Remarks
Reported Initial Fees 402,500 9,081,500 FY '68 - 2 rights; FY '69 - 25 rights
Less: Fee from repurchased rights (19,600) (525,000) See Note E - Franchises
Adjusted for repurchase 382,900 8,556,500
Overstatement 105% 106%

As a potential investor, we would normalize the Company’s earnings by deducting the income
originally recognized from the repurchase by $525,000 in FY 1969.

Related party transactions. Transactions from related parties made in an arms-length basis (or
at the usual market rate) will not pose any material risk for misstated earnings, especially if
these are insignificant or immaterial to a company’s revenue.

We noted however that Fotomat sold almost half of its initial franchise fees to its closely
related parties in FY 1969. It reported a significant initial franchise fee from the limited
partnerships (whose general partners are wholly-owned by the Company) and from its officers
& principal stockholders, as shown in the table below:

Exhibit 2 - Initial fee income from related interests


In USD FY 1969 % of Initial Fee Remarks
Income from limited partnerships 2,562,000 28.2% Terms of rights: 25 years
Income from officers and stockholders* 924,000 10.2% same as above
Total 3,486,000 38.4%
Generally initial franchise fee paid is for a 10 year term

We also noted that Fotomat did not transact at market rates, but gave a superior franchise
term life in favor of its related parties by granting 25 years compared to the usual 10 years3. As
a potential investor, we would make a $3,486,000 downward adjustment to earnings from
related party transactions.

Potential loss from litigation. The Company also disclosed that two (2) franchises refused to
accept delivery or pay for additional Fotomats due to a court action brought by one of its
competitor, Eastman Kodak Company. It disclosed that this may continue to have an adverse
effect on the Company’s ability to sell. Although it has fully provided an allowance in its
receivable balance, we will normalize its earnings with a $571,000 downward adjustment in FY
1969. As a potential investor, we would want to be covered from any risk on our investment;
hence, by capturing the potential loss, we would better see its true earnings.

3
See Exhibit 6 of Prospectus: Note B – Certain transactions and accounts with related interests, under Limited Partnerships,
“…The franchise rights are for 25 years at a sales price which is generally the price applicable to 10-year franchise…”
Conclusion

Considering all the items above, we conclude that Fotomat’s earnings before tax should be a
$(539,690) loss after making a $(4,582,000) downward adjustment in FY 1969. The table below
summarizes the normalization we made:

Adjusted earnings before tax


In USD Reference FY 1969
Reported EBT 4,042,310
Normalization adjustments:
a) Repurchase of previously sold franchise Note 2, E (525,000)
b) Income from officers and principals Note 3 (924,000)
c) Income from limited liability partnerships (LLP) Note B (2,562,000)
d) Potential loss from litigation Note B (571,000)
Total Adjustments (4,582,000)
Normalized EBT (539,690)

Looking at the Company’s normalized earnings compared to its reported earnings below, a
potential investor would have been wary in investing at Fotomat’s IPO. Its quality of earnings
remained questionable since it relied heavily on its related parties to boost its topline.
Therefore, its revenues may not be sustainable moving forward if its growth is only acquired
internally.

Reported Income Statement


In USD Reference FY 1968 FY 1969 Inc/Dec
Revenues Note A and E
Gross Sales 377,205 5,517,436 1363%
Cost of Sales 101,438 1,916,074 1789%
Net Sales Note 7 275,767 3,601,362 1206%
Initial franchise fees:
Regular Note 1,2,4 402,500 5,595,500 1290%
Limited partnerships Note B, 1, 4 - 2,562,000 100%
Officer and principal stockholders Note B, 3, 4 - 924,000 100%
Rent and monthly franchise fees 22,467 489,991 2081%
Other Income 2,413 156,738 6396%
REVENUE 703,147 13,329,591 1796%
Product and processing costs Note C (220,054) (3,031,060) 1277%
Operating (297,420) (3,474,985) 1068%
SG&A Note 1 (142,753) (2,482,693) 1639%
Depreciation and amortization Note D (8,599) (204,080) 2273%
Interest and financing costs (6,831) (94,463) 1283%
COST & EXPENSES (675,657) (9,287,281) 1275%
Earnings before Tax (EBT) 27,490 4,042,310 14605%
Less: Taxes (3,918) (2,148,000) 54724%
Net Earnings (loss) 23,572 1,894,310 7936%

Key Ratios
Gross profit 73% 65%
Cost Ratio -96% -70%
Tax rate -14% -53%
APPENDIX

Reported Net Assets


In USD Reference FY 1969
Advances to related interests Note B 74,054
Deposits and other assets 293,322
Properties leased to franchisees Note D 119,480 2,152,196
Property and equipment Note D and H 185,120 4,533,311
Intangible assets:
Franchises Notes E and H 602,760
Cost in excess of net assets of consolidated subsidiaries
at date of acquisition Note A and B 43,058
Non-Current/Other Assets 7,698,701
Cash 1,242,487
Franchisees, less allowance for doubtful accounts of $595,000
and sales returns of $125,000 Note L 1,507,565
Other 144,770
Inventories Note C 26,132 768,403
Other current assets 116,815
Current Assets 3,780,040
Notes payable, unsecured Note F 3,418,565
Accounts payable 1,255,109
Payrolls and amounts withheld from employees 246,435
Other current liabilities 220,708
Deposits under franchise agreements 302,534
Taxes on income Note G 2,054,524
Installments due within one year on long-term liabilities Note H 89,541
Current Liabilities 7,587,416
Net Working Capital (3,807,376)
Long-term liabilities, less installments due within one year Note H 808,317
Deferred taxes on income Note G 91,237
Advance rent and deposits 61,405
Commitments and contingent liabilities: Notes B, F, I & L -
Debt and other liabilities 960,959

Net Assets 2,930,366