Business Strategy (1)

PAGETURNER

Business Strategy (1)

• Pageturner’s Stated Strategy Is to “Combine the Economies of a Large Bookstore Chain with the Benefits of Local Ownership”;

• The Long-Run Viability of Pageturner’s Business Depends on Their Ability to Deliver Benefits to the Franchisees that Are Worth More than the Royalties They Charge - Currently 1.5 to 2.5%;

• Most of the Services Provided by Pageturner such as Computerised Operating and Inventory Management Systems or Advisory Services Can Be Acquired Directly from Sources other than Pageturner;

• Pageturner Must thus Achieve Sufficient Economies Relative to Other Vendors to Justify their Royalty;

PAGETURNER

Business Strategy (2)

• Pageturner’sAbility to Create Value Depends on Taking Advantage of:

-Economies in Activities (such as Advertising) that Involve a Large Fixed Cost Component;

-The Bargaining Power Afforded by Combining the Individual Bookstores and Dealing with Suppliers as a Group;

• Beyond this, Pageturner Can Justify Royalties by Providing Valuable Consulting Services and Training Opportunities;

PAGETURNER

Business Strategy (3)

• Ultimately, Pageturner’sSuccess Hinges on the Viability of the Franchise Network:

-Pageturner Should Be Able to Bring Economies of Scale to the Network, but There Is No Apparent Reason Why These Economies Should Be Any Greater than Those Available to the Larger Chains;

-In Fact, Pageturner’sBookstores Avoid Competing with the Larger Chains on the Basis of Cost and, Instead, Attempt to Differentiate Themselves by Offering a Wider Selection and a More Knowledgeable Sales Staff;

-Ownership of Individual Stores by Franchisees Supports this Differentiation Strategy by Providing Incentives to Invest in and Maintain the Human Capital It Requires;

PAGETURNER

Fundamentals

• Pageturner Reports a Loss of $71,000 for 1987 and only a Modest Profit for the First Nine Months of 1988;

• The Firm’sPretax Return Has Never Exceeded 7% in the Last Three Years;

• Even if Pageturner Turns in its Best Year ever in 1988, as Projected, its Pretax Return on Assets Would Still Be ”Only” 15%;

• Cash-Flows Look even Weaker than Earnings:

-Cash Flows from Operations for 1987 are ($110,000) and Are Forecast To Be ($67,000) for 1988;

-Cash Flows after Investment in Receivables from Affiliates, Notes Receivables, and Plant Were ($157,000) and Are Forecast To Be ($254,000) in 1988;

PAGETURNER

Sources of the Cash Flow Problem (1)

• At First, Noting the Buildup in Working Capital, One Might Speculate that Pageturner’sHigh Growth Rate Is the Source of its Cash Flow Problem;

• However, a Little Arithmetic Shows that Growing the Size of Pageturner’sChain Is Not the Source of their Difficulty:

-New Store Openings Represent a Net Cash Inflow at All Points in Time;

-In Fact, 8 Weeks Prior to Opening, Pageturner Is in a Nearly $100,000 per Store Net Cash Inflow Position;

-By the Time the Store Is Complete, Pageturner Remains $25,000 in the Black, Ignoring Any Fixed Costs Related to Staff Time Devoted to the Opening;

• Pageturner Is Highly Dependent on New Store Openings to Survive!

PAGETURNER

Sources of the Cash Flow Problem (2)

• The Single Largest Adjustment to Convert Earnings to Cash Flow for 1987 Is the Growth in Receivables:

-The Balance at the End of 1987 Is Nearly $650,000, an Amount Exceeding All of the Royalty Income for the Entire Year;

-The Franchisees Are Clearly Not Paying Pageturner on a Timely Basis:

Are Franchisees Themselves Having Cash Flow Problems?

Are Franchisees Not Pleased with the Services Received from Pageturner?

-The Balance of Receivables Is Much Lower in September 1988 at $281,000, But Then, Much of Pageturner’sFees Are Not Generated Until the Fourth Quarter;

Pageturner Is Forecasting that the Balance Will Be Much Lower at the End of 1988 than at the End of 1987;

PAGETURNER

Sources of the Cash Flow Problem (3)

• Another Source of Cash Outflow, Especially in 1988, Is the Receivable Due from Affiliates:

-The Balance of that Account Is Projected To Be $260,000 by the End of 1988;

-The Case Indicates that Most of the Account Reflects Amounts Due from Pageturner-Collegetown;

-What Story Lies behind this Amount?

This Amount Has Been Building Slowly, with No Seasonal Fluctuation, for Years;

For a Bookstore with only a Normal Stock of Inventory, a Payable of the Same Order of Magnitude as Total Assets Is Very Large;

The Case Discloses that Pageturner Is Essentially Financing the Collegetown Bookstore’sLosses;

Pageturner Bookstores Inc Is Essentially Financing the Collegetown Bookstore’s Losses! Is this Receivable Fully Collectible?

PAGETURNER

Sources of the Cash Flow Problem (4)

• Another Source of Cash Outflow, Especially in 1988, Is the Increased Balance of Notes Receivables Projected at $88,000 for the End of 1988:

-The Notes Are Received in Lieu of Cash from Franchisees Who Are Delinquent on their Receivables;

-These Notes thus Confirm the Difficulty that Some Franchisees Are Facing;

-They also Make Less Impressive the Decline in Trade Receivables Noted Earlier;

PAGETURNER

Sources of the Cash Flow Problem: Summary

• Pageturner Has Survived Largely on the Basis of Cash Inflows from New Store Openings;

• The Existing Franchisee Network Produces a Profit before Allocation of Corporate Overhead, but Thanks to the Buildup in Receivables, Translates into a Net Cash Outflow;

• Pageturner’s Success Depends Ultimately Not Only on Generating More New Store Openings But Also on Opening Stores That Can Be Stronger than Those in the Current Network;

PAGETURNER

Rationale for Collateral

1. Although Pageturner Is Forecasting a Profit for 1988, It Reported a Loss in the Most Recent Year and Has Never Been More than Moderately Profitable;

1. Pageturner’s Cash Flow Problems Appear Based on Difficulties in Collecting from Franchisees and the Collegetown Bookstore - Suggesting Weakness in the Network that Pageturner May Not Be Able to Control and Raising Concerns about the Viability of the Business Strategy;

1. Pageturner Has at Least Been Highly Dependent on New Store Openings for Survival. The Franchiser Is Vulnerable to Events that Would Curtail Additional Store Openings;

These Considerations Would Be Sufficient to Cause a Banker to Lend Only on A Secured Basis, If At All!

PAGETURNER

Evaluation of Collateral (1)

Is Pageturner’sCollateral Sufficient to Support the Loan Request?

• Accounts Receivable - Trade:

-It Is Not Unusual for a Bank to Lend Up to 80% of the Balance of Trade Receivables;

-However There Are Doubts about the Quality of Pageturner’sReceivables, as Much of the Balance Represents Slow-Paying Accounts from Franchisees;

-Keep in Mind that the Only Scenario under which Collateral Becomes an Issue for the Bank Is When the Borrower Defaults and That Is the Very Situation under which Pageturner’sReceivables Are Most Likely to Be Difficult to Collect;

This Suggests that the Amount that Might Be Lent on Trade Receivables Could Range from 40 to 60%!

PAGETURNER

Evaluation of Collateral (2)

• Inventory and Prepaid Expenses:

-Prepaid Expenses Clearly Do Not Qualify as Good Collateral;

-In Contrast, Bankers Often Lend up to 50% on Inventory, when It Can Be Resold;

-However, the Inventory Held by Pageturner Would Be Difficult to Resell as It Does Not Consist of Books but of Various Small Items, such as Bookmarks, Displays, and Other Supplies, Used to Support Store Operations;

-In a Foreclosure Scenario, Such Inventory Would Have Little or No Resale Value;

• Furniture and Fixtures:

-In a Foreclosure, Pageturner’sFixed Assets Would Be Difficult to Sell for Amounts as High as Depreciated Cost;

Possible Lending Percentages Range from 0 to 30%;

PAGETURNER

Evaluation of Collateral (3)

• Accounts Receivable - Affiliates:

-A Banker Would Typically Be Reluctant to Lend Much on a Receivable from an Affiliate;

-The Main Reason for this Being that, when the Borrower Is In Financial Distress, the Affiliate Is also Likely to Be Stressed;

-For Reasons Discussed Earlier, the Quality of these Receivables Is Furthermore in Doubt;

Possible Lending Percentages Range from 0 to 50%;

• Notes Receivable:

-Since These Notes Have Been Taken from Franchisees Who Were Delinquent on their Payments, Their Quality Is in Doubt;

Possible Lending Percentages Range from 0 to 50%;

PAGETURNER

Should A Loan Be Granted?

• Lending to Pageturner Is (At Best) Difficult, but Could Not Necessarily Be Ruled Out on the Basis of the Information in the Case. A Case in Favour of Lending Would Need to Be Based on:

-Confidence that Management’sProjections of Stronger Earnings Performance Are Reasonable;

-Expectations that the Pageturner Network Will Grow Enough to Improve Profitability and Offer Opportunities for the Bank to Provide Additional Services;

-Assurance that the Collateral Is of Sufficiently High Quality;

-A Loan Structure that Protects the Bank from the Significant Risks This Business Involves;

• Pageturner Has Requested a Long-Term Loan:

-A Long-Term Loan Should Be Secured with Permanent Assets;

-But Pageturner’sPrimary Collateral Is Working Capital!

PAGETURNER

Containing The Bank’sKey Risks

• Containing Exposure to Overhead Incurred by PBI:

-One of Pageturner’sCurrent Difficulties Is that IT Faces Large Fixed Costs, Many of Which Represent Management Fees Charged by PBI;

-Without Proper Safeguards, the Bank Would Be Exposed to PBI’sDraining of Pageturner Bookstores Inc;

-To Contain this Risk, the Loan Should Include a Guarantee from PBI and Possibly a Personal Guarantee from the Owners;

• Dependence of Pageturner on New Store Openings and Cost Containment;

SUBSEQUENT DEVELOPMENTS (1)

• Two Local Regional Banks Approached with Pageturner’sLoan Request Declined the Opportunity to Lend;

• The Primary Concern of One Bank Was the Quality of the Trade Receivables;

• The Other Bank Was Concerned Most About Problems at the Pageturner-Collegetown Bookstore and its Implications for Pageturner Bookstore’sReceivables from Affiliates;

• Ultimately, Pageturner Was Forced to Borrow Again through its Main Supplier, a Book Distributor. The Loan Was Granted at Prime Plus 2.5% (A High Rate for a Commercial Loan), Had a Two-Year Term, and Was Secured by All Assets of Pageturner as Well as the Personal Guarantee of the Owners;

SUBSEQUENT DEVELOPMENTS (2)

• The Year 1988 Turned Out Nearly As Well as Expected for Pageturner, in Terms of Profitability and the Number of Stores Opened (26);

• Management Incentives and Compensation Were Restructured at the Pageturner-Collegetown Bookstore, and Losses Were Contained;

• From 1988 to 1991, Pageturner Bounced out of and then back into the Black, Never Achieving Strong Profitability;

• Ultimately, a Regional Bank Became Pageturner’s Primary Financier;

EXHIBIT 1

Cash Flow from Operations

1987
($000) / 1988
I,II,III
($000) / 1988
($000)
Net Income / (71.5) / 27.0 / 132.0
Depreciation / 6.3 / 8.0 / 9.3
(65.2) / 35.0 / 141.3
Changes in Non-Cash Operating Working Capital
Accounts Receivable - Trade / (195.3) / 367.5 / 268.5
Inventory and Prepaid Expenses / (14.0) / (104.6) / 2.4
Accounts Payable / 150.3 / (338.8) / (478.8)
Franchise Deposits / 14.5 / 283.6 / (0.4)
Cash from Operations / (109.7) / 241.7 / (67.1)

EXHIBIT 1

Cash Flow after Investment

1987
($000) / 1988
I,II,III
($000) / 1988
($000)
Cash from Operations / (109.7) / 241.7 / (67.1)
Cash Used for Investment
Accounts Receivable - Affiliates / (30.0) / (96.7) / (107.7)
Notes Receivable / (5.5) / (43.8) / (40.8)
Plant, Property, Equipment / (12.1) / (23.9) / (38.2)
Cash Flow after Investment / (157.3) / 77.3 / (253.7)

EXHIBIT 2

Cash Flow from New Store Openings ($000)

Amount / Timing
Initial Cash Flows
Initial Franchise Fee / 7.5 / Prior to Site Development
Receipts for Inventory / 60.0 / 8 Weeks Prior to Opening
Receipts for Fixtures / 25.0 / 8 Weeks Prior to Opening
Net Cash Flow
(8 Weeks Prior to Opening) / 92.5

EXHIBIT 2

Cash Flow from New Store Openings ($000)

Amount / Timing
Initial Cash Flows
(8 Weeks Prior to Opening) / 92.5
Subsequent Cash Flows
Payments for Inventory / (60.0) / Payment Due Weeks after Delivery
Payment for Fixtures / (21.0) / Payment Due Weeks after Delivery
Receipt of Remainder of Initial Franchise Fee / 13.5 / Due Prior to Opening
Net Cash Flow from Opening / 25.0

EXHIBIT 3

PROFIT ALLOCATION: NEW VS EXISTING STORES (1)

($000) / New Store Openings / Existing
Stores
Initial Franchise Fees / 264
Sales of Inventory / 325
Sales of Fixtures / 582
Royalty Fees / 457
Advertising Fees / 155
Retail Service Income / 126
Other Income / 245
Total Revenues / 1172 / 983

EXHIBIT 3

PROFIT ALLOCATION: NEW VS EXISTING STORES (2)

($000) / New
Openings / Existing
Stores / Other
Total Revenues / 1172 / 983 / 0
COGS - Stocks & Fixtures / (862)
COGS - Other / (5) / (190)
Advertising / (164)
SG&A / (57) / (216) / (312)
Management Fees / (67) / (247) / (106)
Total Expenses / (991) / (817) / (418)
Pretax Income / 181 / 166 / (418)

EXHIBIT 4

Adequacy of Collateral for Pageturner Bookstore Loan

Pessimistic Hypothesis

Type of Collateral / Projected Balance
9/30/88 ($000) / Lending
% / Lending Amount
($000)
Accounts Receivable - Trade / 281 / 40 / 112.4
Inventory and Prepaid Expenses / 147 / 0 / 0
Accounts Receivable - Affiliates / 249 / 0 / 0
Notes Receivable / 91 / 0 / 0
Furniture and Fixtures / 82 / 0 / 0
Total / 850 / 112.4

EXHIBIT 4

Adequacy of Collateral for Pageturner Bookstore Loan

Optimistic Hypothesis

Type of Collateral / Projected Balance
9/30/88 ($000) / Lending
% / Lending Amount
($000)
Accounts Receivable - Trade / 281 / 60 / 168.6
Inventory and Prepaid Expenses / 147 / 0 / 0
Accounts Receivable - Affiliates / 249 / 50 / 124.5
Notes Receivable / 91 / 50 / 45.5
Furniture and Fixtures / 82 / 30 / 24.6
Total / 850 / 363.2

EXHIBIT 4

Adequacy of Collateral for Pageturner Bookstore Loan

Pessimistic Hypothesis

Type of Collateral / Projected Balance
12/31/88 ($000) / Lending
% / Lending Amount
($000)
Accounts Receivable - Trade / 380 / 40 / 152.0
Inventory and Prepaid Expenses / 40 / 0 / 0
Accounts Receivable - Affiliates / 260 / 0 / 0
Notes Receivable / 88 / 0 / 0
Furniture and Fixtures / 95 / 0 / 0
Total / 863 / 152.0

EXHIBIT 4

Adequacy of Collateral for Pageturner Bookstore Loan

Optimistic Hypothesis

Type of Collateral / Projected Balance
12/31/88 ($000) / Lending
% / Lending Amount
($000)
Accounts Receivable - Trade / 380 / 60 / 228.0
Inventory and Prepaid Expenses / 40 / 0 / 0
Accounts Receivable - Affiliates / 260 / 50 / 130
Notes Receivable / 88 / 50 / 44
Furniture and Fixtures / 95 / 30 / 28.5
Total / 863 / 430.5