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