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America Coffee Case Study (2ND PART) (FIRST PART IS ABOVE)

Company Background

America Coffee House Limited (ACH) started out as a breakfast diner over 70 years ago in the heart of Texas that was known for its bottomless coffee and cheap food under the original name Bob's Breakfast. Due to the popularity of the coffee, the firm started to expand nationally with cafs under the America Coffee House banner over the next several decades, as well as breakfast locations. The firm entered Canada in 1993, opening up over a hundred cafs under the "Canada Coffee House" banner.

Due to increasing competition from North American competitors Denny's and IHOP, ACH struggled in the nineties, filing for bankruptcy and closing down hundreds of its breakfast locations in North America, reorganizing, and ultimately emerging from bankruptcy in 1999. The company was eventually bought out by a private equity firm in 2001. The private equity firm needed to take on a substantial amount of debt at the time of the buyout to purchase all the outstanding shares of ACH.

Under privatization, the company started to expand outside of North America, as it closed down substantially all of its American and Canadian breakfast locations. The company also started selling its coffee beans, ready-to-serve coffee powder, and bakery products (muffins, cupcakes, etc.) in grocery chains. Thus, America Coffee House had become a coffee provider and wholesaler, moving away from its roots as a breakfast chain.

In 2006, the brand saw a resurgence in popularity in North America with increasing demand for stand-alone caf locations. ACH started to rollout cafes again, building a loyal fan base for its affordable coffee. During this time, the company rebranded with a new mission statement:

"Our mission is to be American families' favorite affordable coffee provider, providing high quality services for our guests and communities through cutting-edge innovation and partnerships."

The company went public in 2007, and is now trading under the ticker ACH on the New York Stock Exchange.

Discussion with Chief Executive Officer (CEO)

Susan Matthews, CEO, joined ACH seven years ago during the initial new expansion plans. She has over 25 years of experience in the food and beverages (F&B) industry, including stints at the executive level at Loblaws, Denny's, and Dave & Busters. She entered ACH after four years as a Vice President of operations at Starbuck's.

Ms. Matthews has reached out to you to help her assess the current financial and strategic state of America Coffee House, evaluate some investment proposals, build a financial forecast for 2018, and evaluate tax consequences of an asset disposal.

"The next few years are going to be transformational for America Coffee House," Ms. Matthews said. "Consumer preferences have been changing, especially the Millennial segment, which is responsible for 70% of our sales. Millennials are becoming more active and more health conscious. Because of this trend, there is greater demand for organic products and healthier alternatives, which is why we are shifting are menu to meet this demand with more smoothies, less sugary coffee drinks, and additional low-calorie food offerings."

"Younger customers are also very politically and socially active, and are quick to use social media to reprimand any companies that do not have a more sustainable operation or viewpoint. We made an ethical commitment back in 2011 to evaluate all of our suppliers to make sure fair trade was being enforced to protect coffee farmers. This move has resonated with millennials and prevented any brand backlash, but has also led to increasing costs for our products."

"Rental rates have also been increasing, with rent being included in the cost of goods sold, leading to a negative impact on our gross margins. We are renegotiating with some of our key landlords to reduce rental rates in our mall locations, and I believe we will be able to reduce rents, due to our value as a traffic driver in these malls, which have had a high exit of retailers in recent years."

In 2017, ACH ended up with a loss for the first time since going public in 2007.

"Our current brand position as an affordable coffee provider prevents us from raising prices to offset higher supplier costs and increasing competition," explained Matthews. "We have a low market share, due to our scale back during our bankruptcy crisis, and we don't have the financial flexibility or power to survive another year or two of losses, especially with our growing debt. I am hoping that changing our menus to be more gourmet or premium, with higher margins, will lead to long-term profitability."

ACH has also been following behind other competitors, like Starbucks, in terms of digital and mobile integration. Starbucks mobile applications allow customers to order ahead of time for later pickup, as well as giving Starbucks the opportunity to engage with customers through promotions, coupons, loyalty rewards, and frequent messages. ACH has no mobile integration, but is considering investing in a mobile app to match the growing demand for online integration for food and beverage companies.

"Some of our market research has also shown that consumers want more diverse product offerings," said Ms. Matthews. "Our competition has been introducing more breakfast options, frozen yogurt, and even marijuana products to increase traffic to stores. We are considering some of these options, although we want our focus to still be coffee and caffeine-related products."

"I need you to examine our current mission statement and determine if we are fulfilling it, as well as what needs to change in order for the mission statement to align with the potential future positioning of the company."

Qualitative & Quantitative Analysis

To help with your assessment of ACH's current state and the investment proposals, Ms. Matthews recommends that you develop a SWOT analysis and also perform financial statement analysis.

"SWOT stands for strengths, weaknesses, opportunities, and threats," explained Ms. Matthews. "It is a standard tool used in internal and external assessment, with a focus on qualitative factors. Strengths are things that a company does well, while weaknesses are areas of improvement. Strengths and weaknesses are internal to the firm, meaning that ACH can have substantial control over them. Opportunities and threats are external to ACH, meaning that these are environmental changes that are outside of our control, but could be working for or against our favour. Government regulation is an example of an externality that could be an opportunity or a threat, depending on your business or point of view."

"Financial statement analysis involves the use of ratios to evaluate the performance, financial health, and efficiency of a company, among other things," carried on Ms. Matthews. "I would like you to analyze the liquidity, profitability, efficiency (asset utilization), and solvency (debt ratios) of ACH, and to fully explain what the trend in these ratios are indicating about my company's historical performance. Ratios can be used to tell a storywhat story do you see coming from the numbers?"

Financial Forecast

Ms. Matthews has asked for your help in developing a financial forecast for 2018, using the 2017 income statement as a reference point.

"Sales are forecasted to grow 13% in 2018, due in large part to a rebound in the North America retail segment, which consists of all the sales in cafs across the US and Canada," explained Ms. Matthews. "72% of 2018 sales are expected to be from North American cafes. We are working on having our new cafes located in several Macy's department stores, as well as a national book chain, but nothing has been finalized as of yet. Nonetheless, we are exploring more and more partnerships in our growth strategy to help spread the risk and the costs with a less leveraged organization."

"12% of 2018 sales are anticipated to be from the wholesale segment, which consists of all products that are sold as pre-packaged items (e.g., bags of coffee beans, bakery products, or pre-made coffee mix), primarily in grocery stores and travel retail at airports. We have been approached by a major grocery chain in Europe to expand our wholesale offerings in their 400 locations across 15 countries. There may be further opportunity to expand our popular blended products in Eastern Europe, as well."

"The international segment consists of international cafes not located in the US or Canada. These cafes often operate through licensing and franchising agreements with local partners in the foreign countries. The segment is expected to continue to grow with our aggressive franchise expansion in Asia, but the strengthening US dollar is reducing our return on foreign sales. Nevertheless, there are still tremendous opportunities for international franchising, including Latin America. Overall, I want your forecast to indicate the total dollar amount that each of ACH's three segments will generate in 2018."

"In terms of our gross margin, there are several positive and negative factors impacting our ability to control costs. There is a lot of uncertainty regarding the recent trade wars between US and several Asian countries that host key suppliers for some of our raw materials (coffee beans), which is expected to negatively impact our 2018 margin by 2% versus our 2017 margin. However, the rising American dollar has increased our buying power, which will mitigate this impact by about 1%. We also have to switch to a more expensive supplier for our gourmet coffee, due to some natural disasters wiping out the coffee fields of our major supplier, which will impact gross margin by -1%. This risk continues to grow for us, as our supply chain stretches globally. We plan on raising our prices to match the increased share of gourmet offerings, leading to a 4% positive impact on gross margin. Taking all these factors into account will help forecast what our expected 2018 gross margin will be."

With the rebranding of ACH into a more premium, hipper coffee provider, Ms. Matthews has indicated that advertising and marketing will grow to 8% of sales in 2018. Minimum wage hikes will also lead to a 4% increase in general and administrative costs, which mostly consist of employee wages. "I'm hoping that higher wages will help with our employee turnover issues," explained Ms. Matthews. "The turnover issues are also part of our deteriorating customer service, as we keep having to train new employees on the job, rather than having them take our two week ACH employee training course."

In order to help ACH restore long-term profitability, Ms. Matthews intends to close several unprofitable stores, admitting that the company may have initially over expanded during its "renaissance." This move will lead to $30M in lease termination payments to landlords in order to compensate them for the early exit of ACH from leased premises. These lease payments will be treated as an expense on the income statement. ACH will finance these payments with the sale of one of its head office properties, resulting in a $20M gain to be recognized in the income statement. The entire head office is now moving under one roof to ensure strategic alignment across the organization. Some intangible assets will be sold, consisting mostly of licenses, resulting in a gain of $15M. The sale of the head office properties will result in depreciation being lower by 25% in 2018. The sale of assets is expected to close in the first two weeks of January.

Excess cash from the disposal of assets (after the lease payments have been settled) will be used to pay down debt obligations, as ACH has had limited access to capital due to the significant amount of long-term debt on its books and deteriorating cash flow. ACH plans on paying down $40M of debt right away, with the remaining debt having an associated interest rate of 8%.

The tax rate is expected to be consistent with 2017. Finally, research, development and IT costs are expected to triple in 2018 as ACH prepares to launch a mobile app for ordering and customer rewards.

Investment Proposals

Ms. Matthews wants you to assess two investment proposals that the ACH investment team is considering.

Ms. Matthews is considering partnering with a frozen yogurt company to introduce more frozen treats on its menus, similar to what the Canadian company Second Cup did with its partnership with Pinkberry. Stores would have to be remodeled to accommodate the extra space required to hold the yogurt bins, and there would be more capital expenditures required for additional refrigeration equipment. The frozen yogurt company, which has many low-fat options, has exploded in popularity over the last year, with lineups that span for blocks for its few locations and several millions of engaged follows on social media. The frozen yogurt company is backed by several private equity investors and has significant amounts of cash to invest in the partnership.

The second investment proposal would be to purchase a coffee roasting plant in Puerto Rico. ACH has been considering vertical integration in order to get more control over its costs, and to lessen its exposure to Asian suppliers under the current trade environment. Puerto Rican coffee beans are becoming more and more associated with premium products due to their exotic taste. Tropical storms have been wreaking havoc in the territory, causing some businesses to sell at attractive prices in order to rapidly exit the industry.

Ms. Matthews wants you to assess how these two proposals align with the strategy of ACH, using your SWOT analysis and ratio analysis, and, ultimately, to make a recommendation whether to accept none, one, or both of the proposals.

Tax Assessment

Finally, Ms. Matthews has one last request; she needs help understanding the tax consequences of the disposal of an old freighting truck. Prepare a CCA schedule for tax depreciation of a freighting truck purchased three years ago on January 1, 2015 for $350,000 (assume Class 16 with CCA rate of 40% and half-year rule applying). Calculate the tax consequence if the truck were to be sold at the beginning of this year (i.e., end of 2017) for either $90,000 or $120,000. The truck is the only asset in the class. Utilize the average tax rate that America Coffee House had in the last five years in your analysis of the tax impact.

Financial Statements

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