Governmental economic reports are grossly misleading (to put it charitably) and the mainstream media (including so-called economists) accept it as gospel. In turn, capital markets react based on computer driven algos (“garbage in-garbage out”) and those of us that look through the headlines have to dig among the details to see what really happened. Last Friday, U.S. non-farm payrolls surprisingly grew by 272,000, exceeding the 175,000 expectation and President Biden touted “the great American comeback”. Interest rates spiked, while gold bullion and gold miners had their worst day in a couple of years. Never mind that the Household Survey numbers showed a decline of 408,000 jobs. The discrepancy came about because “part-time” (second & third jobs) employment, considered “new”, exceeded the 272k total and about 175k new government jobs were within the total. This is why the unemployment rate rose from 3.9% to 4.0% and the participation rate fell from 62.7% to 62.5%. The true picture is more accurately described by a household saving rate again near its low as credit card debt, carrying an interest rate over 20%, remains near its high. While the Federal Reserve and the administration touts their success in reducing inflation close to their 2% target, it is especially relevant to point out that the Consumer Price Index (CPI) was overhauled in 1983 to eliminate interest expense from the cost of living. A scholarly paper in February ’24, co-authored by former Treasury Secretary Lawrence Summers, pointed out that today’s “cost of money”, reflected in credit card interest, mortgage interest, car loans, etc., would take the inflation rate up by about 600 basis points to about 9%. This may be why McDonald’s and Burger King need to offer two burgers for the price of one, Wendy’s is providing their breakfast sandwich for $3 and Chili’s collects only $10.99 for Three for Me.
Franchisee complaints have become a predictable result of the recurring need for aggressive traffic building promotions. Franchisees at numerous chains, at McDonald’s most prominently, are bemoaning the deterioration of their store level cash flow. Consider that just six months ago, in the normally active holiday season, similar promotions were necessary, and the same concerns were expressed. Especially in the wake of a presumed post-Covid return to normalcy, we believe the again-evident economic tension between franchisors and their franchisee partners is symptomatic of a more profound problem. Succinctly put, the profit-sharing equation between franchisor and franchisee has become outdated. When Ray Kroc started franchising McDonald’s restaurants over 60 years ago, the royalty was 1.9%. By the 1960s, franchisors had started charging 2-3%, by the 1970s 3-4%, by the eighties 4-5%. Today: 5%, plus advertising and other fees, seems to be the standard. At the same time, there are no material expenses that are lower, as a percentage of sales, certainly not occupancy expenses, insurance, utilities or labor, and food costs are unpredictable commodities. The biggest single negative trend that nobody would debate is the immense competition that has become commonplace. This competitive pressure has also created the need for far more support, particularly with digital technology, from the franchisor, if the increasingly critical public is to be satisfied and the franchisee partner is to succeed. Over the last fifty years, the franchisor should be providing more support and burdening the franchisee less, but that is not necessarily the case. The result today is a total of 8-10% of sales that is being sent “home”, consisting of royalties, brand advertising & a variety of fees. Considering that most four wall “profits” (before depreciation which, over time, is not free cash flow) most often is under 20%, after royalties well below 10% remains in franchisee hands, before re-investing 3-5 points of depreciation, Consider further that local G&A can well amount to an additional 3-5% of sales, which then leaves hardly any return on capital for too many franchisees. It therefore is understandable why only a handful of publicly held franchise systems are showing meaningful unit growth.
An appropriate remedy is lower royalties and fees, accompanied in most cases by an increase in franchisors’ services. While admittedly a tough “pill to take” for existing large chains, because it would be such an obvious reduction of the current royalty stream, well established franchisors could, and should, absorb more of the additional system-wide needs, such as technology upgrades. Early and mid-stage franchising companies could put some part of the following suggestions in place. I would install a sliding scale royalty system, charging 2.5-3.0% at a modest sales level, higher if the franchisee does better. If the store really clicks, everybody is happy and 4-5% on the higher sales won’t seem like such a burden. For my multi-unit franchisees, I would charge lower upfront fees for development of 2nd, 3rd and additional stores, logical and appropriate, because less franchisor support is required as a franchisee builds local infrastructure.
It seems to us that a young franchising company adopting this strategy would have a huge competitive edge. Profitable franchisees, and a more appropriate sharing of store level profits in today’s economic reality, will create a more successful system in the long run.
Roger Lipton
