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ROGER’S “FOLLOW THE MONEY” APRIL ARTICLE – in the prestigious RESTAURANT FINANCE MONITOR

ROGER’S “FOLLOW THE MONEY” – APRIL ISSUE, RESTAURANT FINANCE MONITOR

Inflation is Coming and My Thoughts on Franchising

By Roger Lipton

INFLATION IS COMING

The U.S. Federal Reserve Bank was formed in 1913 to control inflation and manage the economy so as to avoid severe economic cycles. It has clearly failed in terms of controlling inflation, since a 1913 U.S. Dollar is worth about $.02 today.  More recently, since the U.S. went off the gold exchange standard in 1971, the Dollar has declined by about 85%. In terms of controlling business cycles, the U.S. has ad: the Roaring Twenties, the Great Depression in the 1930s, World War II, which had to be financed with debt in the ‘40s, inflation running to 12% and the Fed Funds Rate at 18% in the ‘70s, the dotcom bubble and burst of 1999 to 2001, the financial crisis of 2008-09, and the monstrous debt buildup and suppressed interest rates over the last 10 years.

More “money” has been created by the Fed in the last 18 months (adjusted for inflation) than was needed to pay for five years of World War II, and the debt as a percentage of GDP is above where it was in 1945. The M2 money supply in the US has increased by 24% over the last 12 months, the highest within recorded data over 150 years, and 27% most recently.

Fed Chairman, Jerome Powell, says there is a need to raise interest rates and reduce the Fed balance sheet, but adds “There will be a time, but not now.” However, the US debt has increased every year since 1957. There was a budget “surplus” in the last three years under President Clinton and the first year under President George W. Bush, amounting to just under $800 billion over four years, but the debt still increased each year due to “off-budget” items. (Only in D.C. can this happen.) Powell has reiterated the Fed’s objective to generate inflation of 2%+, indicating potential rampant inflation can be controlled, but the current financial experiment is unprecedented in time and magnitude. Our bet is that inflation is coming, higher than the Fed expects and it will be difficult to get the genie back in the bottle. Manage your business accordingly.

THE TIMES THEY ARE ‘A CHANGIN’ IN THE FRANCHISE  WORLD

We wrote here last month that almost all of the mature publicly held franchising restaurant chains are hardly growing their U.S. units. We pointed out that, for a number of reasons, the unit level economics are just not attractive enough for franchisees to encourage unit expansion. Needless to say, higher sales would be transformational. The less obvious, and potentially contentious “adjustment” that could help a great deal is a revision of the franchise structure.

When Ray Kroc started franchising McDonald’s more than 60 years ago, the royalty rate was 1.9% By the 1960s, franchisors had started charging 2%-3%, by the 1970s 3%-4%, and 5% seems to be the standard today, plus at least 2% for advertising and other fees.

Some franchisees, at chains such as Dunkin’, Burger King and Jack in the Box are still making decent returns at  the store level because the store leases were signed 10 or 15 years ago and occupancy expenses are lower  than today’s economics would allow. While single unit franchisees who personally manage their stores can still make a living, a multi-unit owner, who  is the best prospect for unit expansion, paying a non-family store manager, is typically fortunate to be making 17-18% store level EBITDA, of which depreciation is not free cash  flow in the long run. Subsequently, rebating 7 points or more out of 17 or 18 points starts to feel like a pretty big load, and there is still local G&A to be carried. Even if store level EBITDA, before royalties, is in the low 20s, rebating over 7 points is a heavy price to pay. Considering the changing economics over the last two to three decades, there are no material operating expenses that are lower as a percentage of sales, certainly not occupancy or labor, and food costs are unpredictable commodities. The biggest single negative trend that nobody would debate is the intensive competition that has become commonplace.

The time has come for lower fees, especially ongoing royalties. We understand that this suggestion will be resisted by existing large chains, most especially those publicly held, because it would be an obvious reduction of the current royalty stream. However, well established franchisors could, and should, absorb more of the additional systemwide needs, such as technology upgrades. “Mid-cap” franchising companies could put some part of the following suggestions in place.

If I were running an early stage franchise company, I would put in place a sliding scale royalty system, charging 2.5-3.0% at a modest sales level, higher if the franchisee does better. Give them a little room to make money if the store doesn’t do quite as well as everybody hopes. If the store clicks, everybody is happy and the 4-5% on the higher sales won’t seem like such a burden. For my multi-unit franchisees, I would charge lower up front fees for additional stores and this is sometimes already being done (whether  admitting it to Wall Street or not). This is logical and appropriate because less franchise support is required as a franchisee builds local infrastructure.

It seems to us that a young franchise company adopting this strategy would have a huge competitive edge and the total royalty stream is likely to build more rapidly using this progressive approach. Profitable franchisees, and a more appropriate sharing of store level profits, considering today’s economic realty, make for a successful system in the long run.

Roger Lipton has followed the restaurant industry for four decades. Founder of money management and investment banking firm, Lipton Financial Services, Inc., he publishes regularly at www.rogerlipton.com.   He can be reached at lfsi@aol.com and 212 600 2266.