Tag Archives: FRANCHISING

THE FRANCHISOR/FRANCHISEE ECONOMIC RELATIONSHIP – IT’S A NEW WORLD !!

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THE FRANCHISOR/FRANCHISEE ECONOMIC RELATIONSHIP – IT’S A NEW WORLD !!

Almost everybody has noticed that their is an increasing strain between franchisees and their franchisors.  It is no accident that new franchisee associations are being formed and existing organizations are getting more militant. There are many intangible reasons, as too many franchisors do not treat their “z’s” as partners. We have written many times that the “asset light”, “free cash flow” model is not reflecting the necessary investments in the system to keep franchisees as profitable as possible. Many franchisees are especially bothered by the fact that their franchisors are spending hundreds of millions, sometimes billions, of dollars buying back stock and making acquisitions, while leaving the franchised operators without the necessary new product development, technology upgrades, marketing initiatives, etc.etc.

With all of that in mind, the bottom line is the bottom line. Too many franchisees are suffering financially, under more pressure than ever. The typical franchise royalty is 5%, give or take a point, plus 2%, as an advertising contribution. There are often additional charges, not all that material in and of themselves, but adding to an already large burden. Let’s say the franchisee is fortunate enough to be making 17-18% store level EBITDA (and Depreciation is not free cash in the long run).  Rebating 7 points 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  twenties, 7 points gets to be a bother.  Additionally: many franchisees, Dunkin’ Donuts and Burger King and Jack in the Box are just a few examples of mature systems where decent money is still being made at the store level because the store leases were signed ten or fifteen years ago, so occupancy expenses are lower than today’s economics would allow. That’s, of course, why so few new units are being built by many mature franchised systems, especially in the USA. Today’s economics do not allow it.

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%, and 5% seems to be the standard today, plus advertising and other fees.

At the same time, there are no material expenses that are lower, as a percentage of sales, certainly not occupancy expenses 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. Even in today’s over-stored situation, there are more new stores being built, within chains, than closing.  This competitive pressure has also created the need for far more support from the franchisor, if the increasingly critical public is to be satisfied and the franchisee partner is to succeed.  Over the last fifty years, as the franchisor should be providing more support and burdening the franchisee less, the trend has been just the reverse.

The answer: lower fees, especially ongoing royalties. 

This specific suggestion will not be adopted by existing large chains, because it would be such 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-stage” franchising companies could put some part of the following suggestions in place.

If I were running an early stage franchising 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 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 development of 2nd, 3rd and additional stores, and this is sometimes already being done (whether admitting it to Wall Street or not). This is logical and appropriate, because less franchisor support is required as a franchisee builds local infrastructure.

It seems likely that a young franchising 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 in today’s economic reality, make for a successful system in the long run.

Roger Lipton

 

 

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ASSET LIGHT, FREE CASH FLOW FRANCHISING COMPANIES ARE “GOLD” – WELL…..NOT NECESSARILY!!

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What goes around comes around. It is inevitable that about the time that common wisdom indicates that this is the only way to go, the formula gets abused. (Golfers understand what I mean: just when you think you’ve “got it”, you lose it.)

In the world of pure franchising of restaurant concepts, almost all the major systems are experiencing hardly any net unit growth. Since franchisees vote with their bank accounts, you can bet that their return on investment is far from encouraging, and the challenges are clear.

Franchisee margins and cash flow have been squeezed by flat to negative traffic combined with materially higher wages, cost of tech upgrades, administrative costs to deal with increased regulation (now abating), higher construction costs which affect the cost of remodels and potential new locations. The saving grace the last several years was that commodity costs were modestly lower, but that is reversing to the upside. We all know that the world is “overstored” and company operated expansion has been slowed as well, but the overstored situation is unfortunately correcting itself at a very slow rate. The leases signed were ten to twenty years in duration and it can more expensive to walk away than to hang in as long as possible.

Franchisors have not been standing idly by in these challenging times. However, their natural inclination is to concentrate on sales, which translates to higher royalties, rather than franchisee profitability. Value Driven promotions have become the focus in an economic environment where middle class customers are still short of discretionary income, as evidenced by “Breakfast All Day”, “$1,$2,$3 Menu”,”2 for $6 Burgers”, “4 for 4”, “$5 Lunch Box”, “Buy One, Take One”, “Two Pizzas for $10” etc.etc.etc. Some chains like McDonald’s and Wendy’s have managed to maintain a “barbell” strategy, with traffic driven by the bargains, and the hope of upgrading at least some of the customers.

While the store level battle for market share continues, franchisors, especially those that are publicly traded, are encouraged by the “asset light” and “free cash flow” mantra of investors, who have accorded high valuations to pure franchisors. Companies are encouraged by investors to employ the presumably free cash flow in large stock buybacks, which keeps the earnings per share moving ahead, and the stock price, and obviously makes executive stock options more valuable. The table provided below this discussion provides the specifics, what we consider a shocking contrast to the financial health of the individual franchised operators. We’re not saying that all franchisees of these systems are on the verge of bankruptcy, but we are saying that it’s a real battle to maintain margins and cash flow. There’s a lot more time for leisure activities if you are the franchisor rather than the franchisee.

The question, apparently not obvious to many investors, especially in publicly held franchised restaurant companies, becomes:

To what extent is the franchisee system being short changed over the long term, enriching shareholders in the short run, by inadequate “reinvestment” of more of the franchisors’ cash flow. The system has “needs”, such as: product development, technology initiatives (including mobile apps), evaluation of the delivery trend, marketing support, remodel and technology upgrade financing, employee recruitment and training and retention approaches, field operations support, etc.etc. Some of this is being done, of course, but how much more could be, should be, perhaps even must be done?

Looking at the table below, we think it is no accident that Domino’s success the last ten years has followed upon the upgrading of their core products almost ten years ago. Combine that ongoing product focus with their focus and major capital investment in what has become their clear technological leadership. It’s been said that DPZ is a technology company that just so happens to sell pizza.

Franchisees at major chains are most often reluctant to go public with complaints. However, the disillusionment within the Tim Horton franchisee community has been well documented. Just in the last week, 20% of the domestic McDonald’s franchisees have publicized their request for a new Franchise Association,  Jack in the Box franchisees have asked for the ouster of JACK’s CEO, and we suspect that these situations are the tip of the iceberg. Popeye’s franchisees are surely looking over their collective shoulder, wondering whether the G&A “savings”, a key part of the play book implemented by Restaurant Brands (QSR) at Burger King and Horton’s will affect the support behind the Popeye’s franchise system.  Franchisees at Sonic, Wendy’s and Dunkin’ Donuts, as well as many others that are not “pure” franchisors, such as Pollo Tropical, Red Robin, Pollo Loco,  or Chili’s can’t be thrilled right now, or they would be building more stores.

A short story, and contrast, comes to mind, starting in 1992 when IHOP came public (and we made a lot of money for our clients and ourselves in the stock). Kim Herzer, now passed, was CEO. Our good friends ever since, Fred Silny and Steve Pettise, were CFO and Marketing VP, respectively. Herzer was a “simple man”, just wanted to be in the pancake business, never considered buying another brand. He and his organization bent every effort to make sure that every franchisee was as profitable as possible. He really understood , not just with lip service, that his franchisees were his partners, their success ensured his success, and he invested his capital and his organizational support accordingly. The company was unleveraged, and they used their “free cash flow” to build new stores and provide a turnkey fully equipped package for franchisees, who had adequate “skin in the game” by way of the $250k franchisee fee plus ongoing rent and royalties.  It was after Herzer was gone that Julia Stewart became CEO in 2002, borrowed $1.2B to buy Applebee’s in 2004, and the game changed. There were then two brands to oversee, debt to service, Wall Street expectations to meet, which included stock buybacks and dividends. For all kinds of reasons both brands have been challenged in the last decade, Applebee’s more than IHOP, and Julia Stewart has moved on. The billion dollars of debt is still largely in place, though refinanced at the lower rates available over the last decade.

In Conclusion: One can only imagine how much better all of the above mentioned brands might be doing if some portion of the hundreds of millions of dollars spent on stock buybacks and dividends had been directed toward operations.

Roger Lipton

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