Tag Archives: FRANCHISING

FRANCHISING IS NOT THE “BE ALL TO END ALL”

FRANCHISING IS NOT THE “BE ALL TO END ALL”

There are a lot of myths that surround franchising, many of which have been embraced by restaurant operators and institutional investors alike. Some of them are briefly and broadly described below.

Myth Number One – Franchising is capable of improving the cash flow for a company successfully operating a handful of restaurants.

Not so fast. Substantial legal expenses must be incurred to register as a franchisor. Since the liability and the expenses to defend in a lawsuit can be substantial, it would be foolhardy to proceed without proper legal advice. Registration requirements vary, state by state, so that research has to be done as well.

Secondarily, just in terms of the first franchise deal, expenses by the franchisor will be incurred, indeed should be incurred, to minimize the risk of failure. If the first franchisee stumbles, it’s case closed except for potential legal liability. Those supporting expenses to get the franchise effort off the ground will likely offset most, if not all, of the initial franchise fees.

Myth Number Two – Accepting the reality of the above, if five or ten franchised units can get going, generating, let’s say $1,000,000 per location, a 5% ongoing royalty would be $50,000 annually per unit, and $250-500k of recurring franchisee income becomes real money. Marketing contributions are on top of that, but presumably would be spent as promised.

Not so fast. If you’ve got 5-10 franchised locations, with more planned, you need a supporting cast to maximize the probability of franchisee success. While it is tempting to use your existing operating personnel to support initial franchisees, you can’t afford to distract the operating personnel at your company stores too much. In addition, sites must be approved, training must take place, marketing materials and programs must be created and provided, ongoing field supervision must take place. Salaries, automotive and travel expenses and employee benefits add up pretty quickly, and you don’t want to hire a second rate staff. So even 10 franchised locations, properly supported, are not going to generate a lot of incremental income for the franchisor. Our experience indicates that something like a minimum of $1M of annual expenses, with the handful of functions described above, to properly support a franchising effort. You can calculate for yourself how many units, at your AUV, to absorb that expense, and begin to look at “free cash flow”.

Myth Number Three – Accepting Myths One and Two, the “Asset Light”,“Free Cash Flow” is really exciting when a chain gets to be hundreds and thousands of units.

This assumption is not completely flawed, but is not as foolproof as often assumed. There are any number of large franchised systems where the franchisor allowed their franchisees to “twist in the wind”, as the former’s executives enriched themselves. Just one example: A number of years ago, I was a guest speaker at a Dunkin’ Donuts (to become Dunkin’ Brands) franchisee annual conference. That conference was sponsored by the franchisee Association, not the franchisor. It was crystal clear that the franchisees were suitably glum. Their sales had been flat to down for a number of years while Starbucks had been “eating their lunch” and breakfast too. Though stores that were fifteen or twenty years old were still profitable, there were very few new stores being built, predictably, because current economics didn’t justify it. In the meantime, the Company had bought back, over five years, over ONE BILLION DOLLARS of stock, to allow for stock options and to shrink the shares outstanding enough to show EPS progress. Wouldn’t it have been nice, appropriate and productive, if a couple of hundred million dollars less had spent to buy back stock at a fully priced valuation? It could have alternatively been spent on new product development, marketing, digital ordering technology, or even a renovation fund (at a low interest rate) for the physical updating of franchised stores. The system would have been healthier in the long run, but, as opposed to the franchisees who have signed twenty year franchise agreements and store leases, most of the executives will have cashed out and moved on. Franchised systems, to remain vibrant, have to be supported. Cash flow it is, but it’s not all “free”. Let’s call it “soft capex”.

Myth Number Four – The Apparent Ease of Duplication – Customers love it. If you build it “they will come”.

There are all kinds of reasons that success at one, or even a handful, of locations might not be indicative of broader appeal. To name just a few: the early location (s) might be unique, even in misunderstood ways. The owner’s personality and physical presence, including operating expertise, might be essential. The menu might not work as well elsewhere. Occupancy Expense and Capex at future locations could change the operating economics. New locations might not be adequately researched, from a demographic or logistical (traffic patterns, etc.) standpoint.

Myth Number Five – If it is profitable for the concept’s creator, and it is not too complex an operation, there is no reason it shouldn’t be just as profitable for a hard working franchisee.

Not exactly. The franchisee has to pay a royalty plus marketing fees plus “incidental” fees. That will very substantially reduce the return on investment for the franchisee. As described in Myth Number Six below, a concept should be generating close to 20% EBITDA at the store level to provide an above average long term economic return for the franchisee. An exception would be if the franchisee is willing to “work the store”, perhaps along with family members, therefore “buying a job”, so the operational salaries can be considered additional return on capital invested.

Myth Number Six – 5% Royalty, plus 1-2% local plus 1-2% brand marketing can be expected, pretty sweet for the franchisor, especially once the overhead is covered.

The restaurant franchising industry has come a long way. What was standard, affordable and acceptable by franchisees decades ago is not so easily in the cards today. We wrote over two years ago, referenced in the link:

https://www.liptonfinancialservices.com/2019/03/the-franchisor-franchisee-economic-relationship-this-is-not-your-fathers-world/

This is not your father’s restaurant industry. In a nutshell: if a franchised store is fortunate to be generating 17-18% store level EBITDA (BTW, depreciation is not free cash), that is before local G&A, which can easily run 2-3 points. Out of 15 points, before allowing for the depreciation “reserve” fund, the franchisee is not going to love rebating half of that back to the franchisor. Not unless there is a great deal of support provided. Once the partners have gotten to know each other, after the early passion has worn off, the franchisor and the franchisee had best become good, mutually responsible, friends. 20% store level EBITDA, or more, is better than 17-18%, and will help keep the romance in the relationship.

We could go on, and would be happy to do so, with any of our readers that would like to explore the above thoughts further.

Roger Lipton

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

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

Almost everybody has noticed that there  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

 

 

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

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