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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

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ASSET LIGHT FRANCHISING – COMPLAINTS FROM FRANCHISEES – LET’S CLEAR THE AIR!!

The long term investment appeal of well established franchising companies is accepted by the investment community. Most of the prominent franchisors’ equities sell at price to trailing twelve month EBITDA multiples in the mid to high teens (Denny’s (DENN), Dine Brands (DIN), Dunkin’ Brands (DNKN), Pollo Loco (LOCO), McDonald’s (MCD), Restaurant Brands (QSR), Wendy’s (WEN), even higher in a couple of instances Domino’s (DPZ), Shake Shack (SHAK), Wingstop (WING), lower in a number of “challenged” situations like Jack in the Box (JACK), Red Robin (RRGB), Brinker (EAT), Fiesta Rest. (FRGI).

The attraction of asset light franchisors revolves around the presumably free cash flow for franchisors, a steady stream of royalty income unburdened by capital expenditures to build stores. The operating leverage is at the store level.  Franchisees are responsible for building the stores, then controlling food costs, labor, rent and all the other operating line items. Franchisors receive the royalty stream and have the obligation of supporting the system with brand development, site selection advice, marketing support, and operating supervision. These supporting functions, it should be noted, are optional to a degree, and we have written extensively about system support sometimes being short changed by corporate priorities such as major stock buybacks.

THE CURRENT WORD, IN THE FIELD, AS WE HEAR IT

We acknowledge that in every franchise system there will be some operators less satisfied than others. In the same way, customer reviews on Yelp or Facebook are more frequently written by critics. Bad news is more noteworthy and more customers are inclined to criticize than applaud, so we have to listen to the complaints but dig further for the reality. With that in mind, we hear the following from franchisees of various restaurant systems:

“I’ve been in this business for thirty years, and I’ve never seen it this bad. Everyone is making money but me; the landlords, the franchisor, the banks. My margins have been killed, and I’m up against my lending convenants”.

“All the franchisors want to do is build sales to build their royalties. The dollar deals are trading people down. My franchisor doesn’t care about my margins. I can’t maintain my margins, especially with the increasing cost of labor, let alone build it”.

“The franchisor is putting pressure on me to sell, even though I’ve always been considered a good operator, with high performance scores. I’m up to date on my development agreement, but they want somebody else to take me out, and the new buyer will agree to what I consider to be a ridiculously aggressive development contract”.

“The franchisor has replaced experienced long term field support with lower priced (and inexperienced) younger people. They’re cutting corporate overhead, but these kids, who never ran a store, are telling me to how to control costs.””

“I’m doing my best with the development objectives, but it is almost impossible to build stores with today’s economics. Rents are too high, labor costs are killing me, and I can’t raise prices in this promotional environment”.

“As if things aren’t tough enough, I’m being nickeled and dimed with demand for higher advertising contributions and fees on services (including software) that I thought would be provided”.

The valuations provided to the publicly held companies do not reflect the situation as described by the admittedly anonymous franchisees. The commentators quoted above don’t want to aggravate their franchisor, and we don’t want to be unfair or misleading to particular companies by relying on just a few conversations, though they do support one another. For the most part, franchisees are strongly discouraged from talking to the press or investment community. The companies will say that “competitive” issues require some secrecy, but there are few secrets in this industry.

The optimistic view, as represented by the valuations in the marketplace, is that the comments above are not typical or representative of the health of the subject franchise systems. Allow me to provide a short story which leads to a suggestion.

A SHORT STORY

Twenty six years ago, in 1992, IHOP had just come public. I was a sell side analyst, thought the numbers were interesting and the stock was reasonably priced. The company, led by the now deceased CEO Kim Herzer, invited me to attend their franchisee convention, which I did. I obviously had the opportunity to interface with many franchisees and it was clear that, while all was not perfect, the franchisor was providing a great deal of support that was embraced by an enthusiastic franchise community. IHOP stock tripled over several years for me and my clients who owned millions of shares. I attended several more of their annual conventions and maintain some of those relationships to this day. Obviously, the conviction I gained from their open attitude was critical to the success of the investment. I should add, that many of those buyers in 1992 owned the stock for many years, not living and dying on quarterly reports.

THE SUGGESTION

As you are no doubt by now anticipating, my suggestion to publicly held franchising companies: open up your franchisee conventions to the investment community. The companies may quickly respond that lenders are already invited to franchise conventions, but franchisees are unlikely to express their system oriented concerns when they are making a pitch to a potential lender. Companies may also respond that their lawyers think it would be a bad idea, not consistent with full disclosure and analysts would be getting “inside information”. Let’s not allow the lawyers to provide “cover”. A good lawyer will provide a solution to the problem, not just provide the pitfalls. Analysts attending a franchise convention are not being told what sales or profits are going to be. Attending a franchise convention is  a “channel check”, no more than talking to a supplier or customer of a manufacturing company, which any decent analyst will do.

The anecdotal critical comments, as described above, have likely been heard by others, but may be atypical of most restaurant franchising companies. There are no secrets in this business. One of the investment appeals of this industry is its transparency. Notable news is going to leak out anyway. The objective of any publicly held company is to build stock ownership by well informed investors. Investment analysts pride themselves on their ability to “build a mosaic”, enhance the information provided in quarterly reports, SEC filings, and conference calls, with “channel checks”. What channel check would be more pertinent than meeting the franchisees of a company that is dependent on franchisee success? Putting it another way, and taking the highest valuation relative to EBITDA as an example: Wingstop (WING) is a company I have the highest regard for. However, you could call it irresponsible to pay almost fifty times trailing EBITDA for Wingstop stock (and I haven’t) if I couldn’t talk to franchisees of my own choosing?

There’s no particular need to invite this writer if I’m not considered influential enough. I have not spoken to these analysts on this subject, but qualified industry followers such as David Palmer, Nicole Reagan, Matt DiFrisco, David Tarantino, Jeff Bernstein, Andy Barish, Bob Derrington, Mark Kalinowski, Michal Halen, Gary Occhiogrosso, Howard Penney, Jonathan Maze, Nicholas Upton, John Hamburger and John Gordon provide the beginning of an invitation list.  I rest my case.

Roger Lipton

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McDONALD’S

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COMPANY OVERVIEW (2017 10-K):

The Company operates and franchises McDonald’s restaurants, which serve a locally-relevant menu of quality food and beverages sold at various price points in more than 100 countries. McDonald’s global system is comprised of both Company-owned and franchised restaurants. McDonald’s franchised restaurants are owned and operated under one of the following structures – conventional franchise, developmental license or affiliate.

The Company is primarily a franchisor, with more than 90% of McDonald’s restaurants currently owned and operated by independent franchisees.

Of the 37,241 restaurants in 120 countries at year-end 2017, 34,108 were franchised (reflects 21,366 franchised to conventional franchisees, 6,945 licensed to developmental licensees and 5,797 licensed to foreign affiliates (“affiliates” – primarily in Japan and China) and 3,133 were operated by the Company.

SOURCES OF REVENUE (2017 10-K):

McDonald’s is the largest restaurant chain by revenue with $22,820 billion through the end of 2017. 56% of this revenue is derived from company units and 44% of the total revenue is from royalties and rental revenues from franchisees.

 UNIT LEVEL ECONOMICS:

As of the end of 2017, AUV of traditional domestic stores opened at least 12 months were $2,947,600 for Company stores and $2,735,000 for franchise locations. Traditionally AUV has been higher at Company stores than at franchise locations. This gap decreased in 2017 due in large part to McDonald’s refranchising initiatives.

Below the top line, the unit level performance of franchised units is difficult to compare with Company units; mainly because the majority of franchised locations are leased, land and building, from the parent company. The Company recovers its investment with a minimum rent and percentage rent component.

Based on McDonald’s 2016 Franchise Disclosure Document (the most current FDD) it is estimated that the average franchise investment is $1.2M which on average generates EBITDA of 14.3% of sales and cash on cash return of 30.9% on the average franchise AUV of $2,624,000. The margins are net of royalty and fees of 4.2% and estimated average rent of 10.4%.

COMPANY STRATEGY (Source: March 2017 Investor Day Presentation):

Prior to the March 2017 Investor Day Presentation, Steve Easterbrook, President and CEO, had in 2015 outlined his turnaround strategy for the Company. The plan included grouping global operations into four segments: U.S., International lead market, International high growth markets, and foundation/corporate markets. This plan combined markets with similar characteristics, challenges and opportunities rather than by geography. The plan of realignment would better focus energy in addressing common challenges and a smoother ability to adopt best practices. As of January 1, 2017, this plan was in place.

In addition, Easterbrook (as of 3/17) targeted the refranchising of 4,000 company units, the majority in the high growth and foundational markets. As of October 1, 2017, this target was achieved – nearly a year ahead of schedule.

On March 1, 2017 McDonald’s unveiled its long-term global growth plan with its financial target and outlined the initiatives to unlock meaningful growth and increase guest counts. The Velocity Growth Plan is vital for growing sales and shareholder value for the future. The accelerated execution of this customer centric strategy is built on the following three pillars, all focusing on building a better McDonald’s:

  • Retaining existing customers
  • Regaining lost customers
  • Converting casual to committed customers.

In each pillar, McDonald’s has established sustainable platforms that enable execution of the plan with greater speed, efficiency and impact while remaining relentlessly focused on the fundamentals of running great restaurants. Additionally, through three identified growth accelerators – Experience of the Future (“EOTF”), Digital, and Delivery – McDonald’s is enhancing the overall customer experience with hospitable, friendly service and ever-improving convenience for customers on their terms. The Company met aggressive deployment targets for each one of these accelerators in 2017. A further breakdown of these growth accelerators is listed below.

  • Experience of the Future – McDonald’s currently has EOTF deployed in about one-third of the restaurants globally, with half of the U.S. restaurants expected to be deployed by the end of 2018.

Accelerating deployment of EOTF restaurants in the U.S. McDonald’s redirected a portion of capital saved from refranchising to modernize about 650 restaurants in 2017. This will give the U.S. approximately 2,500 Experience of the Future restaurants by year’s end. McDonald’s intends to have most of the traditional free-standing restaurants modernized by 2020.

  • Digital – As the Company accelerated its pace of converting restaurants to EOTF, it is placing renewed emphasis on improving its existing service model. By evolving the technology platform, the Company is expanding choices for how customers order, pay and are served through additional functionality on its global mobile app, self-order kiosks and technology-driven models that enable table service and curb-side pick-up. In the U.S. alone, McDonald’s now has over 20 million registered users of the McDonald’s application.

Enhancing digital capabilities and the use of technology has dramatically elevated the customer experience. To enhance digital capabilities to elevate the customer experience, McDonald’s must be relevant to customers. This is being done through Kiosks, additional staffing to assist in the Kiosk process. Additionally, to skip the Drive-Thru, McDonald’s has introduced an improved order and pay app and chose curbside delivery while stopping the Drive-Thru.

  • Delivery – The Company continues to further scale its delivery platform as a way of expanding the convenience customers receive from McDonald’s. In 2017, McDonald’s added delivery to 7,000 restaurants in 21 different countries. Including previously offering of delivery in Asia and the Middle East, McDonald’s is now delivering meals from over 10,000 restaurants. In addition to added convenience, delivery transactions tend to realize a higher average check and a higher customer satisfaction rating.

Redefining customer convenience through delivery. McDonald’s is uniquely positioned to be a world leader in delivery. 75% of the population in the USA, France, Canada, UK and Germany live within 3 miles of a McDonald’s and in 2017 McDonald’s had annual sales in delivery of over $1B across various markets – mainly in Asia, China, Singapore and South Korea.

RETURNS TO SHAREHOLDERS:

In 2017 the Company returned $7.7 billion to shareholders through share repurchases and dividends and recently announced a new $22-24B cash return target for the 3-year period ending 2019. The dividend provides a yield of 2.5% at the current stock price. The common stock, after trading in a relatively narrow range from $90 to $100 per share from early 2012 through Q3’15, has been one of the better performers among restaurant companies since then, rising about 60%.

RECENT DEVELOPMENTS (Per Q4’17 Earnings Release and Conf.Call on 1/30/18):

McDonald’s continued to outperform most of its QSR peers in Q4’17, with global comp sales up 5.5% (4.5% in the US), including positive guest counts up 1.5% in Q4 and 1.9% for year. While consolidated revenues were down 15% in constant currencies (CC), due to refranchising, systemwide sales were up 8% CC and consolidated operated income was up 6% CC (4% in the US). Excluding the Tax Act adjustment, diluted EPS was up 16% CC, reflecting the impact of share repurchase, $661M worth in Q4 alone, and a cool $4.6B for the year. Also in Q4, the dividend was increased 7% to $1.01 quarterly. With the exception of South Korea, virtually all segments were strong. Development plans call for the opening of about 1,000 new restaurants in ’18 (75% non-US), with the investment of about $2.4B of capital, the majority of which will be accelerated deployment of the EOF in the US.

In the US, in Q4, company operated margins declined 150 bp, due to higher labor costs and higher commodity costs. Menu pricing was up 3%, which is expected to adjust downward in Q4’18 with the $1,$2,$3 Dollar Menu. Delivery is now offered in over 10,000 locations worldwide, and these orders have an average check 1.5-2.0x other orders. There are now over 20M registered users of the mobile app, now offered in 20,000 worldwide locations.

The refranchising effort continues and reported results could be “choppy” with the consolidated transaction effect. The effective tax rate will be 25-27%, down from the historical range of 31-33%, allowing for a cash savings of $400-500M which will be available for other uses. The priorities remain the same, first to invest in the business, second to pay dividends, and, lastly, for the repurchase of stock.

Regarding the planned reduction of G&A, $300M of the targeted $500M was achieved in ’17, the rest to be achieved through 2019.  Capital expenditures will be about $2.4B in ’18, $1.5B of which will be dedicated to the US, primarily focused on acceleration of EOF.

As of the end of January, with the conference call, the new $1,$2,$3 menu was only in place for 20 days, so no comment was provided relative to the customer reaction other than “we are not seeing a material shift in product mix”. Subsequently, Wall Street speculation was that the response was not especially good, which caused a short term correction in the stock (since reversed),  but our channel checks have indicated continuing positive comp sales in Q1, in spite of the possibly tepid response to this particular offering. The $1 “any size” drink, as well as the $3 Happy Meal and continuation of previously successful offerings such as All Day Breakfast are no doubt contributing to ongoing strength.

Relative to expected operating margins, management indicated that historically a 2-3% comp was necessary, but something higher is necessary today because of labor pressures. Since comps have exceeded that recently, and are expected to continue, franchisee cash flow in the US was said to be “near all-time high” and operators are willing to move forward with EOTF projects.

Delivery continues to be a major initiative, one of 5-7 major platforms for growth, with around 5,000 US locations utilizing UberEATs. Further expansion through UberEATs naturally depends on their geographical coverage, and the expansion rate may slow because major urban centers are already covered. Markets such as UK, Australia, Canada and the Netherlands are apparently getting superior results from delivery and the Company is studying those markets to adopt best practices. Margins are lower due to the delivery fees, but the business seems to be largely incremental, so the profit contribution is worthwhile even if the overall margin rate comes down.

The fresh beef initiative provides high hope for a positive customer reaction, which has apparently been the case so far. As of the Conference Call, 2-3,000 restaurants had the fresh beef for Quarter Pounder and Signature platforms. Further rollout, involving new distribution procedures and store level training continues. The rollout of this major new program continues.

Overall, the multiple initiatives of this premier worldwide brand continue to be the focus. There is no reason to believe that the momentum established by Steve Easterbrook and his team will be short circuited. The operating improvements complemented by unmatched marketing muscle should allow McDonald’s to provide the latest chapter as they once again “write the book” in the QSR business.

 

 

 

 

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CONSUMER SPENDING IS 65-70% OF THE ECONOMY. WHAT’S HAPPENING?

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INCLUDED IN YOUR ANNUAL SUBSCRIPTION:

  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.

RESTAURANT STOCKS COMING DOWN – FUTURE OUTLOOK?

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INCLUDED IN YOUR ANNUAL SUBSCRIPTION:

  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.

McDONALD’S REPORTS Q4 – A 5.6% U.S.COMP – EPS UP 16% – GREAT, RIGHT? HOLD THE CHAMPAGNE!

To access this content, you must purchase Website Subscription.

INCLUDED IN YOUR ANNUAL SUBSCRIPTION:

  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.

McDONALD’S (MCD) (OPPORTUNITY LOST), by Steve Pettise, “Friend of Rog”

To access this content, you must purchase Website Subscription.

INCLUDED IN YOUR ANNUAL SUBSCRIPTION:

  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.

McDONALD’S STOCK UP BIG! IS IT TOO LATE TO BUY?

To access this content, you must purchase Website Subscription.

INCLUDED IN YOUR ANNUAL SUBSCRIPTION:

  • Broad economic insight. As described in “Restaurants/Retail – Why Bother?” the restaurant and retail industries provide a leading indicator of far broader economic trends. You no longer have to be the last to know.
  • Two to three analytical pieces per week (“Roger’s Rap”) personally written by Roger Lipton describing corporate developments within his industry specialization, including their relevance to the broader economy.
  • Periodic “macro” discussions personally written by Roger Lipton, analyzing fiscal and monetary matters that will likely affect your investments and your business.
  • Opportunity to “Ask Rog” about your personal concerns, regarding individual companies or broader economic trends. Roger will use his best efforts to answer questions submitted, obviously limited by the number of requests . He may answer your question by email directly and/or include your question with his “Roger’s Rap” releases.
  • You are provided access to “Friends of Rog”, depending on your financial and operational needs. The outstanding individuals suggested here, have been personally “vetted” by Roger over decades. Roger receives no compensation based on whether or not use their services.
  • A free copy of the legendary best selling book, How you can Profit from the coming devaluation, as shown at right, written in 1970 by Harry Browne, which predicted the 2000% rise in the price of gold. This profound piece is more relevant today than ever, so Roger re-published it in 2012. This book will help you preserve the fortune you are in the process of accumulating.

ALL DAY BREAKFAST IS COMING! McDONALD’S NEEDS HELP!

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ALL DAY BREAKFAST IS COMING! McDONALD’S NEEDS HELP!

Lots of chatter among investors relative to McDonald’s serving breakfast all day. In our opinion, this is far from a game changer. Not going to affect other breakfast purveyors, such as IHOP and Denny’s in casual dining, or Dunkin’ and Starbucks in quick service, in fact many others are piggybacking on MCD advertising to increase renewed emphasis on their own breakfast offerings. McDonald’s corporate still in relative disarray, with lots of franchisees looking for more consistent direction from above. Marketing message has been muddled for some time now, and industry trends have been unforgiving for operators functioning on less than all cylinders. McDonald’s stock doing better lately, but best thing going for MCD stock is the possibility of financial engineering of some sort relative to their huge real estate holdings.

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