Large franchise companies are watching as their margins tighten and many have shifted to a strategy of “refranchising” to improve their capital efficiency. Refranchising is the process of selling off company-owned franchises, usually to multi-unit franchise holders, to lower costs and boost income without the additional expenditures needed to run that particular unit. It’s a sound strategy and one that generates revenue, but many corporate franchisors have yet to figure out the perfect balance between company holdings and franchisee holdings, but as more businesses attempt it the likelier an answer will be forthcoming sooner rather than later. For more on this continue reading the following article from Blue MauMau.
There have been many recent articles about the phenomenon du jour in franchising – franchisors selling off company-owned units, almost exclusively to large multi-unit franchisees – but none that touch on the economics of this emergent strategy.
At its simplest level, franchisors employ this strategy to boost their capital efficiency. The textbook definition of capital efficiency is the ratio of output divided by capital expenditure. Obviously, the bigger the ratio, the better. But an old McKinsey consulting report describes it best: restructuring the balance sheet to squeeze all possible earnings from every dollar of investor capital
Looking at refranchising at a more granular level, it's a strategy by which the franchisor generates an infusion of cash and
decreases company-owned unit sales and the costs of such sales,
increases franchise revenues and the costs of such revenues,
decreases general and administrative costs, and
decreases interest expense, to the extent that the proceeds from the refranchising are applied to reduce and/or restructure debt.
Because franchise revenues are largely comprised of fixed royalty payments, re-franchisors effectively are eliminating unit operating cost fluctuations and the associated margin compression. This, in most cases, leads to stable and more predictable costs and higher margins and, in many cases more free cash flow. These are all welcome features for publicly traded franchise companies as Wall Street hates surprises and punishes unexpected bad news with a swift, predictable market judgment.
But where is the company-owned/franchised unit sweet spot? The answer is definitively that it depends. DineEquity (DIN) just announced that the Applebee's brand is now 99% franchised. Denny's (DENN) is closing in on the 90% franchise-operated target of its Franchise Growth Initiative (FGI). McDonald's (MCD) is fat and happy meal at 80%. And Panera Bread Company (PNRA) is betting its dough on just over 51%. In fact, Panera, along with Buffalo Wild Wings (BWLD) and Five Guys, are bucking the trend and have been buying franchised units.
So, who knows something here that the others don't know? No one really because the factors that go into a refranchising decision vary as do the underlying economics of those factors. For example, during the 2005 – 2011 period, Denny's FGI reduced its total debt to Adjusted EBITDA ratio from 5.1X to 2.5X. While during the same period Adjusted EBITDA declined because of the FGI strategy, the Adjusted EBITDA margin increased by 530 basis points and free cash flow is expected to be five times more this year than it was at the start of the FGI strategy in 2005. These results, of course, are great news for investors and have been rewarded handsomely by Wall Street over the past few years, but a less highly leveraged company might not see nearly the same benefits.
And there's the little matter of control. The sine qua non for any business format franchise is control over the quality and uniformity of products and services. While the franchise agreement generally imposes rigid control over the franchisees, numbers matter. And if ownership of a franchisor's system pivots toward large multi-unit franchisees, control becomes more of a challenge. When dealing with the occasional single-unit nail that sticks out, franchisors have few reservations about hammering it down. But large multi-unit operators present more of a Whac-A-Mole problem .
So, franchisors need to weigh the balance sheet and income statement benefits of refranchising, which may vary considerably among different franchise systems, with the attendant cost of less franchise control.
Mike Sheehan is a franchise consultant and attorney. He is the president of Focus Ventures (www.focusonfranchise.com) and formerly served as a securities attorney and as general counsel for a Fortune 100 financial services company. His Franchise Focus Blog (www.franchisefocus.blogspot.com) focuses on helpful information, tips and current news for prospective franchisees.
This article should not be construed as legal advice or a legal opinion on any specific facts or circumstances. The contents are intended for general information purposes only and you are urged to consult your own franchise attorney concerning your own situation and any specific legal questions you may have.