Franchise Growth Present Both Challenges & Opportunities

The International Franchise Association and the Franchise Education and Research Foundation jointly released their report in January entitled “Franchise Business Economic Outlook for 2017”.  The report shows the major role played by restaurants in creating franchise and employment opportunities for both business owners and workers.

Among the key findings of the report are the expanding economic output of franchise restaurants, and the employment associated with this growth.  In 2017 growth among Table/Full-Service Restaurants is expected to register at 6.8%.  Meanwhile, productivity is anticipated to increase by nearly 3 percentage points, as employment gains are expected to register a 3.9% increase.  In the QSR Segment output is expected to be nearly as great, up by 6.7%, with employment growth at 4.0%.  Table/Full-Service and QSR Restaurants rank in 1st and 2nd place among all types of franchised businesses according to these metrics.

An important point to note is that output and employment by franchise locations are growing much faster than the overall restaurant industry and the 1.9% unit growth (for both Table/Full-Service and QSR Restaurants) expected for restaurant franchise locations in 2017.  But the entire story is a mixed bag.  This development is taking place as corporate owners are shedding locations in pursuit of an “asset-light” strategy.

The goal of the “asset-light” strategy is three-part.  First, shed (or close) lower-performing locations.  Second, avoid the expense of updating restaurant locations as stores undergo a “brand refresh”.  Third, improve the return on invested capital for the corporation (i.e. brand).  Corporate owners can do so by removing assets from the balance sheet while continuing to collect royalty fees.  For stockholders, this generates a higher return.  Additionally, corporate management generally uses the proceeds from the sale of stores (and highly appreciated real estate) to pay down debt, buy back corporate shares, and hence increase earnings per share, stock price, and ultimately compensation for senior managers, which is usually tied to stock price.  The increasing popularity of the “asset-light” strategy is the dominant driver of franchise growth, as ownership transfers from corporate to franchise owners.

A shift in ownership of individual stores from corporations to franchisees shifts risk to the franchisee.  The good news is that with risk comes opportunity.  New franchise owners are closer to local markets and day-to-day operational challenges.  As a result, they have the opportunity to improve the results of individual stores.  Additionally, former employees or other entrepreneurs can go from being workers to becoming owners.

Now let’s shift the focus somewhat to output and employment.  As a part of the total franchise business environment, restaurants continue to play a key role, making up 26% (QSR) and 4% (Table/Full-Service) of all franchised business establishments.  With respect to employment, the numbers are even more dominant, with 46% of franchise jobs being held in QSR outlets and 13% in Table/Full-Service Restaurants.  Collectively, restaurants are responsible for 59% of all franchise jobs.  Output by QSR & Table/Full-Service Restaurants makes up 33% and 10% of franchise business activity, respectively.

Peeling the onion shows that lower worker output is an issue in the restaurant industry.  With 46% of franchise jobs, but only 33% of franchise business activity, QSR outlets employ 39% more (46/33 = 1.39) workers per unit ($) of output, compared to the average franchise business.  Similarly, Table/Full-Service, with 13% of franchise jobs, but only 10% of franchise business output, employ 30% more (13/10 = 1.3)  workers per unit ($) of output.  The higher ratio of employees compared to other (non-restaurant) franchise businesses translates into a lower dollar output per worker.  That’s a challenge for profitability, made more acute as labor costs increase.

On the bright side, restaurants can improve performance through a number of measures.  If acquired for a good price, a new franchise owner can realize superior financial upside through smart operating practices, the use of technology, and higher worker productivity.  Industries that already have high worker productivity and greater efficiencies have less room for improvement, and (all else equal) will initially sell for a higher valuation, resulting in lower returns over time (given the higher initial purchase price).  The key for new owners is to initially buy for a good price and to identify areas of the operation that can be optimized.  In buying at an attractive valuation, an operator can adopt the “value investing” approach used by sophisticated investors like Warren Buffet.  Purchase an undervalued asset, improve operations, and realize a higher financial return over time.

Despite near-term challenges, restaurants continue to offer a major opportunity for business ownership & employment for Americans.

 
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