November 2011 Archives

Earlier this year, we reported that in KFC Corporation vs. Iowa Department of Revenue, the Iowa Supreme Court upheld the state's ability to assess income tax on KFC Corporation and other out-of-state franchisors who, despite not having a physical presence in Iowa, nonetheless derive revenue through its franchisees. The Iowa Supreme Court held that a franchisor's physical presence in Iowa is not a required element in determining whether a sufficient tax nexus exists to justify the imposition and collection of state income tax.

Recently, the United States Supreme Court declined to review the Iowa Supreme Court's ruling with respect to physical presence and substantial tax nexus. The implications of the Supreme Court's declining to review the KFC nexus case are potentially far reaching in that other states, including Iowa, will now begin to aggressively pursue the collection of income tax from out-of-state franchisors who have no physical presence in a state. The tax nexus ruling could also affect other areas of interstate commerce where there is no physical presence.

We expect that states will begin adopting their own tax nexus analysis based loosely on the Iowa Supreme Court's analysis and will soon require out-of-state franchisors to begin filing income tax returns if they are not already doing so.

Franchisors with significant presence in multiple states should begin preparing for what seems to be an inevitable outcome with respect to reporting and paying state income tax in each state they will be deemed to have a sufficient tax nexus.

Franchisors may consider spreading the cost of additional tax among their franchisees through higher fees or higher cost of goods. This could result in the consumer's paying a higher price for the franchisor's good or service.

If required to file and pay state income taxes, franchisors who previously were not subject to state income tax need to begin analyzing their taxable income with respect to those states in which they derive franchise income not only to determine their potential state income tax liability, but also to begin planning with respect to reporting and accounting procedures.

Franchisors should conduct tax planning and analysis at the state level where they will now be required to report and pay income tax, but the analysis should start at the federal level with respect to income, expense, deduction and planning opportunities to minimize tax exposure at the state level. As part of the analysis, franchisors may want to examine their current franchise structures to determine whether income and deduction items are properly characterized.

This has been a guest post by Tae Shin, Associate with Roetzel & Andress. For help in tax planning for out-of-state franchisors, please contact attorney Tae Shin in Roetzel’s Franchise Law group.

Give Yourself a Raise!

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When I ask merchants what their total cost is per credit card transaction, in most cases I get either a blank look or the standard I don't know but it's very low as an answer. But, if they knew the correct answer, they might be able to give themselves a raise by finding a cheaper solution.

But it is hard to get that raise. The simple truth is that small business owners are as busy as the proverbial bee, being constantly pulled from one problem to another, having to exercise the wisdom of Solomon in order to keep the ship running on course and all hands happy!

The vast majority of small business owners rarely get the opportunity to open their monthly merchant statement, it ends up in the bookkeeper "pile".

For those of you who have looked at, tried to read or even for that matter tried to understand your merchant statement, exactly what your total cost is for a Visa or MasterCard transaction may not be the easiest thing to grasp.

You will easily see your discount rate, however, you will also see things called Visa & MC ASMTS, Non Qualified Fees, Interchange Differential Fee, Brand Fee, Assessment fee, Settlement Fee, Authorization fee, Item Rate, but what are you paying, bottom line?

Do you wonder if someone is trying to keep something from you?

That as well as many other concerns regarding the Payment Card Industry (PCI) and lack of disclosure and transparency led to a voluntary Code of Conduct.

(Many associations and organizations such as the Retail Council of Canada, Canadian Chamber of Commerce, Canadian Federation of Independent Business to name a few of the heavy hitters were instrumental in getting the government to act on the many complaints regarding PCI.

The black and white of the matter is that after gathering information and having the PCI and the way it operates explained to him by leaders of the industry such as Jeff van Duynhoven, TD Merchant Services Senior Vice-President, Minister Flaherty created and released the Code of Conduct for the Credit and Debit Card Industry in Canada.)

This new code is designed to promote fair business practices and ensure that merchants and consumers understand the total costs associated with credit and debit cards.

Under the Code, merchants will be:

· Provided with clear information regarding fees and rates.

· Given advance notice of any new fees and fee increases.

· Able to cancel contracts without penalty should fees rise or new fees be introduced.

· Given new tools to promote competition, and in particular, will have the freedom to accept credit payments from a particular network without the obligation to accept debit payments and vice versa.

(For more information, please see: http://www.fin.gc.ca/n10/10-029-eng.asp)

The third bullet is golden if you're a business owner who is locked into an agreement and you think or are aware that you're rates are too high.

  • Under the new code, your acquirer is required to inform you of a rate change.
  • If you receive notice from your acquirer regarding an upcoming rate change, you can call your processor and cancel with no penalties.
  • This opt out clause lasts 90 days.

Although, this new code though voluntary, it does have teeth.

This was evident earlier this year when Moneris sent out rate change letters to thousands of merchants about upcoming changes to the fees it charges for processing credit cards.

But, the letter was very misleading at beast, talked about a rate decrease and then discussed the Interchange Differential which is for the most part incomprehensible for your average small business owner.

These changes occurred on April 1, 2011.

The CFIB argued that for many businesses, the changes could actually amount to a substantial increase in processing fees and filled a formal complaint with the Financial Consumer Agency of Canada, the voluntary code's enforcer, FCAC.

The FCAC turned the heat up on Moneris and in order to avoid the FCAC's wrath, Moneris agreed to extend the 90 day opt out period by another 90 days or until June 30, 2011.

Moneris's tactic was used again, this time by Global Payments, the CRFA's merchant program provider.

Global circulated a rate change letter towards the end of August, 2011, however, the language used is less jargon filled than Moneris' letter, Global, out of the kindness of their hearts is decreasing rates, however, they do mention something about an Interchange Downgrade Fee Merchant Table.

For anyone who is aware of the Interchange or non qualified fees for the current CRFA program and who decides to compare existing fees to this table, he will discover that the rates for the vast majority of credit card transactions will see the Interchange increase or in other words, the non qualified fees for these transactions are going up.

In typical fashion, they give it to you in one hand and take it away from the other hand!

All this to let you know that you do have options, get in touch with a reputable salesman who represents a reputable organisation and have him explain to you if he can save you any money, who knows, maybe in doing so you'll be able to increase your profit margin and give yourself a raise!

For the 5 Most Fascinating Stories in Franchising, a weekly report, click here & sign up.

This has been a guest post by Scott Irwin. Scott Irwin is a regional sales executive with TD Merchant Services, the only Bank-owned and operated Acquirer in Canada. [email protected]

Dennis Monroe writes, in the September 2011 issue of the Franchise Times

"Private equity is back.
In the last year there has been significant funding by private equity for the multi-unit concept world (this has been particularly true with restaurants). In fact, the pace of investment has accelerated.

Some of the more notable recent transactions are:

• Falfurrias Capital Partners' acquisition of Bojangles' Restaurants (July 2011)

• Goldman Sachs' investment in American Apple, the largest Applebee's franchisee with 270 units in 11 states (May 2011)

• Palladium Equity Partners' acquisition of TB Corporation, parent of the Taco Bueno restaurant chain (July 2011)

• Golden Gate Capital's acquisition of California Pizza Kitchen (July 2011)

• Roark Capital Group's acquisition of Corner Bakery Café and Il Fornaio (June 2011) and Arby's (July 2011)."

 

Executive Summary

We’ve updated our 2010 PE and Restaurants article to identify what’s going on in the US restaurant space by private equity (PE) firms. The result: a lot of activity and investments, some high profile failures but just a modest number of apparent successes to date.  This new round of private equity investors should reflect on what the results were in 2005, the last big wave of private equity investing in restaurants.

PE’s often target distressed investments, and this shows up in the results. Failure is not unexpected. Every PE firm is different and has different strategies.

The PE effect on different stakeholders is important to consider. The stakeholders have some common interests, some contradictory: (1) the PE sponsor investor (2) the company operator itself (3) franchisees (4) other stakeholders (employees, creditors, consumers).  

Franchisee unit level reporting is very poor and makes the effect on franchisees difficult to read. Data in general for this topic is very limited.

 

However, our conclusion is: There have been some apparent”successes”, but with the surge of 2011 PE Chapter 11 filings (AKA failure for investors, employees and creditors), “failures” right now outnumber the successes. Most of the class of 2005 acquisitions has failed.

All the recent 2010-2011 acquisitions and many of the 2005-2009 acquisitions are unreadable, still in the works.

 

PE and Restaurants: the model and background

 

The “PE model” was that best practices and synergistic management practices could be introduced, and that companies could build/grow without supercharged Wall Street/investment community pressure. That premise is still being tested.

The restaurant space had two big waves of PE acquisitions in 2005-2006 and 2010-2011. Since 2005, we’ve seen almost $21 billion in transactions, and we count seventy plus major chain restaurant brands PE owned. This count exceeds the 53 publicly held/traded US chain restaurants as of October, 2011.

 

Proxies for Bankruptcy and Distress:

 

Of the 56 PE transactions since January 1, 2005, nine concepts have filed Chapter 11 and two have announced technical default, one has had a sure investor’s loss. By transaction timing, many of the 2005 transactions have failed.

Chapter 11s: Charlie Brown’s, Unos, Barnhill Buffet, Perkins/Marie Calendars’, Claim Jumper, Real Mex, Sbarro’s, Friendly’s and Bugaboo Creek. Average EV/EBITDA multiple of 7.4 X at acquisition. Five were 2005, two were 2006, and two were 2007 era transactions.

Announced Covenant Breech: Quizno’s, El Pollo Loco. Average EV/EBITDA multiple was 10.8X at acquisition.

Three PE investments sold via management buy out (MBO), that we estimate had to be at a large loss for the PE sponsor: Pacific Equity, Sizzler (9.3X) and Pat N Oscars, and Cheeseburger in Paradise (Outback/Bain parent). Pat N Oscar’s, part of the Sizzler acquisition, was sold by MBO and filed for Chapter 7- liquidation in 2011.

High acquisition price multiple alone does not explain the Chapter 11s or announced default group. Of this group, only Quiznos was a national scope, most were older, regional chains. The average time cycle to Chapter 11 was about 5 years from acquisition. We’d speculate that lack of menu renewal, lack of effective marketing budget size, lack of capital spending and older site locations were factors.

 

Defining Success:

 

Since most privately held company earnings data is not made public, one must gather data wherever possible: debt disclosure, press reports, surveys, bankruptcy filings, resale transactions and the like. Generally, though, growth in chain system sales and number of units can be a proxy for success, as can resale to other PE firms. Chapter 11/7 filings and distressed, near default conditions are badges of failure.

For chain restaurants that franchise, little franchisee specific data is available. This is one of the great financial reporting weaknesses in the restaurant space. Franchisees power the capital and unit development of most franchisors, and represent the effective source of the bulk of the brand valuation.

 

2010-2011 Transactions: Not enough time yet:

 

There have been 20 major restaurant PE transactions in 2010 and through 2011. Two large 2010 acquisitions, Burger King (BKC) and CKR Restaurants (CKR) are still doing quarterly reporting but have shown little trend movement since their acquisitions. Roark Capital acquired Arby’s in 2011, and now owns 11 restaurant brands. Only estimated sales data and unit count data is available, so economics is not discernible yet. Many transactions have just occurred and no trend is possible.  

 

Proxies for Success:

 

National/international brands seem to have done better. Dominos (DPZ) went public in 2004, levered up and levered down, and transitioned through the pizza recession of 2008-2010. DPZ is growing internationally but their US franchisees are struggling or in no growth mode. Dunkin Brands (DNKN) had a successful 2011 IPO and is about to begin issuing quarterly guidance. US Dunkin Donuts franchisee store counts are up.

Bojangles, Logan’s, Papa Murphy’s and Church’s have been resold to other PE firms, with positive press reports of system sales and EBITDA growth.  Dave and Buster’s, Logan’s and Chuy’s are in pre-IPO mode.

While still listed as to be determined, Yard House, Noodles, Moe’s and Corner Bakery are apparently building AUV and unit counts, which have to be good signs.

 

The To be Determined Group:

 

There are some very large chains in the TBD group. Outback Steakhouse Group is the largest group of brands that struggled through the recession and have lost AUV and a modest number of US units.

Burger King (BKC) had a successful 2006 IPO but then ran into global headwinds especially in the US, which resulted in its forced 2010 sale to 3G Capital. Burger King US franchisees have suffered sales/profit declines and are best described in rebuilding mode. And Arby’s has just been acquired and bears watching, as do the three Golden Gate capital brands: Macaroni Grill, On the Border and California Pizza Kitchen.

 

2005-2011 Transaction Summary:

 

Chapter 11 filing: 9

Distressed/covenant breech/ investor loss: 2

To be determined: 36

Pre-IPO status: 3

Resale to other PEs: 2

Positive trend: 3

Completed IPO: 1

Grand total: 56

 

Write us for the detailed spreadsheet: John A. Gordon, Pacific Management Consulting Group, email: [email protected], voice: (619) 379-5561  

There is a way to sell unsold rooms without disrupting the demand and pricing of our primary product. It involves looking at other industries to see how they can deal with the product that they cannot sell.

At the basic level, hotel inventories can be divided into two categories:

(i) The salable inventories, and

(ii) The non-salable residual inventories - the leftovers - our daily waste. In most industries, to generate incremental revenues, waste from one product is reused to produce a different or modified product.

This is not new to hotel business either, ex: in F&B the extra fat from a cut of steak is added to the ground beef and not thrown away. As a matter of fact, some of these unsold rooms are used by hotels to create packages, still a large portion of these unsold rooms are left vacant and written-off as "waste".

Can this "waste" be sold at a lower price point or even at "scrap" value (in the least)?

In retail business it's a common practice, even expensive brands have clearance outlets. Many clothing suppliers differentiate the products sold at the clearance outlets by calling them "seconds", implying there are some minor flaws with the product hence the lower price.

While hotels can create their version of a "seconds" product, the challenge, the major stumbling block, has been our inability to find appropriate distribution channels to sell them without disturbing the price equilibrium of our primary product.  We need a distribution platform to sell these "seconds" that doesn't unravel the price we are getting for our sold rooms.

What ingredients can be combined to create a "seconds" product?

It could be rooms with limited level of services, laced with various flavors of rate hurdles specific to each property - a "stripped down" price, blended with a mixture of customized rate barriers - advance booking, advance payment, multi-night stay, day of week, multi-rooms, non-refundable, non-changeable, non-cancellable, among others.

Will the resulting "seconds" product be sufficiently different so it may be advertised and openly sold through online channels of OTA and direct sales? I do not believe so.

At best we may marginally reduce the segment over lapping if it's carefully planned and fenced with appropriate rate hurdles. (Can the new emerging models (flash sales, private sales, last minute specials, mobile deals and similar channels) be the right conduit to sell these "seconds"? While the verdict is still not in, some "experts" are labeling them as ground breaking models. I'd venture to predict that they will not work and would actually hurt the hotel business in the long run. In Yogi Berra's words "This is like déjà vu, all over again!" Reminds me of the late ‘90s and early '00s when the OTA model was considered a secondary channel for selling excess inventories resulting in a pricing chaos.)

In this soft economy consumers are already leaving the hotel booking decision to couple of days out instead of the typical 5 - 7 days. The obvious reason - consumers know they will find a room at a good price even if they book a day or two in advance.

By introducing last minute "desperate" sell-offs conveniently flashed online and on mobile, we are in essence telling the consumer not to book at all until the day of arrival since better deals are available on the last day. This is an extremely short sighted, irresponsible solution to generate a few extra bucks.

We are contributing toward changing the consumer behavior that works against us. A change in consumer behavior to book on the arrival day will throw our demand forecasting in complete disarray. It will make measuring of future demand almost impossible because there will be none (at least not until the economy improves dramatically and demand returns).

Hotel occupancy could ultimately become a function of who has the cheapest room on the last day.

Opaque models are the solution. These models have the potential to fit our need and should be examined in depth. 

The obvious advantage - Price is not publicized and the lower rate offered remains confidential between the hotel and the buyer.

I think if rates on these models are properly fenced they should not disturb the price equilibrium of our primary product.

Opaque models may be grouped into two categories.

(i) The ‘Price Driven' models

a. Priceline - http://www.priceline.com , where both the product and its price is opaque.

b. Hotwire - http://www.hotwire.com, where the product is opaque and not the price.

(ii) The ‘Value Driven' models

a. Travelsurf's [email protected] -http://www.travelsurf.com, where the price of the room is opaque and not the product.

b. Packages - where the price of the room is opaque and not the product.

Both these categories can help generate incremental revenues through sale of unsold inventories. The ‘Value Driven' models have a better potential of improving yield.

In the ‘Price Driven' opaque models price is the only differentiating factor. On Priceline, the consumer makes one flat offer solely based on a star category located within a certain area.

Or, in case of Hotwire, a ‘mystery' star rated hotel is available for a certain low price. This approach to selling tends to commoditize the hotel room.

The models treat all hotels within a classification as generic commodities that have no unique differentiating features. Therefore it falsely assumes that the best "deal" for the consumer is the one with the lowest price. In reality no two hotels are the same.

Hotels compete on many fronts, service standards, facilities & amenities offered, cleanliness, brand, location, security, etc. price is used as an incentive to drive traffic and should not be the only distinguishing factor among hotels.

A consumer may not necessarily place much emphasis on a particular type of hotel, or even its star rating for that matter, but rather on each hotel's real "value" to the consumer. Plus, the "value" for the same hotel will vary among different consumers or, even for the same consumer at different times.

For example, a consumer may be willing to pay a higher price for a four star hotel located within a block from where he needs to be, rather than a five star hotel located a number of miles away. I call this the consumer's "PainConsideration Factor" (PCF), the lower the PCF the higher the perceived value for the consumer.

‘Price Driven' models ignore this reality. In a 'Value Driven' model the consumer can examine and understand the value proposition of each hotel product, create a short list of hotels, and place dissimilar (different) offers for each property on the list all at the same time ([email protected] model) or, in the case of Packages the consumer reviews the package and understands it's benefits before purchasing it.

‘Value Driven' models typically deliver higher yields, as the buyer is not making a blind offer but understands the value and the benefits of the product he is planning to purchase.

I believe, by introducing a ‘seconds' product in the marketplace hotels would not only improve their occupancies and RevPAR but would even help boost the overall demand for hotel rooms in their market segment.

This has been a guest post by Jim Burney. If you wish more information on this solution, please go to Travel Surf or write to Jim at [email protected]

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This page is an archive of entries from November 2011 listed from newest to oldest.

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