How Private Equity Should Evaluate Franchise Systems

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Some franchisors are "pure play" restaurant, Dunkin Brands (DNKN), Burger King (BKW), and DineEquity (DIN). Sonic Drive In (SONC) and Domino's (DPZ), because they have more than 90% franchised units.

Each of these has moved towards or has always has been at a 100% franchised model for years, eg. (DINE, BKW).

Wall Street likes these storylines: "asset light", "capital light" and "franchisees are exposed to commodity risk, not the company" logic lines.

Lofty stock valuations follow, at least for many of them.

But these "stories" do raise some questions for investors:

(1) Who is then paying for expansion, or for commodities;

(2) If the company essentially franchised, how is the underlying health of the company being reported or analyzed?

Franchisors rarely talk about this, and on some earnings calls, there is not one question from the sell-side community on this (perhaps anticipating resistance from the company).

McDonald's (MCD) has made franchisee owner/operator cash flow (EBITDA) narrative in several recent calls, and DPZ did once.

In the past, what few questions asked by the sell-side revolved around:

(A) same store sales levels;

(B) stores opening or closing, or;

(C) franchisor bad debt expense from uncollected royalties.

While these factors are interesting, they only collaterally get at the true health of the system.

Here are six factors that could be asked by the sell-side community and reported by companies to improve investor disclosure:

(1) What is the store development pipeline (stores under franchise agreement that haven't been opened yet)?

(2) What is the 5 year historical miss of stores in the pipeline that don't get opened?

(3) How many franchisees are in default of their franchise agreements but still open?

(4) Is the franchisee operator expanding number of stores or not?

(5) What percentage of total franchisee operators are franchisee cash flow positive (store level EBITDA isn't the best number, but its something).

(6) How many franchisees are remodeling or current on their remodels?

These are all metrics that the franchisor has or should have, that could be reported either annually, or on a trailing twelve months basis.

Disclosure: When I originally wrote this almost 2.5 years ago this was true: "I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

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Fantastic short checklist for buyers of franchise companies.

I have some friends who would have liked to start with John's list.

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