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Chain Reactions

High stakes and fierce competition make franchising a tougher game than ever.
Hilary Rosenberg, CFO Magazine
February 1, 1999

It seemed like a good idea at the time. To launch a new brand in the cutthroat retail food market, Boston Chicken's management used a new model of franchising. It offered extremely generous loans to attract large, experienced franchisees, which then expanded the restaurant chain at record speed, thereby creating a dominant position in the "home-meal replacement" fast-food category. Such blazing growth heated up the stock, which in turn allowed the Golden, Colorado-based company to raise funds for more franchisee financing.

But, by last October, the only thing brilliant about Boston Chicken was how quickly it was going up in flames, as the company filed for protection under Chapter 11 of the U.S. Bankruptcy Code. What went wrong? The franchising model was intriguing, although it was effectively reverse-franchising. Instead of using franchisees to shoulder the risks of expansion, the company carried most of the risk itself through its bountiful financing deals. But then, as franchisees hurriedly set up new restaurants in high-cost urban areas, they failed to achieve the lofty revenues needed to break even.

Meanwhile, analysts say, Boston Chicken's finance department failed to keep a sharp eye on the profitability of the restaurants, while its strategists failed to preserve the unique focus of the concept. The markets were fooled, because a franchiser's financial reports do not have to show the franchisees' profitability--in this case, heavy losses. "Boston Chicken needed to continually raise more money to support the operating losses," says Christopher M. Weis, an analyst at Sutro & Co., in Los Angeles. "Who really got hurt were the public investors." As the company's debts mounted and store sales fell, the markets turned off their spigots. (Mark Stephens, who resigned from the CFO post last spring, could not be reached for comment.)

Share the Risk
Boston Chicken's collapse raises the question: How does one run a franchising operation successfully in an increasingly competitive economy? The answer is, it's a balancing act that involves giving franchisees incentives while making sure they stay profitable. "The CFO plays an increasingly critical role in making predictions and doing analysis as programs unfold, to make sure there is an acceptable return on investment and good synergy," says Lewis G. Rudnick, senior partner at the Chicago law firm of Rudnick & Wolfe, which represents franchisers.

But, as the financial coordinators of businesses that effectively have numerous partnerships, CFOs of franchisers have a particularly challenging job. They must make decisions that will please franchisees by helping to make them profitable-- and then convince the franchisees of the value of the strategies. "With a company-owned operation, you can mandate a change; with a franchise, you have to use influence and management skills," says Scott Colabuono, CFO of Norrell Corp., an Atlanta-based provider of temporary employment services.

The growth of franchising businesses itself makes successful franchising all the more difficult. Today, franchising can be found in 75 industry categories (up from 67 in 1990) and accounts for 3,000 separate businesses. There are about 663,000 franchised outlets in the country today, according to estimates determined by the Washington, D.C.-based International Franchise Association, which represents franchisers, franchisees, and their suppliers.

In this competitive climate, the finance function has had to become more sophisticated. CFOs of major franchisers must cope with all of the challenges confronting their counterparts outside franchising, and often manage legions of autonomous entrepreneurs, to boot. Using sophisticated tools and techniques, finance departments develop computerized control systems for monitoring sales, royalties, and profitability. Large franchisers assign subsidiary finance departments to far-flung businesses and brands. And dealmaking is becoming commonplace, with brands, products, and whole franchising operations changing hands almost routinely.

Boston Chicken supplies the object lesson in financial strategies that go awry. The following four examples highlight more-successful results and the pivotal roles that CFOs play nowadays in the franchising business. One company relies entirely on franchisees and shares risks accordingly; another bolsters its franchisees through brand acquisitions; a third has curbed growth; and a fourth emphasizes consolidation.

Managing Mailboxes
Mail Boxes Etc., a subsidiary of U.S. Office Products Co. (USOP), of Washington, D.C., represents the extreme of operating an entire company with franchisees. Founded in 1980, the company has more than 3,000 centers in the United States and 600 abroad, and aims for a total of 5,000 by the year 2000.

The advantage of an all-franchised company is the highest-possible growth at the lowest-possible cost and risk. If the company were to operate its own centers, it would have to have a minimum number per region to justify the cost of regional administration, says Mahasty Seradj, vice president of finance. Instead, San Diego-based Mail Boxes chose to carry only the costs of supporting franchisees.

In contrast with Boston Chicken, Mail Boxes franchisees take virtually all the investment risk, with the home office providing some borrowing options. To help franchisees get swift financing for furniture and equipment, Mail Boxes grants leases of up to $40,000 at market rates. It currently has about $6 million in capital leases outstanding, representing loans to about 900 operators. If a qualified "area franchisee"--which buys the right to sell store franchises in a region and provides some support services in return for some royalties--wants to add new centers, the company will lend up to 70 percent of the area's value.


Mail Boxes also lends to individual franchisees that want to purchase more outlets. Currently, the company records $28 million in notes receivable representing franchisee loans. "The company has elected to finance this expansion internally because it believes it receives a higher return than can be achieved from alternative investments," states the fiscal 1997 10K, the last one before the USOP acquisition. Interest earned on notes receivable in fiscal 1997 and 1998 was nearly 10 percent.

Without having to worry about company-owned center operations and all the franchisee-support services, Mail Boxes's corporate staff can emphasize development of new products and services, or "profit centers," for the stores. The company establishes 10-year contracts with its franchisees that specify the profit centers their outlets must offer--currently 10 to 15--including everything from mailbox rentals to shipping, copying, faxing, office supplies, and money transfers. Before contract renewals, franchisees have the option of adding newly developed services. Recent additions--such as national accounts in which major corporations' customers and employees have access to Mail Boxes's services--in combination with internal growth have enhanced the sales growth of existing centers. Same-store sales rose 12 percent in the first half of fiscal 1999, compared with 9.2 percent in fiscal 1998 (excluding the impact of the United Parcel Service strike in 1997).

Seradj's main concern is that a unit's gross sales continue to grow and that it pays its royalties on time. If units fall behind, which happens several times a year, Seradj's team scrutinizes the finances and, with the help of the operations and legal departments, tries to pinpoint the problem and possible solutions. For example, she says, "If the sales are OK but costs are high, [the unit] may be concentrating on the wrong profit center."

With good financial systems in place, high growth is realistic. The company's revenue growth has been strong, at about 15 percent annually since fiscal 1995 (excluding fiscal 1998, when the UPS strike and the USOP acquisition had their impact on results). Revenue growth was 11 percent in the first six months of fiscal 1999, while the operating profit margin approached 21 percent.

Grow to Be Great
AFC Enterprises Inc.'s management took a bankrupt company with two chicken brands (Church's and Popeyes) at a total of about 1,800 restaurants, and rebuilt it by forming a tight, creative relationship with franchisees. Today, the group's six brands are sold in 25 countries by 3,200 units, of which some 77 percent are franchised.

In 1992, new management arrived at AFC, in Atlanta, to take it out of bankruptcy, where it had been wallowing for more than a year. The first priority: rebuild sales and earnings. "Finance had to decide whether to allocate its capital to 'reimage' the restaurants, build more restaurants, or simply do maintenance on existing restaurants," explains Gerald Wilkins, CFO since 1995. It figured that the best returns on investment would be achieved through reimaging the chains' run-down facilities--modernizing them at a cost of $75,000 to $150,000 per unit.

The company performed the work on its own restaurants from 1993 to 1998; franchisees began in 1994, when they saw that the improvements could charge up results. Sales at the company-operated restaurants jumped 10 to 15 percent after the renovations. And profits soared by 15 to 20 percent a year. For example, Church's company-owned restaurant operating profit margins expanded from 15.5 percent in 1993 to 21 percent in 1998. And Popeyes experienced the same magnitude of increase. AFC broke into the black in 1996 with $3.4 million in net profits, and from 1993 earnings before interest, tax, debt, and amortization (EBITDA) increased an average 23 percent a year, largely due to the new image.

Franchisees will complete their renovations shortly. The company does not release franchisees' results, saying only that average margins are higher than those of the company-run restaurants and have shown similar percentage gains.

Wilkins's staff acts as a resource for franchisees. It surveys 600 franchisees, collecting the profit-and-loss statements on their units to see sales, total costs, and individual costs as percentages of sales. Finance then breaks the units down into several categories of revenues. If a restaurant's profitability falls below the average in its category, finance shares that information with the franchisee. "They'll ask us or the finance people within the brands to help them figure out how to replicate some practices followed by more-profitable franchisees," Wilkins says.

AFC further aids its franchisees by buying new brands it can present to them--brands that could give operators up to 30 percent pretax returns. "If you're a franchiser, you'd just as soon offer those opportunities to your franchisees than have somebody else do it," Wilkins says. In the past two years, Wilkins has helped engineer the acquisition of Chesapeake Bagel Bakery, Seattle Coffee, and Cinnabon International. To set purchase prices, Wilkins evaluates whether the concept is widely "franchisable" and whether the existing brand franchisees can meet their standing commitments to develop new units. Prices are set as a multiple of EBITDA, since a key measure of a restaurant's success is its cash flow. In recent years, prices have ranged from four to eight times EBITDA.


Wilkins hopes to take AFC public this fall. "Then," he says, "franchisees will have a franchiser with more visibility and more capital to grow, and with more motivated people working in the brands."

Apply the Brakes
McDonald's Corp. provides an example of how even a granddaddy of franchising can antagonize its family and then have to mend relations. In the mid-1990s, the chain's U.S. franchisees--which operate 85 percent of its more than 12,500 domestic restaurants--were increasingly distressed as the company threw up thousands of new restaurants that cannibalized their sales. Meanwhile, many of the new restaurants were poorly situated and recorded mediocre initial sales. What's more, in 1996, McDonald's angered franchisees with its Franchising 2000, a set of onerous criteria franchisees had to meet to have their contracts renewed and to be granted more restaurants. (Franchising 2000 was eliminated in 1998.)

These problems, plus some big-time menu flops, fried McDonald's earnings. U.S. operating income declined 9 percent in 1996 and increased just 6 percent in 1997, to $1.2 billion, while total operating income was flat in 1996 and rose almost 7 percent in 1997, to $2.6 billion.

Facing these numbers and some lawsuits from franchisees, "McDonald's finally acknowledged that a lot of its strategies were not in the interest of franchisees," says Mitchell Speiser, an analyst at Lehman Brothers. As executive vice president and CFO Michael Conley says: "You can't design things that hurt the operator and help the company, or that hurt the shareholders. It's a balancing act. We had to motivate the operators."

First, management slowed unit growth. Net new U.S. restaurants increased by a mere 286 in 1997, compared with 726 in 1996 and almost 2,000 collectively in 1994 and 1995. (The chain opened 1,824 restaurants abroad in 1997.) Last year, the company closed 200 low-volume restaurants, primarily in the United States, and so opened a net of 125 in the States.

The slowdown has allowed finance, in conjunction with the real estate department, to devote greater resources to finding sites where new restaurants not only should have good sales, but also will not unduly harm existing restaurants. It also cut McDonald's U.S. capital spending by $300 million in 1997 from the 1996 level. "Slower unit growth is a good thing, much more intelligent," says Dick Adams, a San Diego-based franchise consultant who manages an association of McDonald's franchisees.

McDonald's also decentralized U.S. management by setting up five geographic divisions, each run by a divisional president, who will be headquartered in the field, not in the Oak Brook, Illinois, headquarters. At the same time, marketing dollars were shifted from 75 percent national and 25 percent local to 50/50, giving the operators more say in advertising. However, franchisee representative Adams tags these moves as "nonevents," because he has seen no evidence of the shift in marketing dollars, and because the five divisions just replace eight previous zones. McDonald's counters that the new system makes regional managers much more accountable for results than they had been. Adams does applaud the elimination of Franchising 2000.

At least some of these initiatives have worked. Through August of last year, sales for the average full-sized franchise restaurant were up by almost $20,000. Through September, U.S. franchised profits rose 7 percent year to year. Overall corporate operating income for U.S. operations was up 12 percent, to $1.03 billion.

Consolidate
Avis Rent-A-Car Inc. has reached a stage of maturity at which it benefits more from owning the vast majority of its outlets than from franchising them. In 1997, the company acquired its two last big franchisees.

The purchases were part of the increasing focus throughout the car-rental industry on shareholder value, as most major rental agencies have come under the dominion of the markets through initial public offerings and spin-offs. Now, the renters are doing more than ever to increase the bottom line, through heftier price increases and efficiency improvements.

In 1997, as Avis, then under the control of franchiser HFS Inc. (now Cendant Corp.), was planning its IPO, it was also planning to buy up its largest franchisee, First Gray Line Corp. First Gray Line, based in Los Angeles, had 70 agency outlets and some $200 million in annual sales. At the time, corporate-controlled offices accounted for 73 percent of the Garden City, New York-based agency's U.S. revenues. "We asked, Does it make sense for us not to own a licensee out in Southern California?" says CFO Kevin Sheehan, who was an HFS senior vice president before coming to Avis in 1996.

The $195 million acquisition cranked up Avis's revenues and earnings. Whereas it had been taking 5 percent of Gray Line's annual sales as royalties, it now put the former franchisee's entire $200 million in sales plus its $11 million in earnings on its books. Then, last May, Avis spent about $220 million (including $136 million in debt) to buy Dallas-based Hayes Leasing Co., which had $77 million in 1997 sales.

The two acquisitions brought considerable cost savings. They eliminated the shuttling costs involved when cars from San Francisco's company-operated offices were left in the Southern California franchised offices and vice versa, and the similar phenomena on the Houston-Dallas route. There were also savings on inventory and back-office operations, where Avis eliminated about 120 people. Cost savings for both deals come to $10 million a year--significant in a business that achieves aftertax profit margins of only 2 percent to 3 percent a year.


Because the First Gray Line acquisition occurred shortly before the September 1997 IPO, "it put a bit of sizzle under the offering," Sheehan says. The company used some of the $359.3 million raised to pay off the debt for the franchisee acquisition; a $204 million secondary offering last March paid for the Hayes acquisition.

In the nine months ended in September, Avis's pretax income surged by 49.5 percent year to year, to $59.9 million. The jump reflected higher revenues and decreased costs and expenses as a percentage of revenue, according to the annual report. Direct operating costs were 40.6 percent of revenues in 1998, versus 42.1 percent a year earlier.

Today, Avis controls offices that generate 91 percent of U.S. revenues. But it still has 71 franchisees that operate some 400 agency outlets in smaller markets and generate more than $200 million in revenues. (In 1997, master licensees in foreign locales contributed 12 percent of Avis's $2 billion in consolidated revenues.)

Says Lehman Brothers analyst Jeffrey Kessler, "It is important that Avis is not buying all the franchisees in areas that are not cost-effective" for the company to operate its own outlets.

In the 1950s, Warren Avis used franchising to expand his new car-rental agency nationwide. Today, Avis is a mature company whose priority is no longer expansion. Franchises, therefore, take a secondary role.

And what about Boston Chicken? Analysts believe the company will survive--although not as a franchiser. As part of its effort to dig itself out of bankruptcy, the chain has recently completed the conversion of its remaining franchised restaurants to company-owned outlets, a process it began in 1997. Now, it's back to basics.

Hilary Rosenberg is a freelance writer based in New York




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