Have Credit, Will Travel: Opportunities Abound For Multi-Unit Operators With Cash And Experience

1) General economy

First, let's set the record straight on what's going on. This isn't just a credit crunch crisis.

It may have been triggered by credit issues, but it is much bigger than that now and won't be solved by governments throwing money at it, although that is a necessary first step. This crisis will get solved when consumer income and debt levels can support a stable level of demand, not just in the U.S., but worldwide.

Between 2002 and 2007, historically low real interest rates stimulated economic activity, compressing into six to seven years what otherwise would likely have taken about a decade. Consumer debt set records each of the last five years. With real wages and salaries dropping since 2004, net increases in consumer spending were fueled by rampant borrowing. The economy is dropping into recession, but consumer debt is not going away. It has to be paid down to more normal levels.

Obscured by the global debt problem is a global growth problem. Without the boost from low rates, U.S., and for that matter, most of the rest of the world, economic growth would have come in considerably lower. Because of these factors, expect a recovery some time in 2010 at the earliest. We will need at least all of 2009 to sort out the implications of the global financial mess.

The Conference Board's consumer confidence index in October hit the lowest level since tracking began in 1967. With the stock market and labor market continuing to move in the wrong direction, it may be some time before consumer confidence, which represents 70 percent of U.S. economic activity, begins to rise. And until it does, the economy is unlikely to gain much strength.

2) Franchise economy

Over the past five years, franchise unit growth has averaged in excess of 4.5 percent per year. This equates to more than 16,000 units each year across 3,000 brands. The first half of 2008 maintained that growth level, but the second half saw an appreciable drop in new unit openings. Development pipelines for 2009 suggest this trend will continue.

Two reasons for this cited by development officers are 1) hesitancy by prospective franchisees, and 2) access to necessary capital to fund a unit. Prospective franchisee hesitancy is understandable, given the above general economic forecast.

Further, demographics are working against a continuation of the kind of unit growth momentum we experienced in the past 10 years. Baby Boomers are entering retirement. There are a lot fewer Gen Xers than Baby Boomers. And the generation after that, Gen Yers, have less experience and capital. For these reasons, there will be fewer interested prospective franchisees in 2009.

Perhaps a bigger issue facing franchising in 2009 is capital access. Experienced franchisee unit expansion will be tough, but prospective new franchisee development will be much tougher simply because the capital access bar has been raised. As a result, we will see a growth in multi-brand franchisees in 2009 as bankers perceive lower performance risk associated with experienced franchisees.

If capital access is one of the two biggest obstacles to new unit development, it's helpful to understand what is happening on the lending front and consider ways of addressing it. With many national lenders facing mortgage and other capital issues of their own, in 2009 franchising will rely to a much greater extent on local lenders. If a bank doesn't already have lending experience with a brand, the bank doesn't have as strong a willingness to make the effort to understand the franchisor and system risks. In 2009, it will be important for franchisors as well as franchisees to pursue banks armed with information that will make bank underwriting easier. Franchisors need to have risk assessments produced in the language banks use to assess risks and presented accurately.

In 2009 we will see some separation between the better and weaker operators and brands. Like the tide raising all boats, the past few years allowed marginal performance to go largely unnoticed. That is changing rapidly now, something that will be good for the franchise business model but painful for many to go through. Many franchisors have worked with their systems to address operational inefficiencies over the past few years.

An increasing number of systems are making unit financial performance claims, and that pace will accelerate as prospective franchisees seek greater comfort that their investment decisions are wise. Franchisors also are looking much more closely at their own expenses, recognizing that the revenue side may have hit a high-water mark for the foreseeable future. There is growing interest in understanding performance data for their own operations and comparing it with that of other franchisors and systems.

Some of this analysis will lead to increased M&A activity, both at the brand level and at the franchisee/unit level. Private equity is still around, helping to spur this activity on the brand acquisition level. Foreign franchisors will be more visible in 2009 as currency rates continue to make investment in the U.S. favorable for foreign operators. At the unit level, experienced franchisees increasingly will look across sectors, not just brands within a sector, for opportunities to acquire company-owned and franchisee-owned units.

The franchise community will see a rise in closed units as higher operating costs root out inefficient and underperforming units. On the other hand, the worldwide downturn is taking pricing pressure off most commodities, lowering the cost of products across the board, which should last beyond 2009. In some cases, we have seen raw material costs drop below half of what they were as we entered 2008.

Multi-unit opportunities and challenges

2009 will bring some interesting opportunities to multi-unit operators. Here are a few, summarized:

• Re-franchising is on the rise for both capital conservation and strategic reasons.
• Marginal unit operators will put more units on the market. As with re-franchising, multi-unit operators will see growing opportunities to expand through existing units.
• Real estate owners will continue to show a willingness to negotiate better terms for space.
• Franchisors may show an increasing willingness to negotiate franchise fees and other agreement terms.
• Unemployment will take pressure off finding and retaining qualified employees.

These trends will put multi-unit operators in the center of demand for franchisors. There also are challenges for multi-unit operators in 2009, starting with taking care of their own businesses. Same-store sales are under stress, particularly in hotly competitive sectors. And capital access will be a challenge for the next few years, particularly for the medium-sized operators with capital needs in excess of what SBA lending can provide, but below what some of the larger financial institutions will view as appealing for a full array of financial services, only one of which is lending.

On balance, the next year or two will be opportunistic times for multi-unit operators who have access to capital. They will become a very appealing category of prospective franchisee for many brands. By the end of 2009 I expect that multi-unit operators will control a comfortable majority of franchised units in the U.S.

Darrell Johnson is President and CEO of FRANdata, an independent research company supplying information and analysis for the franchising sector since 1989. He can be reached at 703-740-4700 or djohnson@frandata.com.