Transfers of Power: Under-Performing Units Present Opportunities in 2010

The difficult consumer business environment has made the economics of new unit expansion more challenging. This makes "getting to yes" with bankers more difficult because the economics do not have as healthy a margin for error as they did in more robust times. As a consequence, capital access will continue to be the most constraining factor as we look at the next few years. Financing new units is relatively more challenging in general, and in this economy that is particularly true.

To be sure, there are positives as well that are helping to make the economics better. Site build-out and leasing costs have come down. Commodity prices have also dropped significantly this year. Franchisors are squeezing dollars out of unit investment costs, thereby easing pressure on the capital requirements. All of this helps offset lower unit revenue assumptions.

Attention to new unit development is, of course, what drives franchising and much of franchisor management attention. While this is understandable, I don't think this is where a lot of the opportunities will lie for multi-unit operators in 2010. Much of the action for experienced operators will lie in opportunities to buy under-performing units.

In the good times of most of this decade, weaker units often managed to make a profit because of the rising tide of a consumer-driven economy. Take, for instance, retail businesses. A strong economy tends to obscure weaker locations. It also allows a lot of new franchisees to learn the business, make mistakes, and still survive. Franchising added more than 30,000 units and hundreds of new brands each year of this decade until 2008, putting tens of thousands of new franchisees into business.

As we know, in tough times the market is less tolerant of mistakes, whether the mistakes are brand, marketing, site, operations, or owner created. Franchisees simply have less margin for error on all fronts. This is particularly true for new franchisees since they are building cash flows from scratch. Therefore, it is safe to assume that a significantly higher number of franchise units are at or below break-even today than was the case just a few years ago. One measure of that is the number of SBA loans that have failed. From 2007 to 2008 (the federal government is on an October through September fiscal year) the number of failed loans across both franchised and non-franchised businesses more than doubled.

That suggests a lot of units started in the past three years--with revenue expectations coming based on the incorrect assumption that the good times would continue--are at risk. The reasons they are at risk are the key to the opportunities for multi-unit operators. To the extent that the risk is created by owner/operator mistakes and inefficiencies, there is opportunity. To understand that opportunity more, let's look at the franchisor's role.

The same rising economic tide that allowed new units to underperform yet still succeed allowed franchisors with less robust performance to ride on the coattails of successful franchisors. One of the three key indirect bank underwriting categories for franchisee loans--system-wide unit performance--was not given much weight during the boom times because a relatively low percentage of franchise loans became problematic. If you have applied for a mortgage application recently, you know how that underwriting process has changed.

The same holds true for franchise loans. Franchisor financial and operational performance, along with system-wide unit performance and unit economics, are no longer being ignored. To the contrary, for the next few years, they will be scrutinized. Performance matters now--a lot. Thus, franchisors have a big incentive to protect their system-wide unit numbers if they want capital to continue to flow to new units, which brings us back to under-performing units.

Since their revenue royalty streams depend on unit sales, franchisors want to keep all units operating. However, now we can identify an additional reason--a very significant one--for franchisors to help facilitate the connection of successful operators with weak operators. To protect the flow of capital to new units, franchisors have a strong interest in the flow of capital to transfers. Many of the requests for FRANdata bank credit reports reflect the recognition that even if franchisors aren't adding many new units, they will still need to facilitate capital access for transfers in the next few years.

That leads us back to under-performing units. If franchisors let these units go dark, they are hurting their system's access to capital for new units. The current economic difficulties not only punish under-performance, they also help bring realism to unit valuations. The reasons for unit under-performance are the key to multi-unit franchisee opportunities. If under-performance is due to operational or owner issues, there exists an interesting alignment of interests among franchisors, owners of under-performing franchises, and multi-unit operators to make something happen.

The opportunities are significant. Based on recent research we conducted for the IFA, we predict that transfers will outpace new unit expansion in 2010. The challenge is how to make this happen efficiently. We have some ideas and would welcome yours.

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.