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2012's Best 10 Franchises to Buy, Least Loan Defaults

By BMM, www.bluemaumau.org
Sat 2012/06/16

Knowing a franchise's bottom line and the ability to get a return on investment is the holy grail for a franchise investor. That's no easy feat. What Blue MauMay has been able to do is to find chains that franchisees are healthy enough with their earnings to at least pay back their loans more than other brands. So here are the ten best franchise brands in which franchisees have enough staying-power to pay back their lender.

To read the full article and see the top 10 best, and a link to the default rates of various franchises, click here.

Article "Food Fight: Franchisees Caught in the Middle"

Food Fight: Franchisees Caught in the Middle
October 1, 2009
By Diana Ransom

IF YOU’VE BEEN to a fast food restaurant lately, you’ve probably seen some of the fallout of the downturn. You may have eaten some of it, too.

In an effort to convince consumers to open their wallets wider, franchisors are not only requiring franchisees to officiate (and pay for) new promotions, they’re also requiring them to serve new products, extend operating hours and hand over more of their profits.

“The whole restaurant industry is struggling,” says Bonnie Riggs, an analyst for the market research firm NPD Group, which tracks industry revenues. Although total sales at quick-service restaurants were flat during April, May and June, overall restaurant sales fell 1% over the same period a year ago — the first decline of that magnitude in more than three decades, according to NPD research.

To boost sales, franchisors are taking a scattershot approach. “Franchisors are trying to be everything to everyone right now,” Riggs says. Given that penny-pinching consumers are eating more meals at home, franchisors are pulling out all the stops to reel them back in. They are asking franchisees to pitch cut-rate sandwiches and burgers and dreaming up premium, often exotic menu items to lure consumers back.

Just ask Mike Wright, a McDonald’s franchisee in Shalimar, Fla. To make way for McDonald’s new McCafé espresso-based coffee drinks, which launched nationally in May, he was looking at paying upwards of $125,000 to remodel the interiors of each of his seven stores. The company eventually changed its tune – after substantial pushback from franchisees – but Wright and his fellow franchisees were still strongly encouraged to purchase the necessary coffee and frappucino-style drink equipment. “At $14,000 a pop, you’ve got to sell a lot of coffee to make it up,” Wright says.

In Southern markets, selling hot coffee isn’t easy, Wright says. “When you start selling Bubba a cappuccino, it’s like trying to sell grits to a New Yorker,” he says. “They forced everyone to put this in their stores regardless of profitability.”

McDonald’s is telling its franchisees to have faith in the new menu. “Despite the economy, we are still seeing consistent growth in both our premium and value offerings,” says Julie Pottebaum, a McDonald’s spokeswoman.

Although offering premium products could be an indication that franchisors think the recession is over, many of the nation’s franchisees are still struggling. And even though offering tantalizing new items and discounts can help prop up sales, those tactics don’t always translate to higher profits for franchisees.

“There is a big difference between traffic and bottom-line profitability,” says Darren Tristano, the executive vice president of Technomic, a food industry research firm in Chicago. “From a franchisee perspective, they are looking hard at their cost structure,” he says. Imagine the profit margin on a $1 double cheeseburger, he says. “There isn’t much.”

Meanwhile, franchisees are also coping with added overhead. Adding new menu items often includes taking on more inventory, equipment and maintenance charges, as well as training expenses.

Franchisees have always been tasked with meeting franchisor demands; it’s the mechanism by which chains offer standardized products and ensure quality control. However, fielding a rush of new demands amid slumping sales and rising materials costs – while paying employees a new, higher minimum wage – is proving to be much more challenging than many franchisees expected.

“We are in a retail business; we don’t have software that takes care of itself,” says Daniel B. Fitzpatrick, the chief executive of Quality Dining, which owns 116 Burger King (BKC) franchises in the Midwest. “We still have to clean the signs and take care of the grass. When real estate taxes go up, we pay it. When the minimum wages rise, we pay it,” Fitzpatrick says.

For years, Fitzpatrick and fellow Burger King franchisees regularly paid for these added costs by dipping into their portion of Burger King’s restaurant operating fund, which is funded in part by rebates that Coca-Cola (KO) and Dr. Pepper Snapple (DPS) contribute in return for being Burger King’s exclusive soda vendors. However, Burger King now plans to reallocate 20% to 40% of those rebates each year to bolster its advertising budget.

Faced with increasingly stiff competition among other quick service restaurants – a risk factor the company noted in its most recent 10k filing – Burger King plans to reallocate restaurant operating funds “for marketing and other promotional purposes in line with industry practice,” says Susan Robison, a BK spokeswoman.

The company says it expects to allocate $25 million in 2010 and increase the sum to almost $40 million in 2012. That’s roughly $5,000 to $6,000 a store each year. For Fitzpatrick, that amounts to a roughly $600,000 loss in the first year alone. “Times are tough; I don’t have $6,000 — much less $600,000 — to give up.”

SBA Studies Say Franchises More Likely to Fail than Small Businesses

SBA Studies Say Franchises More Likely to Fail than Small Businesses

Posted Fri, 2009/08/28 - 00:06 by Mr. Blue MauMau

WASHINGTON - Separate studies by Professor Timothy Bates and now two studies by the Small Business Administration report that franchises fail more than independent small businesses.

Over the years, studies have emerged with opposing views when comparing “success rates” of franchising to independent business ownership. Franchise experts are familiar with the reports from the U.S. Commerce Department and those authored by Bates (1996). There are numerous private studies as well delving into franchise ‘success’ and franchise regulation, such as those cited and discussed in “Beguiling Heresy: Regulating the Franchise Relationship," co-written by Paul Steinberg and Gerald Lescatre.

However, two lesser known studies undertaken by the Small Business Administration have received little to no attention. In September of 2002, the U.S. Small Business Administration’s Office of Inspector General’s Inspection and Evaluation Division published a report comparing the failure rate of the SBA’s non-franchise loans to the SBA’s franchise loans. Titled “SBA’s Experience With Defaulted Franchise Loans," the SBA queried:

“If franchise-based businesses are indeed “safer”, then Section 7(a) and Section 504 loans to franchisees – hereafter called franchise loans – should perform better than non-franchise loans in terms of SBA having to purchase defaulted guaranteed loans. In other words, franchise loans should have significantly lower purchase rates than those of non-franchise loans.” (pg 1)

The SBA’s findings?

“Despite the popular view that franchisees are much more successful than non-franchisees, SBA’s experience with defaulted loans does not support this.”(pg. iii)

The SBA also found:

“There is also potentially more exposure per loan on franchise loans. In FY 2000, the average (mean) franchise loan origination was 40% larger than that of the average non-franchise loan. In FY 1991, the comparable figure was only 1%.” (pg iii)

Equally interesting was the following point:

“Moreover, a previously mentioned SBA-funded study [Shane’s 1997 study] found that a franchisor must reach a minimum efficient scale to lower its (as opposed to a franchisee’s) costs. Given this necessity plus the need to collect franchisee-paid fees, franchisors have an incentive to encourage as many prospective entrepreneurs as possible to become franchisees and find financing. Moreover, there is always a risk of some franchisors’ overly optimistic financial projections enabling under qualified prospective franchisees to obtain – and default on – SBA guaranteed loans.” (pg. 1&2)

Prior to publishing, the OIG’s Office of Inspection and Evaluation forwarded this report to the SBA’s Office of Financial Assistance (OFA) for review. In James Rivera’s, the Associate Administrator for the OFA, response to this request for review he stated “A member of my staff conducted a similar study and analysis of the SBA loan data base for the same period under inspection and came to the same conclusion supported by your finding related to the relative success of franchise verses non-franchise loans.” While a copy of this specific OFA’s report is not currently available, the aforementioned letter appears as Appendix C to the attached report.

Although not looking into franchisee success rates as the other studies did, Prof. Scott Shane and Foo conducted research (1997) that shone a light on the high mortality of franchisors, revealing that 1,292 franchise brands studied between 1979 and 1996, only 15% of the franchisors lived to be 17 years old, a rate comparable to independent start-up failures.

Editor’s note: This article was written by Blue MauMau member Oldsword, a former franchise owner-operator. This article has been edited and the facts verified by this journal’s editor.

Chains, franchisees square off over discounted menu items

Chains, franchisees square off over discounted menu items


By RON RUGGLESS

(July 27, 2009) The recession-driven rush to grease sales with promotions and value deals is leading to mounting frictions between franchisors and franchisees.

Brands such as Burger King, McDonald’s, Quiznos, Subway, Popeyes and KFC all have recently found themselves working to restore the delicate balance between the franchisor’s need to drive traffic and the franchisee’s need to protect margins.

Burger King recently battled franchisees over plans to offer a $1 double cheeseburger.
Most recently, Burger King franchisees in mid-July twice rejected plans by Burger King Corp. to offer a $1 double cheeseburger that could square off against value items from quick-service competitors. The Miami-based franchisor eventually capitulated, deciding to offer the value item with a coupon program planned for August.

“It’s a challenge for any franchisor to push through a promo that cuts at franchisee’s profit margins,” said Lorne Fisher, chief executive and owner of Fish Consulting Inc. in Hollywood, Fla., whose clients include a number of restaurant and retail franchisors.

Communication from both parties is key to dissipating such tensions, Fisher said.

“From our experience, it is important to quantify the benefits to the franchisee to ensure they understand the value despite the cut in margin,” Fisher said.

“Whether the increase comes in consumer traffic, average check size or brand awareness, the franchisor must be able to present the tangible benefit to sell the promotion successfully and maximize the system’s participation,” he said.

Quiznos is among the franchisors that have run into conflict with franchisees this year. The Denver-based franchisor encountered wide pushback from franchisees over the $5.29 sandwiches it had hoped to give away in its “Million Sub Giveaway.” McDonald’s franchisees reportedly expressed concerned over the national introduction of the premium Angus burger in early July, while some Subway franchisees were upset by the chain’s ongoing “$5 Footlong” promotion.

Tempers also flared at both Popeyes and KFC over one-day product giveaways that found many franchisees emptying their larders as cash-strapped consumers rushed in for free goods. KFC’s high-profile marketing boost from Oprah Winfrey exacerbated the situation.

Burger King on July 14 reached detente with its franchisees when it said it would beef up the promotion of its $1 Whopper Jr. and feature the double cheeseburger in an August coupon offer.

“Burger King Corp. remains fully focused on its value offerings and delivering value for the money to its guests,” the company said in a statement. “As such, many product and menu options are always in development and under consideration.”

The company added, “BKC will also be deploying traffic-driving national coupons to nearly 80 million households during this time period with almost $50 in savings per coupon booklet.”

A spokeswoman added: “The direct-mail coupon book includes a $1 double cheeseburger offer from Burger King restaurants, and with more beef than a similar sandwich from McDonald’s, the offer will represent motivating affordability to burger lovers nationwide.”

McDonald’s replaced its double cheeseburger that had been on its Dollar Menu with the McDouble, above, which has only one slice of cheese.
Rival McDonald’s raised the price of its double cheeseburger from $1 to $1.19 late last year amid rising costs and franchisee complaints that a profit could not be made on the item. The double cheeseburger was replaced on the Dollar Menu with the McDouble sandwich, which contains two patties but only one slice of cheese.

Joe Buckley, an analyst with Bank of America-Merrill Lynch, said in a report that franchisee tension stemming from an ongoing soft-drink contract dispute could be a roadblock for Burger King as it seeks to add value offerings to drive traffic.

“We are concerned that the lack of alignment between Burger King and its franchisees could complicate efforts to turn sales,” Buckley said in downgrading the stock to “neutral” from “buy.”

The economic downturn has only served to heighten franchisee-franchisor tensions. Analysts said low-margin promotions in flush times could be a “loss leader,” drawing in customers who may buy additional, more profitable items to raise the check average. However, as patrons cut back on those extras, the “loss” loses its “leader,” and the franchisee is left holding the bag.

McDonald’s recent introduction of both the new coffee line, of which both the iced and hot mocha are being offered for free on Mondays through Aug. 3, and the new premium Angus burger have raised the eyebrows of franchisees. They have expressed concern that McDonald’s is trending too far away from its value focus and placing too much strain on franchisee operations.

In an April survey of McDonald’s franchisees by former stock analyst and independent researcher Mark Kalinowski, one unidentified McDonald’s franchisee called the Angus burger “another poor-margin item.”

However, Danya Proud, McDonald’s senior manager of U.S. communications, said many franchisees’ concerns were allayed.

“The franchisees told us they couldn’t get it in their restaurants quickly enough,” she told Nation’s Restaurant News earlier this month. “I think people misconstrued things. During the early stages of the test we were using a slightly bigger burger that would have required new equipment. But we went to slightly smaller burgers that can be prepared on existing grills.” —rruggles@nrn.com

Restaurants, Franchising and Discounting

Restaurants, Franchising and Discounting
by john a. gordon

In a June 23 New York Times Business article, Discounts Have Restaurants Eating Own Lunch, the woes of chain restaurants offering discounts—and the possible long term effect of doing so, was well outlined. The following passage caught my eye:A T.G.I. Friday’s promotion in April and May offering $5 sandwiches and salads led to a small-scale revolt among franchisees. Ross Farro, who has seven T.G.I. Friday’s restaurants in Ohio and Pennsylvania, said the promotion included salads that normally sell for as much as $10 and a steak sandwich priced at $11.89 on the regular menu. The ingredients alone for each steak sandwich cost about $4, he said.

The promotion was supposed to run at lunch and dinner, but Mr. Farro said he and some other franchisees put away the $5 menu inserts at night to stop the bleeding.

This was not the first such example just this year of such issues plaguing chain restaurants and franchisees. Sonic (SONC), for example, has been struggling for almost the entire last year by promoting either drinks or its $1 value menu, and having declines in average customer ticket, not offset by increases in customer traffic. It reported earnings on June 23, which were still weak. And Burger King (BKC) and Subway franchisees have also noted the same problem. But Subway units, with their overwhelming US presence, seem to be visually busy, and seem to of the right scale.

Routinely, in my field visits of restaurants so far this year, I find situations where the company’s central marketing thrust is all but hidden or ignored by misplaced restaurant outdoor posters, in store merchandizing, OR where cashiers actually “trade down” customers to the more discounted offers, from a higher margined item. Either action results in a very sub-optimal outcome.

In the example above, the TG I Friday’s franchisee pointed to a gross margin of only about 20% on that particular steak sandwich item. That’s far below the typical 60-70% margin. I’d bet that not every item in the mix resulted in such a steep discount. But any discount means that incremental sales traffic must be generated to offset the lower margin resulting from the promoted item sales.

Franchisees are more margin centric in their needs and outlook, while the large publicly traded companies are more comp sales oriented, because that is a key metric The Street is looking for.

A lot of that tension is due to the franchise model, where franchisors get royalties based on sales but franchisees make profit the old fashioned way, taking what’s left after expenses are paid. Also, franchisees generally have higher cost of capital (if they can get credit at all right now) and have lower potential margin structures, as they must pay a royalty to the franchisor off the top, usually 3-8%.

Very clearly, deal and value is very important in retailing, but how do you drive it optimally?

One, is that you avoid the mistakes noted in the TGI Fridays example above: work to make the discounts meaningful but not such that individual item sales are slashed beyond feasible (rule of thumb: 50% gross margin is a starting point).

Another is that Fridays could have limited the discount to lunch only—most casual dining operators are slower daytimes and are much busier in the evening. Work to fill in your gaps but play to your strengths.

Another is offering attractive, limited time offers with the price point and margin you can tolerate. Both Brinker (EAT) and Darden (DRI) have kept their product development groups busy lately, creating and rolling out such items.

About the author: John A. Gordon is with Pacific Management Consulting Group, an analytically oriented chain restaurant management consultancy; focused on restaurant economics and earnings

SBA Numbers

SBA numbers

Declining loans? Whose de-fault is it?

By Jonathan Maze
As published in: Franchise Times - April 2009

Amid all the concerns about the decline in SBA lending is one relatively simple explanation that gets little attention: skyrocketing default rates.

The default rate on SBA-backed loans given to franchisees has more than quadrupled since 2004, according to information prepared by the Coleman Report, a newsletter out of California that tracks the SBA lending market. In 2004, the default rate for franchisees was 3.1 percent. By 2008 it was 13.4 percent.

Meanwhile, 2 percent of franchisees receiving SBA loans failed and liquidated last year, an increase of two-thirds over the year before and more than six times the rate of failures as in 2004.

Both figures reflect an overall increase in loan defaults in the SBA program, in which businesses had an 11.9-percent default rate last year, up from 2.4 percent in 2004.

The higher default rates may help explain a 57-percent decrease in SBA-backed loans in the last three quarters of 2008 and a general decline over the past couple of years. That decrease has generated deep concern among lenders and small business advocates as well as government officials who view small business creation as a key to any economic improvement.

In February, Congress passed an economic stimulus package with provisions designed to increase SBA lending. The stimulus package reduced fees and increased the government guarantee on 7(a) loans to 90 percent, and it enables the agency to lend to dealers who sell loans on the secondary market - which many believe would stimulate lending.

The higher default rates on SBA loans in recent years are a likely symptom of the decline in the nation's economy. But many of the defaults predate the serious economic downturn. That suggests the numbers may reflect one of the causes of the recession: banks' loosening lending standards in a period of historically low interest rates.

Darrell Johnson, CEO of the franchise information firm FRANdata, said that while the number of loans in default is near 12 percent, the dollar amount defaulted is much lower, less than 5 percent. In other words, the loans more likely to go into default were for lower dollar amounts.

Companies with higher default rates among their franchisees typically require smaller loan amounts. The 10 companies listed on the Coleman Report with the worst default rates - ranging from 55 percent to 86 percent - had an average SBA loan amount of $173,060. By contrast, the companies with the 10 best default rates - or the 10 companies with the most loans and no defaults - had an average loan of $742,594.

Lenders commonly performed less due diligence on smaller loans, because the amount of paperwork required for an SBA loan is the same whether it's $50,000 or $500,000. So banks didn't take as deep a look at borrowers of loans for less than $150,000 - the peak amount in the agency's now-defunct "low documentation" program that required less paperwork. "The smaller size loans were getting less bank scrutiny, that's the issue," Johnson said. "With less bank scrutiny, they were defaulting at a higher rate."

"In a rising economy, it's still problematic," he added, "but it is accentuated because of the down economy, when defaults would be up, anyway."

Johnson attributed much of the reduction in SBA lending to a reduction in bankers making smaller loans because of the default rate and the departure of some large lenders that had specialized in low documentation loans. Indeed, the most significant reports of lending problems have come from franchises that have a lower initial investment cost.

Johnson doesn't think the lending environment will change anytime soon. Lenders are making fewer, more conservative loans and given the cost are likely to focus on bigger amounts. Banks "are being overly conservative now," he said. "And that over-conservatism is being applied to a greater extent to smaller loans."

That franchisees had a 1.5-percent higher default rate isn't entirely a surprise - Johnson himself authored a report more than a year ago with a similar finding. He believes it's rooted in the fact that many franchises require smaller loans and are therefore more likely to default.

And Bob Coleman, publisher of the Coleman Report, stressed that not too much should be read into the difference. He said that the majority of franchise loans are in the 7(a) program, which has a higher default rate than the 504 program, which is tied to property. The default rates include numbers for both programs.

Fixing the problem?

The higher rate of defaults has not gotten past the SBA, which in attempting to solve the problem announced in early February that lenders should restrict the value of "goodwill" in a loan to 50 percent of the total amount and no more than $250,000.

The SBA's decision led to an outcry among brokers and lenders who said the restriction would bring loans for business acquisitions to a virtual standstill. "Moving goodwill to 250 does not help us in any way, shape or form," said Steve Mariani, founder of North Carolina-based Diamond Financial. "All the people on employment lines who would like to get a loan to buy a franchise or a business, you're stopping them from getting that business. It's just been an absolute mess the last couple of weeks."

That outcry did cause the SBA to back off a little by the end of the month. The agency said any loans exceeding the goodwill cap could be submitted to its central processing office for the next six months. That didn't pacify critics of the plan, who say that at the very least sending the applications to central processing would delay loans and generate more paperwork. And a definitive goodwill cap is still possible.

Goodwill is the value tied to a business above its physical assets, or the premium associated with buying an established business, rather than starting one from scratch. Many established businesses on the market have some sort of goodwill value attached to them, especially service-oriented companies that have less equipment and buildings.

Franchises likewise have a certain amount of goodwill value, such as the brand name and the territory rights, said Steve Mize, managing partner at Gulf Coast Financial Valuations, a business valuation firm.

The SBA contends they're also the riskiest. In a memo to SBA employees in February, Grady Hedgespeth, director of the agency's office of financial assistance, said that many lenders don't finance goodwill on conventional loans, and that neither should an SBA backed loan.

Mize disagreed, and he noted that the number of service-oriented businesses with higher amounts of goodwill value is increasing. "The less risky deals are the deals with simple business models and higher amounts of goodwill and good customer diversification and good management," he said. "The riskiest are high capital businesses with higher capital expenditure requirements and high working capital requirements."

Mize said that 76 percent of the loans made for business acquisitions last year would not qualify under the new cap. It's uncertain how many SBA loans are for business acquisitions, but Mize said those sales nevertheless represent an important piece of any economic improvement.

Sales at businesses tend to stagnate in the years when the owner is closer to retirement, he said. If the business can be sold, then it would bring in a young, energetic owner who could bring in new ideas and generate sales and employment. Restricting goodwill would keep those owners from selling. "By limiting financing on goodwill, they're limiting the value on the most valuable assets that the business can own," Mize said.