Financial Sniff Test
A Simple Financial Test Using Due diligence, UFOCs, and Industry standards
Although a version of this blog entry was previously posted in another forum, it is reposted here in order to illustrate a simple method that can be utilized to determine overt franchise concept viability. By overt, I mean this is but a preliminary screening test. There is no reason to go the expense of hiring a lawyer, a forensic accountant, or pay for in depth analysis if a concept cannot pass a simple “sniff” test.
The methodology is simple. Many concepts are in industry verticals, and in general if there are players in the vertical there also are trade groups that attempt to disseminate information “for a fee”. The disadvantage is often you need to be a member of the trade group which can runs hundreds of dollars. One way around this is to simply ask someone involved in the vertical for a back issue or other relevant data on a one time basis. People tend to be very accommodating.
What you are trying to do, is use industry averages to determine overall viability. National data is available for QSRs, certainly for sub and other sandwich shops. In this example I was examining the “Quick Lube Market”. There is an trade journal for the quick lube industry, NOLN (National Oil Lube News) that formed the basis for simple comparison test. Armed with the data from NOLN and the companies UFOC a simple screening sniff test could be employed. In this case we are comparing a 2004 UFOC and 2003 NOLN data, the information is dated but the purpose of this post is to demonstrate a simple screening technique.
The prerequisites:
Get the UFOC, what you are after is the Income Projects – Exhibit J, click here
| An Excerpt from 2003 National Oil & Lube News (NOLN) Survey | ||||||
| Year | 1999 | 2000 | 2001 | 2002 | 2003 | 2003 |
| Independent/company-owned facilities | 81% | 85% | 84% | 87% | 85% | 40% |
| Franchised Facitilies | 19% | 15% | 16% | 13% | 15% | 60% |
| Years in Fast Lube Business | 7.1 | 7.6 | 8.1 | 8.9 | 8.2 | 17 |
| Ticket Total | 32.55 | 35.25 | 36.66 | 38.51 | 39.18 | 48.27 |
| Number of Cars Serviced Per Day | 41.6 | 40.6 | 41.4 | 40.3 | 37.6 | 40.7 |
| Break Even Car Count | 28.9 | 26.6 | 26.7 | 25.8 | 24.8 | 28.1 |
| Operators Planning to Sell Next Year | n/a | 7% | 8% | 8% | 6% | 0% |
| Operators Planning to Sell Five Years | n/a | 24% | 21% | 25% | 21% | 0% |
| Number of Bays Per Facility | 3 | 3 | 2.8 | 2.7 | 3 | 3.4 |
| Price of Standard LOF | $24.18 | $24.71 | $25.35 | $26.86 | $26.71 | $29.13 |
| Cost of Goofs for Standard, Full Service LOF | $7.98 | $8.29 | $8.54 | $8.40 | $8.73 | $6.62 |
| Time Required to Perform a LOF | n/a | 11 Min. | 11 Min. | 11 Min. | 11 Min. | 11 Min. |
| Operators Who Offer Up-Scare/Premium LOF | n/a | 68% | 70% | 63% | 63% | 70% |
| Price, if Offered | n/a | $36.37 | $38.03 | $43.82 | $44.33 | $49.32 |
| Operators increasing LOF | 29% | 72% | 66% | 34% | 51% | 60% |
| How Much? | $1.39 | $1.43 | $1.46 | $1.49 | $1.47 | $1.35 |
Note: LOF = Lube, Oil & Filter Job. The 2003 column on the left represents "Less than 30 stores", the 2003 column on the right represents "more than 30 stores". NOLN started breaking this down in this fashion in 2003 for select categories. Operators increasing LOF" means operators increasing LOF price in the past 12 months. "How much" in the next line is how much the LOF price has been increased.
In view of some industry standards (NOLN survey) I find the Franchisor’s earnings claims enlightening. According to NOLN (National Oil Lube News) the "average" car count was between 37-40 in 2003 (the latest year I have numbers for), but historically the car counts have been closer to 40 [a sign either the market has matured (not likely) or a sign of competition as historically this is a price inelastic service]. And in the same report NOLN's number for breakeven in terms of cars served s between 24-28 cars a day depending on lease/buy arrangements. Looking at the Franchisor’s exhibit J we can see that about 40% of their franchises hovering around or more significantly below the break even threshold at 30 cars a day. What is more telling is that 85% of the NOLN respondents are independent. That makes me question the overall "value" of the franchisor’s franchise process. Why is it that operationally independent lube shops are outperforming a franchise operation? It makes you strongly question the "operation" side of the equation and makes you wonder if their selection process is more geared to selecting candidates who will stay with the "system" and put money in the franchisor’s pocket rather than looking for candidates with the ability to expand market share as the independents must be doing. Another way to say this is, your franchise fee may buy you somethings procedurally but they certainly are not buying you a process that even slightly approaches what I would term success.
There is another thing, here is information from one of the Franchisor’s web pages:
Site Selection Assistance: We provide the tools and real estate information necessary for the franchisee to make an informed decision on the correct location for a new center. Our real estate department will help select a X location by evaluating market conditions and trends, population density, traffic patterns, demographics and proximity to traffic-driving influences, such as primary retail centers.
Hmmm, what do you know? Part of your franchise fee goes for site location. Given that 40% of their franchises are either below the breakeven point, at the break even point, or barely turning a profit, you have to wonder the value of the site location.
The esteemed barrister Webster made the following observations:
- Exhibit J, an earnings claim, shows that 11 out of 32 participants in a disclosure program, from a maximum of 177 franchisees, earned less than 10k before paying rent, or any debt repayment. Basically, you could not survive on these stores average ticket count of 19.
- Even the 4 stores with an average ticket count of 27, are only showing 61k before paying rent. Rent, from their estimates, could be anywhere from 36 - 72k.
Basically, half the reporting stores are either insolvent or barely making the rent. Unless you average 40+ cars per day, you are going to have a tough time, especially if you financed the construction of the site.
I put this out here for discussion and analysis. I deliberately did not mention a lot of things you can pull out of this to stimulate some discussion. But here are a few additional points. Look at the NOLN data,one thing to notice is the % of owners who are planning on selling. It is relatively low…that implies a few things and casts more doubt on the franchise proposition proffered by the franchisor.
And the point is diligence, which is what Michael, Paul, Mr. BlueMauMau, Richard Solomon and so many others have tried to get across to many of the posters. Folks it is your money on the line. If you are not willing to ferret out industry norms and compare the franchisor to those norms and normalize the figures for the circumstances you are simply gambling.
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Related reading:
| Attachment | Size |
|---|---|
| 2003 Fast Lube Operators NOLN Survey.pdf | 1.42 MB |
2003 was a watershed year in the lube biz
About that time there were new entries into the Quick Lube business, and any notion of price inelasticity went out the window. Franchisors are owned by oil companies, and the name of their game is to use the system to push product sales. The game became extremely aggressive about then, with at least one franchisor's owner starting another competing chain under another name, and at the same time making deals with new groups of stores to sell them product and provide them allowances at more favorable prices and terms than their franchises received. At about that time, this same oil company made a national deal with WalMart, which entered the quick lube business and brought per job prices down to about $ 15 and even less. Notions of $ 24 lube jobs were no longer reliable, Many of these new organizations offered other car maintenance services that the franchised chains didn't offer, and the franchisor refused franchisee requests to allow them to offer competing services.
A customer could obtain from their competition several items of service in one stop that they could not obtain from the franchisee systems. The franchisor refused consent to the diversification of services request. The name given was that it would diffuse the brand's identity - total assinine bullshit. The real reason was that the franchisor and its oil company owner didn't want bays that could be used to sell oil changes being used for other services.
On top of that disaster, quality control at company owned stores went in the toilet and there was enormous press coverage of the situation, especially focused upon the unresolved complaint records at the BBB. Many franchisee owned stores were similarly rotten.
However, it is correct that in any mature business there is frequently a trade association that offers services that are the equivalent of anything any franchisor has to offer. These resources are available from the association for membership fees (usually a few hundred dollars up to a thousand dollars annually) and some small fee for some of the programs. If you have resort to the association you do not pay a franchise fee, or royalties or advert fund fees. You do not have a covenant not to compete or a liquidated damages contract term in your life, and there is no need for dispute resolution protocols to be rigged against you because the entity with which you would have disputes is simply not in your life.
An excellent example of this is to be found in the quick print industry. It used to be called the NAQP (National Association of Quick Printers), but is now called something else. If you Google up NAQP, you will find it immediately. Sometimes the availability of resources from the trade association is of such high quality that its availability can be used to defeat any claim by a franchisor that it is necessary to enforce a covenant not to compete to protect a franchisor's confidential/trade secrret "stuff". That is certainly true in the quick print industry. No one in the quick print industry would ever have to worry about any covenant not to compete if they were represented by counsel who knows how to do that.
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Richard Solomon, FranchiseRemedies.com, has over 45 years experience with franchise litigation and crisis management. He is a graduate of The Citadel and The University of Michigan Law School
Great post...
Franchise and independent business desicions are about dedicated and thorough due dliligence. It is not hard to do; it's just easier no to do it and cry foul later.
People who buy franchises absent sufficient due diligence do so at their own peril.
The Truth Shall Set You Free!
TIF
Independent Trade Associations
Fuwa 's original post was from the franchise-chat. The full thread from franchise-chat is here.
Fuwa and I have always been in agreement about what the decision to purchase a franchise should include: opportunity costs, and valuing the trade-off between brand awareness/royalties versus independent business.
NOLN is not the only independent trade association:here is a partial list of trade associations for independent businesses.
A couple of small points. One, if no earnings claims is made you can always use the financial reports to obtain some measure of expected gross earnings. Two, the expected value from paying royalties/national ad for higher volume is tricky.
One quibble: the spreadsheet has 2 "2003" entries.
One question for Mr. Blue - what is the significance of the option "add a child page"?
Michael Webster PhD LLB
Franchise News
FuwaFuwaUsagi's Sniff Test
Always good advice ---and I'm sure that most franchisees and their attorneys don't ferret out industry norms, etc.. for comparisons of those franchising the concept. This kind of deep due diligence is only done by the due diligence attorneys who are the experts in sniffing out the best possible opportunities for their clients.
Richard Solomon and FuwaFuwaUsagi are not in disagreement because they both recognize and warn that if the concept cannot be franchised to provide viability and profit for the franchisee, it isn't an investment.
Anyway, FuwaFuwaUsagi has often said that he doesn't like the smell of most franchise offerings and that few, if any, franchises are good investment vehicles, and that we should turn away from bad smells.
I think he posted this article to help the naive and inexperienced attorneys and brokers and advisors who permit their clients to sign contracts of adhesion on high risk franchises. Those who surround the industry so often protect their innocence because they really don't know and don't want to know the risk involved to the client.
Financial Sniff Test Template for Other Industries Needed
This article and financial table is such a valuable tool for franchise buyers to quickly measure up a system that I am placing it on the top of the front page for a stint.
Readers, please feel free to give comment on this Franchise Sniff Test. The goal is to build a worksheet that a buyer can use to quickly determine if a franchise looks like it will make money or not.
I invite readers to contribute a completed table like the one above on other franchise sectors - e.g. Quick service restaurants, Quick print, Mail Services, and others.
Mr. Blue MauMau
Standard Deviation
Fuwa;
I wonder if you would care to comment on what this table show about about: a) the mean of jobs done, b) the chances -expressed as a standard deviation from the norm- of breaking even, and c) the type of person who could or should take on this type of risk.
Michael Webster PhD LLB
Franchise News
What Is 'Add a Child Page'?
Parent / Child Page is a social media function, a simple wikipedia for business people, that allows members to collectively work on a franchise book.
The Book / parent / child page helps organizes participatory journalism to contribute to our community intelligence. This is one of the features that seperates a multiple-author blog page from a social media tool.
"Add a child page" gives our members the ability to add a sub-chapter to a topic - in this case, to individually contribute tools for our community's book on tools for franchise buyers, specifically, Fuwa's financial metrics chapter to help evaluate a franchise purchase. Fuwa's entry acts as a parent to the sub-topic or child page. You as a member have the ability to add a child page to our body of knowledge. As the author of the parent page, members can edit their specific entry.
Think of Blue MauMau as a group software and platform that helps organize members so that what they individually can contribute is coordinated to create an entire book on a given subject, with chapters, sub-chapters and sections to our collective community intelligence. Child pages create a sub-topic to the parent page. This writing coordination is the essence of participatory journalism.
The menu on the bottom of the book page allows the reader to go up and down the chapters, sub-chapters of the book.
As editor and moderator, I have the ability to move news stories and blogs to our books, where and when appropriate.
Other books on franchising that our members are currently building:
I have added Fuwa's blog as a financial chapter to our community book on Franchise Tools. That's why in the menu you can go up topics or go down to topics related to this. If members have an additional tool or metric in buying a franchise, they should add a sub-chapter to Fuwa's.
Besides clicking on 'add a child page', members can go to the 'share' tab and click on 'book page' to contribute material. The second field below the subject of your posting is 'parent'. This pop-up menu of existing chapters and sub-chapters is where you decide which topic your entry best fits under.
When in doubt to where your entry should go, just select Franchipedia for our franchise encylopedia.
Note: A child page is not the same as a comment. Please do not create a child page if you just meant to comment on the merits or demerits of Fuwa's financial tool.
Mr. Blue MauMau
allow me clarify this...
Michael writes:
One quibble: the spreadsheet has 2 "2003" entries.
My reply:
You are correct. The 2003 column on the left represents "Less than 30 stores", the 2003 column on the right represents "more than 30 stores".
Apparently NOLN started breaking this down in this fashion in 2003 for select categories.
Excelsior,
FuwaFuwaUsagi
NOLN is not a trade organization
it is a for profit trade magazine. The data that they gather is from a questionaire sent out to lube operators, and the data is not verified by any source, so use this data knowing that it is so.
The lube business is very different depending on the number of competitors in a market, and where the market is.
For example, from experience, I know the car counts are much higher in California and in the northeast than they are in the middle section of the country.
While I think NOLN is one good source of data, and the UFOC is another, any potential franchisee would need to perform very specific due diligence in the market of interest to him.
You also might note that because NOLN depends on advertising from the lube industry, you won't find much investigative journalism there. Most of the articles in the magazine are (to me at least) articles to make those in the industry feel good about their business, or to help them learn more on products they can sell.
While I think looking at NOLN numbers is useful in coming up with questions to ask, it is not data I would use to buy a franchise; but you would also see that there are a number of oil companies (including the one that owns Jiffy Lube), that have independant programs that do not require royalty payments or franchising. That may lead you to the next question, which is whether those programs compete with the franchises - then you have some valid questions to ask!
Once again, an investment in a franchise almost requires you to be your own (or to hire) a private investigator, and this person must not be getting money from the franchise you are considering (a broker). He must be independant and have only your interests at heart.
Blog Comments Moved to Forum Remarks
A comment thread here was getting way off the subject of Fuwa's article and tool. Those blog comments have been moved to a new discussion thread in the due diligence forum.
Mr. Blue MauMau
Community Umpire
for you, sure...
Michael:
Yeah, for you, I'll run the actual numbers. If it is alright with you I'll make a few assumptions and shortcuts (I'll document them) that I would never use if "real" money was on the table. For instance I will not go through the process of actually verifying my baseline which in this case would be the methodology that NOLN utilized when compiling its numbers - i.e. I am assuming their numbers are good enough to form my baseline.
For example we are using 2003 franchisor data, so I will use the 2003 figure of 37.6 cars from NOLN as the base for calculating the standard deviation from the UFOC numbers. And in real life I would examine the heck out of how they determined the yearly break-even car count, there is too much variation in those numbers to make me comfortable. I tend to think I would arithmetically average those figures.
I'll get on it when I find some time. Maybe when I am on the Tarmac tomorrow.
FuwaFuwaUsagi
"Never underestimate the power of stupid people in large numbers."
The Sniff Test, Self-Reliance
This looks like a very helpful financial template for an initial measurement on whether this franchise purchase will bring money or not. No need for the government to get involved. No need to believe the franchisor or its salesperson. No need to trust in the capability of an accountant or attorney at this stage.
It's a simple tool.
The experts can help later after your sniff test shows the concept has a sweet, floral smell.
NOLN Numbers
20morezee writes: You also might note that because NOLN depends on advertising from the lube industry, you won't find much investigative journalism there. "
Wouldn't that you make the numbers more reliable, since they are more conservative?
Michael Webster PhD LLB
Franchise News
In the lube biz...
2003 data is completely useless. The world turned upside down in that business since this information was published. No one could reasonably rely on 2003 information in vetting an opportunity in that business today.
And in my opinion, anyone making a franchise investment in the auto care business today is simply commiting seppuku with his personal wealth.--
Richard Solomon, FranchiseRemedies.com, has over 45 years experience with franchise litigation and crisis management. He is a graduate of The Citadel and The University of Michigan Law School
The numbers definitely have a place in the due diligence process
I do think they are a good starting point, but since the responses are voluntary, and I don't think the sample numbers are that high, they could be misleading to someone with no background in similar businesses.
If a potential franchisee was in the due diligence process, they could get a lot of great information here, and then if they do what most on these blogs recommend, they will take the additional steps.
These steps include visiting with as many franchisees as they can find - current, terminated, happy and unhappy, building "what if" spreadsheets, talking to suppliers, visiting competing businesses in the area they are considering, and hiring a competent franchise attorney that has adequate experience in vetting franchises.
2003 Data
Richard, you have missed Fuwa's point here. He is trying to explain how you can use trade industry data and the sort of information that can be gleaned by it..
It is his due diligence model that we should be talking about.
Michael Webster PhD LLB
Franchise News
Michael, I appreciate your comment, but...
what I suspect is missing based upon selection of the lube business - or the print business - is the impact of life cycle analysis. The cataclysmic events in the business selected for the initial presentation here suggest strongly (to me at least) that this work should be overlaid by life cycle assessment.
Where in the concept life cycle are the businesses to which you are applying this analysis that Fuwa-San provided? Notwithstanding a positive result from Fuwa-San's test, the question then becomes what is the likelihood of continued reliability of any results that may be found. That is what calls out for the life cycle testing.
On another point, I just loved your oblique quip about the mean deviates who post in here from time to time. I wonder how many of the serious people recognized your commentary on the character of certain folks.--
Richard Solomon, FranchiseRemedies.com, has over 45 years experience with franchise litigation and crisis management. He is a graduate of The Citadel and The University of Michigan Law School
Fuwa's Model as a Filter
Richard writes: "Where in the concept life cycle are the businesses to which you are applying this analysis that Fuwa-San provided? Notwithstanding a positive result from Fuwa-San's test, the question then becomes what is the likelihood of continued reliability of any results that may be found. That is what calls out for the life cycle testing."
I think Fuwa meant to construct a simple model which would filter out crap franchises.
You are quite right that much more is needed in order to pull the trigger.
Michael Webster PhD LLB
Franchise News