The Franchising Cloud of Mystery, Issues with Wage Increases

September 2nd, 2013

Over the last couple of weeks, several items in the news highlighted the math in the franchising space. On August 22, 2013, the Wall Street Journal published its biannual franchising supplement in its paper editions. A summary table listed franchisee median income of $50-74,000. A flurry of articles and posts on Blue MauMau, dissected that number further. On August 29th, the restaurant "fast food" strike occurred, with some workers marching for a $15 per hour minimum wage. The national press reported that restaurant margins were narrow and that franchisors noted it is the franchisees that set their wage rates.

The reality is everything affects everything else, and every single number used in such discussions needs to be carefully parsed.

Why can't restaurants pay a $15 wage?

In a typical quick service restaurant, crew labor and related indirect expense, excluding management, is around 20-25% of net sales, with some concepts higher and some lower. The restaurant average wage is about $8 to $9, with some higher. For example, California-based hamburger chain In N Out pays $11/hour and some pay less (if tip credit is authorized). So, without price increases, the crew labor cost percentage could double, and that would certainly wipe out any profits or cash flow whatsoever for both company and franchisee operators.

Associated Press suggested that <a href="http://finance.yahoo.com/news/workers-protests-highlight-fast-food-1301… can't have both a dollar menu and a $15 per hour wage</a>. That is true. The percentage of dollar menu item sales compared to total menu sales vary from 10 to 25%. Dollar menus were implemented by publicly traded restaurant franchisors (McDonalds, Wendy's, Burger King) in the headlong chase for sales comparisons that Wall Street values so highly. Franchisees then, and now, are almost universally opposed to dollar menus.

Restaurant margins are low. Restaurant profits are best viewed on a per store profit basis and on a fully allocated free cash flow basis. As I've <a href="http://www.bluemaumau.org/ebitda_limited_financial-metric" target="_blank">noted on Blue MauMau in June</a>, the earnings before interest, taxes, depreciation and amortization (EBITDA) per store profit view is misleading and insufficient, since franchisee overhead, principal, interest and capital expenditures (CAPEX) must be subtracted to arrive at free cash flow. Nonetheless, even on a store EBITDA basis, a shocking number of franchisee operated locations (and some company locations, too) have EBITDA below 10%. Anything under an EBITDA margin of 15% would have difficulty meeting all other economic subtractions needed from EBITDA.

Franchisees have the additional burden of paying royalties to the franchisor. Franchisors are paid from the franchisee's top line. The franchisees manage on what is left. Franchisors could universally lower royalties paid by franchisees to offset any minimum wage increase, but both Wall Street and the credit markets would have fits. Royalties back up the high stock prices and the high debts that many companies have run up.

This leads us back to the essence of the franchise relationship. The franchisor is the steward and keeper of the brand, and receives royalties and other forms of economic gain from its franchised system in return. If the minimum wage increased to $15, it is the franchisor's responsibility to rebalance the store model. The SEIU President seems to <a href="http://www.bloomberg.com/news/2013-08-29/fast%20food-strikes-expand-acr…; target="_blank">understand the franchisee's conundrum</a> but talk won't fix this problem.

Cloud of Mystery

There is near universal misapplication of what I call "franchising math." This misapplication is contrary to investor interests, and has the effect of creating and maintaining a cloud of mystery over franchising. Some examples follow:

<div class="photoright">
<table align="right" border="1" cellpadding="1" cellspacing="1" height="209" summary="Year X" width="256">
<thead>
<tr>
<th scope="row">Cash flow</th>
<th scope="col">$$</th>
</tr>
</thead>
<caption>Franchised Store Economics (simplified)</caption>
<tbody>
<tr>
<th scope="row">Store EBITDA</th>
<td>$200,000</td>
</tr>
<tr>
<th scope="row">Less: Overhead</th>
<td>($75,000)</td>
</tr>
<tr>
<th scope="row">Less: Principal</th>
<td>($60,000)</td>
</tr>
<tr>
<th scope="row">Less: Interest</th>
<td>($60,000)</td>
</tr>
<tr>
<th scope="row">Less: Cash taxes</th>
<td>($20,000)</td>
</tr>
<tr>
<th scope="row">Less: CAPEX</th>
<td>($10,000)</td>
</tr>
<tr>
<th scope="row">Equals: Free Cash Flow</th>
<td>($25,000)</td>
</tr>
</tbody>
</table>
</div>

<ul>
<li>
Only one restaurant franchisor, Popeye's (AFCE) routinely reports franchisee profit and loss (the EBITDAR number, or Earnings Before Interest, Taxes, Depreciation, Amortization and Rent). McDonald's infrequently provides "owner cash flow" numbers, which are now in dispute by franchisees. There is little discussion or inquiry into restaurant franchisors by Wall Street analysts in the earnings calls other than to ask about same store sales, units open/closed or royalties not paid affecting bad debt expense.
</li>
<li>
One sophisticated international lender finds themselves stuck with $500 million in bad paper (non performing loans), resulting from one US quick service restaurant franchise concept. This snuck up on the lender, partially because the reporting and disclosure by the franchisor was so poor. The $500M could have gone to other potential loan applicants. So could have the SBA loan guarantees that paid for the many failed Quiznos and Coldstone franchise loans. These are among the <a href="http://www.bluemaumau.org/sba_loan_failure_rates_brand">highest number of SBA loan defaults in the restaurant space</a>.
</li>
<li>
Only a few franchisors reveal franchise stores' profit and loss in the Franchise Disclosure Document Item 19, "Financial Performance Representations". Some list store gross sales only. Many list nothing. Of course gross sales is not net sales. Net sales is not profit. And profit isn't free cash flow, which is the only element that reflects the true investment cash gain. (See the table above)
</li>
<li>
Many franchisors report a so-called "cash on cash return" to relate restaurant cash flows to the investment cost. The problem is that the cash-on-cash return is typically a year one EBITDA based number, just after the restaurant has opened. The year one sales are unrepresentative going forward due to the so called 'honeymoon" effect. EBITDA doesn't equal free cash flow, as displayed above.
</li>
<li>
Finally, the $50,000-$74,000 median pre-tax average income reported (<a href="http://www.bluemaumau.org/vital-stats_franchise-ownership">by Franchise Business Review</a>) is a federal tax return, individual income number. It is flawed from an economic reporting basis as only interest, not principal payments are deductible, and CAPEX in excess of depreciation also isn't deductible.
</li>
</ul>

What can be done?

The $15 minimum wage began as a political thrust from groups allied with the White House against House GOP efforts to kill the Affordable Care Act (ACA). For the good of all, Washington should split the difference, by agreeing to raise the ACA coverage threshold to forty hours per week per employee, versus the prior thirty hours per week trigger, as well as a minimum wage increase of $.90/hour, phased in via three $.30 hour increments in 2015, 2016, and 2017, when hopefully consumer spending improves.

This will take leadership and compromise.

Otherwise, better business sense by all investors is necessary. Every number provided must be parsed. Assume as a going in proposition that any projected investment revenues are overstated, and that expenses are understated. Do the detailed due diligence.

<ul>
<li>
Once franchise systems reach a tipping point of 80% of units that are franchised, franchisors should disclose the financial health of the franchisee system by revealing average store unit EBITDA grouped into like-kind. Franchisors should also disclose the percentage of troubled franchisee units with negative accumulated free cash flow.
</li>
<li>
All states, not just the "disclosure states," should require franchise disclosure documents be filed and publicly available in full. For example, California, a disclosure state, does not require full public disclosure. It currently grants many franchisors allowances and exemptions from having to publicly disclose based on the size of the franchisor's balance sheet.
</li>
<li>
The Small Business Administration should report loan default rates, for any loan backed up by federal funds. This year they have stopped doing so.
</li>
<li>
The security analyst community should take the lead to dissect the quality of the franchising business model beyond just opened stores and noncollectable royalties.
</li>
</ul>

The Franchising Cloud of Mystery, Issues with Wage Increases

john a. gordon