Franchise Restaurants Protect Shareholders From Labor Costs, at First

(Bloomberg View) -- Investors in fast-food chains have long appreciated the steady income from franchise fees, but that model comes with risks that aren't apparent on an income statement -- especially if conditions change, like labor costs going up faster than menu prices.

The most well-known historical franchise model might be McDonald's. It's been said that McDonald's is more of a real estate company than a restaurant company. The McDonald's model is buying the real estate for future McDonald's locations, leasing it to franchisees, taking a cut of the store's revenue, and watching the profits roll in. The company owns tens of billions of dollars' worth of real estate. Owning the real estate gives McDonald's leverage over franchisees. It's no wonder that other chains would want to come up with some version of the model.

Looking at the financials of Dunkin' Brands, parent company of Dunkin' Donuts and Baskin Robbins, shows just how good a deal for investors the franchise model can be. Systemwide sales -- the total sales of all 12,500 Dunkin' Donuts and 8,000 Baskin Robbins locations worldwide -- totaled over $11 billion in 2017. But that's not what Dunkin' Brands recorded as revenue. The revenue recorded totaled $860 million, comprised of franchise and royalty fees, rental income, and some ice cream sales. On that $860 million in revenue, it booked operating income of $447 million, for an operating margin of over 50 percent, a far cry from restaurant profit margins that are often in the single digits.

And then there's the financial engineering. High profit margins from a stable source of franchise fees, royalty fees and rental income give the company a lot of capacity to take on debt. The company now has over $3 billion in debt, up from $1.8 billion three years ago, with plans to continue borrowing as profits grow. That debt funding has helped power a return of capital to shareholders. Since the initial public offering in 2011, Dunkin' Brands has returned over $2 billion to shareholders via dividends and share repurchases.

But not everyone is Dunkin' Brands. Subway has had multiple stumbles in recent years, and caused a franchisee revolt in attempts to bring back the well-known “$5 footlong” promotion. The $5 footlong promotion originally ran in 2008 during the financial crisis. During recessions, food and labor are cheap, so the timing allowed Subway to make a popular offer that could still be profitable for franchisees. The price went up to $6 in 2014 and then $7 in 2017 -- before the return of the $5 deal for a limited number of sandwiches recently.

What's good for the franchiser isn't always good for the franchisee. The franchiser is driven by franchise fees from new locations and royalty fees from sales growth. That means franchisers would rather have low menu prices to drive traffic and sales, even if it comes out of the profits of franchisees. Franchisees, on the other hand, only care about the profitability of their locations. If that means higher prices and less traffic (along with lower expenses like labor), that's a trade many would be willing to make to protect profits.

Another side effect of the franchise model is to shift the costs and benefits of labor market fluctuations onto the franchisees, and off the income statement of the franchiser. But that doesn't mean the parent companies are immune, only that their investors won't see the impact coming.

One can imagine a restaurant franchise location that did $1 million in revenue per year with a profit margin of six percent, or $60,000. Maybe that franchise pays the franchiser 10 percent of revenue in fees between the royalty fee and rent, or $100,000. If profit margins get cut in half (because of rising labor costs or any other reason) but revenue remains flat, that $100,000 in fees still gets paid to the franchiser, so an investor in the franchiser wouldn't notice the deterioration of the business. But if profitability fell by the same amount the following year, the restaurant location might close, eliminating all $100,000 in fees overnight. It's possible the franchiser could then bail out the restaurant by cutting fees or providing other financial help, but that would mean a significant deterioration in its own profit margins.

As restaurants find their costs going up faster than their revenue, this will be an increasing concern for franchise-heavy restaurants. That's not just a theory: Subway closed 900 locations in 2017.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Conor Sen is a Bloomberg View columnist. He is a portfolio manager for New River Investments in Atlanta and has been a contributor to the Atlantic and Business Insider.

To contact the author of this story: Conor Sen at csen9@bloomberg.net.

To contact the editor responsible for this story: Philip Gray at philipgray@bloomberg.net.

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