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THE LATENT RISKS OF HEAVILY FRANCHISED BUSINESS MODELS

This is an introductory note ahead of our conference call with industry expert John Hamburger, President of the Restaurant Finance Monitor, next Tuesday, June 19, 2012 at 11am EST.  

 

Over the course of this call, we will discuss consensus thoughts on franchising in the restaurant industry.  Specifically, we will discuss the implications that franchising can have for the valuation of restaurant companies and the validity of the assumption that franchised business models are inherently more stable.  Historically, the steady cash flow generation, lack of exposure to variable costs, and relatively low capital spending needs of franchised systems has led investors to award premium multiples to the equity of franchised companies.  Together with John Hamburger, an expert on restaurant financing, we will discuss the valuation premium, relative to less-franchised peers, of the equity of several restaurant companies.  Below, we provide some background on the issue of franchising within the restaurant idea, as well as some thoughts on why franchising should not always been seen as a positive by investors.

 

 

The Crux of the Debate

 

The interests of franchisees and franchisors do not always align; in fact, in today’s environment of tight capital supply for small businesses and increasing competitiveness among restaurant companies, they can sometimes diverge.  Through franchising, franchisors gain more stable cash flow, protection from swings in variable costs, and lower expenses.  In turn, franchisees, ideally, gain operational expertise from companies and brand recognition while assuming much of the operational risk of the business.  Most of the decision-making authority pertaining to the business remains with the company and, in difficult business conditions, this can be a source of contention.

 

As franchisors seek to grow royalty fees, decisions made by corporate restaurant executives in the past few years have tended to focus on promotional strategies and capital-intensive store and process alterations.  Of course, as long as the consumer and financing environments cooperate, this behavior may not meaningfully impact the franchisee’s bottom line.  However, with the backdrop of a fragile economy, volatile commodity costs, tight access to capital, and increasing labor costs, there is a potential for friction.  The addition of any controversial business decisions that magnify franchisees’ difficulties all but guarantees disharmony between management and the franchise community.  Examples over the past few years are numerous, from Kentucky Grilled Chicken at KFC to bun toasters at Wendy’s to 99 cent double cheeseburgers at Burger King.

 

 

The Franchising Grenade – Sold to You!

 

While franchising has obvious benefits for franchisors, it seems that conventional wisdom may not appreciate the risks of companies using franchising to mask deeper flaws that exist within their business models.  The increasing ranks of activist investors within the restaurant space might offer further explanation, beyond a consumer weakness and declining margins, for the refranchising trend of the past few years.  Short term actors looking to maximize immediate-term cash flow are less likely to focus on the long term implications of business decisions than are operators.  “Deal guys” get paid to do deals but their strategies too often ignore the long term and increase the risk of a tipping point being reached where a concept is rendered uncompetitive, heavily indebted, and immobile.

 

Many of the concepts that make up the Quick Service Restaurant industry represent broken business models and it is little wonder that ageing properties, declining margins, and increasing economic uncertainty have moved the operators of those concepts to seek the security that franchising offers.  Generally, the refranchising trend has been driven by concepts that have been slow to adapt their facilities and offerings as consumer preferences have evolved.  The emergence of fast casual concepts has increased competitive pressures for traditional quick service restaurants in a low-growth industry. 

 

As weaker players fall away and large franchisees increase their holdings, the corollary is obvious in a system where management and franchisees are not seeing eye to eye.  Larger franchisees wield more power and influence in discussions with franchisors and this can lead to stand offs that impede the progress of capital reinvestment and, in turn, tie companies to practices such as discounting and promotions which, as strategies, are less and less effective over time. Ultimately, all parties suffer – especially investors.

 

In theory, franchising is a system that works well.  In practice, prioritizing revenues over sustainable profits can leave concepts in a downward spiral of non-competitiveness.  We believe that picking out those companies, particularly given the valuation premium that is uniformly awarded franchised businesses in the restaurant industry, is essential for investors in this space.  In discussion with Mr. Hamburger on 06/19/2012, we will discuss this issue in greater detail and answer client questions on the implications of our views for the individual companies and the broader industry.

 

 

Howard Penney

Managing Director

 

Rory Green

Analyst

 

 

 


LVS IS THE PRE-OPENING KING

Nobody expenses ‘em like LVS.

 

 

Q2 is likely to tell us little about the ongoing cost structure of Sands Cotai Central (SCC) and LVS’s combined Macau operations.  As can be seen in the chart below, LVS has been aggressive in the past, to say the least, in terms of expensing costs into the convenient pre-opening expense line.  While some of pre-opening costs are inevitably recurring, companies and analysts exclude them from ongoing operations. 

 

With a very disappointing post-SCC top line, one would expect very weak margins.  However, given the flexibility with the pre-opening bucket, the only clear takeaway on future margins from the Q2 earnings release will be that there is no clear takeaway.  We are projecting only a net $45 million YoY increase in Macau property EBITDA for LVS in Q2, despite almost a full quarter contribution from the $1.5 billion SCC.  Moreover, over $30 million of that increase was at Four Seasons.  Given the additional investment, our overall Q2 Macau margin falls from 33.0% to 29.2%.  Of course, we have no idea how much LVS will allocate to pre-opening so the margin could be higher.

 

The chart below shows that pre-opening as a % of total capex has already exceeded Venetian and we haven’t even included the Q2 expense.  Obviously, there is precedent for an additional 3% to get to the level of Four Seasons which would imply an additional $40-45 million in pre-opening costs.

 

LVS IS THE PRE-OPENING KING - lvs34



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HedgeyeRetail COTD: Happy Anniversary Ron Johnson

JCP reached new 52 week lows today and is finally immediate-term TRADE oversold just 2 days prior to the 1 year anniversary of JCP’s biggest hire in history.

 

With the seismic shift in JCP’s pricing strategy that has left consumers scratching their heads coupled with underappreciated capital investment required to ultimately bring RJ’s vision to life, there’s little to support the stock here over the intermediate-term. It will likely be a while, perhaps a long while, before we revisit the $29.92 strike price at which RJ’s warrants are struck. Lucky for him, he has 5-years to get there. Unfortunately, investors typically operate under a far different duration.

 

Today, we wouldn't touch it on the long side until it is a mid-teenager. 

 

HedgeyeRetail COTD: Happy Anniversary Ron Johnson - RJ COTD

 


DURATION MATTERS FOR SBUX

Starbucks seems to be acutely aware of past mistakes and we do not expect management to repeat the mistakes that brought the stock under $10 in 2009.  We would not advise buying the stock at this point, however, given that the Street is likely too bullish on EPS for 2HFY12.  The longer-term story for Starbucks remains one of the very best in the space but the likely impact of near-term headwinds leads us to look elsewhere over the TRADE (three weeks or less) and TREND (three months or more) durations.

 

Starbucks CFO Troy Alstead took the stage today at the William Blair Growth Stock Conference.  Below are the primary takeaways of the presentation:

  • The company now expects $0.44-0.45 EPS in 3QFY12 and $0.46-0.47 EPS in 4QFY12 versus prior guidance of $0.45-0.46 and $0.46-0.48, respectively.  The Street, according to Bloomberg, is expecting $0.46 and $0.49 EPS in 3QFY12 and 4QFY12, respectively.  The revision in guidance is due to costs associated with the Bay Bread LLC acquisition.  Overall, the La Boulange acquisition will be $0.02 dilutive to FY12 EPS and will also dilute FY13 EPS.
  • Investing in La Boulange and Evolution Fresh is going to be a headwind to EPS going forward; there is a potential for capital needs to come in larger than expected given the distribution capabilities that need to be built out to cater for both brands on a national basis.
  • Starbucks see continuing weakness in the EMEA division.
  • Coffee is expected to be a tailwind in FY13

 

Conclusion


We would not advise clients to buy this stock at this point in time.  We have liked the name for over three years but believe that sentiment has gotten ahead of the fundamental outlook of the company.  Company guidance is indicating that estimates are too high for FY12 and increasing economic uncertainty in Europe could cause actual earnings to come in even lower than the guidance is suggesting.  

 

 

Howard Penney

Managing Director

 

Rory Green

Analyst


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