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Hedgeye Restaurant Sector Head Howard Penney hosted a conference call with industry expert John Hamburger on Tuesday to discuss the risks revolving around heavily franchised restaurants. The main takeaway is that franchisors are realizing that it’s easier to sit back and collect royalty payments than to own and operate a store, but areas of difficulty in the industry have arisen that plague weakly franchised companies.

They include, but aren’t limited to:

  • Poor asset quality: concepts that allow their asset bases to unduly deteriorate tend to fall behind and aren’t able to rectify the situation. Cash-hungry private equity firms do not help with the situation as they focus on the cash and not the subsequent consequences.
  • Franchisor/Franchisee disharmony: The disagreements between management and franchisees has been well documented over the years. Communication is more crucial than ever and when a franchisee goes “rogue” by going around corporate-directed rule sets, it raises concerns about the relationship.
  • Inconsistent unit performance: Management teams resorting to short-term, promotional strategies to “dress up” the numbers tend to produce choppy results.

FRANCHISING: Fool's gold - franchisors

The current turnaround strategy at Burger King and Wendy’s (WEN) have been particularly capital intensive as older stores remodel to comply with the new image management has created for them. To quote John Hamburger: “Half of the current restaurants operated by chains are not at the current prototype standard and it’s very capital intensive when remodeling.”

McDonald’s (MCD) will always be a top dog, but Burger King and Wendy’s have their work cut out for them over the next few years.