TO: Dr. David L. Anderson
FR: Dominique Smulkowska
DA: January 28, 1997
RE: Franchise Industry Analysis
Franchising is a system in which a producer or marketer of a product or service, the franchisor, sells others, the franchisees, the right to duplicate the concept and use the trade name while providing sales support in a certain territory for an agreed length of time. The location can involve the right to exclusivity and the amount of support varies from providing the product to resell to extensive sales training and control over business operations.
The most simple of the three types of franchises involves a contract between a supplier and a business owner. The latter agrees to only sell one version of a particular product, e.g. McDonald's only sells Coca-Cola soft drinks. Conversely, product-trade name franchising, which accounts for 52 percent of all franchise sales and 33 percent of all the franchise units in the U.S., involves selling products to distributors who resell them. The fastest growing type of franchise is the prototype or "package" franchise in which a whole mode of business operations including the product or service, inventory system, sales and marketing methods, and record keeping procedures are sold to the franchisee. Package franchising has grown ten times faster than product-trade name franchising (11.1 percent versus 1.1 percent on average per year).
Currently 8,000,000 people are employed by and 41 percent of retail sales are attributed to franchises. They typically start with one business that becomes successful and in turn expands to additional units. The entrepreneur behind the business idea believes that it can be profitable on a larger scale only he lacks the capital to expand any further. This is solved by selling his business prototype as a franchise while maintaining control to ensure conformity to his standards. By franchising, the business can quickly grow and achieve higher market penetration than a single owner business. From the franchisee's perspective, who are often entrepreneurs lacking the knowledge of starting a business, franchising allows them to adopt a business concept without having to start from scratch. They also face less risk than encountered in starting a business because the concept behind the franchise has already proven to be profitable on a limited scale. Hence, the five year survival rate for franchises is much higher than that of start-up businesses (85.7 percent vs. 23 percent).
The franchiser's revenues are in the form of a start-up fee, ranging from $10,000 to $600,000 depending on the size and market share of the franchise, which is for the trade name, managerial training and support, as well as royalties that amount to 3 to 8 percent of gross sales. For example, the start-up fees for McDonald's, Subway and Domino's are $45,000, $10,000 and $1,300 respectively. There are also additional initial outlays which include rent, inventory, legal fees, equipment, insurance and licenses which can amount to ten times the start-up fee and in the case of McDonald's can reach $500,000. The average initial cost of $330,000 accounts for franchising being a difficult market to enter. There may be additional conditions before beginning; franchisers can require that purchasers have experience in the particular franchise or in the business segment it represents.
Besides covering the costs needed to acquire a franchise, the buyer needs to commit to train in its every aspect. Franchisees who fail have typically bypassed immersing themselves in the business and instead attempt to merely be managers. The training program for McDonald's, for example, can take months and require a degree from Hamburger U for completion. Another liability of this form of business occurs when franchisees find more efficient way to manage their businesses in their particular markets or feel a slightly altered product mix would be more profitable. They are often unable to implement these ideas due to the restrictions imposed by the franchiser who has a commitment to standardization within his franchise. The amount of control that a franchiser can exert is stipulated in the contract; most franchisees are required to submit monthly, quarterly and annual financial reports to the franchisor while certain owners may be required to purchase supplies from a select list of vendors.
Investing in franchise stocks allows one the ability to choose which industry to invest in and the desired levels of business maturity ranging from new businesses to established "graying" enterprises. Obviously, the risk and therefore potential returns, are higher on new ventures. Some of the risk is diversified away because the investment represents a stake in a multitude of independent stores located in different areas of the country such that unfavorable economic conditions in a specific area will not be detrimental to franchisers in different territories. Franchise stock holders need also be aware that sometimes when a franchise is successful and the franchiser raises sufficient capital, he may begin repurchasing some of the units which causes slowed growth initially but may lead to bigger dividends on the investments in the long term.
Another point of consideration if contemplating investing is that even though franchises can be very competitive, due to the support afforded by a franchiser and the expertise learned from the parent organization, higher efficiency can be achieve than that in individual small businesses and "mom and pop" stores. Franchisers do not have to be concerned with internal competition because their franchise contract stipulate how many units can coexist within a particular area. Additionally, franchise owners who leave to open a related business are often precluded from opening one within a specified vicinity of their former operations.
Financially, the outlook in investing in a start-up franchise is modest profit and growth until market share increases . Due to substantial competition in low barrier-to-entry industries such as restaurants, cleaning services and food delivery which are prevalent throughout the country, franchise operators must keep profit margins low. Therefore, in order to be profitable and generate a considerable return on assets, a large volume of sales must be generated. This is a task difficult to achieve until market penetration is attained. During the initial stage when returns are low, the franchisor bears most of the costs which cover finding prospective franchisees, training (ranging from $22,000 to $26,000) and providing a lot of initial support as the franchisees attempt to learn the business. This, coupled with low early revenues, translates to low profits. As the franchisee becomes more adept at handling the business and gains a larger market share, sales and royalties increase while the amount of support needed decreases. The average medium to large franchise can make a yearly gross profit of $1,100,000. Therefore, franchisers may have to wait to be profitable and bear many costs before seeing a return on their investment. This makes franchising somewhat risky.
Likewise, by becoming a fanchisee, one is not expected to immediately produce substantial returns. Because franchisees, as described above, face low profit margins due to stiff competition, they often experience salary decreases, which on the average fall from $66,000 to $35,000, upon leaving corporate America and face a 65 to 80 hour workweek. To be profitable, they must own multiple units. Nevertheless, despite these statistics, franchising has continued to be a popular field creating 170,000 new jobs in 1995. This can be attributed to the sense of autonomy franchisees attain which accounts for their high level of job satisfaction. Additional components accounting for the popularity of owning a franchised business include the recent corporate layoffs which have left many qualified middle managers ready to undertake new challenges as well as the growth the field has experienced.
Franchising has experienced considerable growth in the past two decades with currently 670,000 franchise units (5000 franchises) existing in the U.S. with a new one opening every 6.5 minutes per business day. According to the International Franchise Association, they are growing at 10 percent per year with sales, which are expected to reach 1 trillion the turn of the millennium, doubling in the last decade. The highest growth has been in the non-food retail sectors such as lodging and services while the most impeded development has been in restaurants. One reason for growth has been the ability of franchisors to adapt their businesses to most effectively service emerging market trends. Sixty percent of boiler plate business concepts have been developed or altered significantly in the last five years. This can be evidenced by McDonald's changing its menu and providing grilled chicken to health conscious consumers while Taco Bell Express opens outlets in diverse places such as the College of DuPage.
As many U.S. franchises, most notably in the food industry, have matured and reached market saturation, franchisers have expanded internationally into formerly closed markets such as Eastern Europe and under-developed markets. This growth began in the 1980's when 400 U.S. franchisers increased foreign units by 70 percent to 40,000. McDonald's entry into foreign markets is expected to increase profits by 14 percent a year for the next five years. International market entrance by U.S. franchisers has been aided not only by the expanding global economy but by easier entry into foreign markets due to international arrangements such as the formation of the European Community and the North American Free Trade Agreement as well as political changes such as the collapse of communism in Eastern Europe.
Technology has also impacted the growth of the franchise industry. Improvements have included electronic systems which help track inventories and sales yielding more efficient operations and ease in the transmission of information between owner and franchisor. Electronic Data Interchange, EDI, is also a recent innovation which is being used by some franchises such as car rentals and hotels to communicate regarding reservations and customers. Prospective franchisers can also use the Internet to find key locations for their business by perusing demographics and market research reports rapidly and at a low cost. Constructing Web pages to advertise to perspective owners is another use of technology. Lastly, because starting a franchise network requires a lot of communication comprised of training and support, technology has made the shift to expand globally easier with features that ease overseas exchanges, such as on line conferencing. This development has allowed the uniformity of the franchise to be preserved at a lower cost. Since the business remaining intact is such an integral part of the franchise concept, this technology has been crucial for international expansion.
Besides international expansion being expected to continue into the future, some other key trends are being predicted for the franchise industry. Growth is expected to continue with franchising expanding from 41 percent to half of all retail sales and sales are expected to reach $2.5 trillion by the year 2010. This growth can be somewhat attributed to the changing demographics in the United States with the elderly making up a bigger portion of the U.S. than ever before. The 21 percent of the population over 55 has access to 50 percent of domestic income. By the year 2000 aging baby boomers' expenditures will increase by 90 percent. The franchises which are expected to thrive in these conditions are home service such as cleaning, food delivery and care-taking.
A trend which is a concern to franchisers are the labor shortages in the economy that are predicted to continue. There is a lot of competition for workers due to low unemployment figures as well as the minimum wage increase. This is partly being offset by corporate layoffs with 35 percent of franchise units being sold to former corporate employees. Also, women continue to enter the work force, with 80 percent of women between 25 and 54 expected to be employed by the year 2000. This has resulted in continued growth, 68 percent, of female owned franchises which has increased their share from 11 percent to 18.5 percent of unit from 1986 to 1992.
In conclusion, although franchising is a risky business venture for the franchisor as well as the franchisee it has continued to expand. This can be attributed to the ability of franchisors to raise capital and replicate a business idea that has been effective resulting in faster market penetration. Franchising has also benefited from international expansion allowing it to continue its growth despite market saturation in certain industries. Lastly, technological advances have increased efficiency in the transfer of information contributing to franchise growth while changing demographics and the current political situation have had offsetting effects on the industry.