Why franchisee debt levels are a big problem

Operators’ rate of leverage has soared in recent years, which may become a burden in an economic downturn, says RB’s The Bottom Line.
Photograph courtesy of Wendy's

the bottom line

Restaurant chains have increasingly relied on franchisees to run their stores, and in the process have asked more of them in terms of remodels and new unit development.

The result of this has been more debt and more risk for the operators of those restaurants in the event of a downturn.

While the industry remains in relatively healthy shape, there have been some ominous signs recently. To wit:

On their own, the issues are separate and distinct. But they demonstrate the precarious position many franchisees are in after a decade of debt-fueled growth.

Debt is a necessary evil in the restaurant business. It takes a lot of money to build restaurants and remodel them. That requires a steady dose of financing.

Franchise systems like McDonald’s, Wendy’s, Burger King, Jack in the Box and many others have been selling corporate stores to franchisees, relying on operators to provide the capital needed to fund remodels and build new units.

Lenders have been eager to make loans to these operators. And franchise systems have taken advantage of this availability of capital to fuel remodel programs.

As a result, debt levels have soared for franchisees. In a note this week, Bernstein Research analyst Sara Senatore noted that the leverage ratio for McDonald’s franchisees grew to 3.1 times earnings before interest, taxes, depreciation and amortization, or EBITDA, in 2018. In 2008, that ratio was just 1.3.

For Wendy’s, that ratio is even worse: 7 times EBITDA, from 5.7 in 2008.

The higher the leverage ratio, the more debt a company has. The more debt there is on a company, the more at risk the company is when times get tough.

For the most part, companies have avoided major problems. Default rates on Small Business Administration loans have been “negligible” since 2010, Senatore wrote. While such loans typically go to smaller operators, rather than the larger operators these big brands prefer, the low default rate is indicative of the overall health of the restaurant business during that period.

But that operating environment has deteriorated more recently as same-store sales in many brands have weakened and labor costs have risen.

With many economists predicting a recession in the near future, many more of these franchisees could find themselves in the same position as RMH. Franchisee risk levels have clearly grown recently.

And brands have started to address these problems. “We’ll need to directly address franchisees who are burdened with too much debt, don’t have access to capital or aren’t committed to the long-term,” Yum Brands CEO Greg Creed said in August, according to a transcript on financial services site Sentieo. He was speaking about Pizza Hut franchisees in the U.S.

Franchisees have noticed, too. The creation of the McDonald’s National Owners Association last year, the first independent franchise association in the chain’s history, was fueled in part by concern over leverage levels following remodel demands. Jack in the Box’s franchise association has also pushed back against some of the company’s plans, citing in part struggles among its operators.

While franchise brands have been able to mitigate their own risk by selling stores to franchisees, that doesn’t mean their own brand health isn’t at risk as these debt levels have grown.

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