Why refranchising and value don’t mix

The push to lower prices, and rely heavily on franchisees, could hurt more operators, says RB’s The Bottom Line.

The Bottom Line

Last week, Jack in the Box CEO Lenny Comma took his competitors to task for pushing both value and refranchising at the same time.

“We’ve been saying for a long time that it’s not sustainable,” he said.

He’s not wrong.

Some time ago, I argued that refranchising has been a net positive for the restaurant industry, and I still believe that.

But pushing so much value along with this refranchising can be a problem.

To be sure, the reality is that value is an important component of most chains’ menus, especially if they aim to serve the masses. A large component of consumers are young or poor or both and need the discounts and the lower prices if they’re going to eat out.

And restaurants need customers. So some value is important for many chains to get more customers.

But pushing so much value to generate traffic and sales, while relying more heavily on franchisees to operate restaurants, is a potential problem. That problem will only worsen as labor costs increase and an oversaturated industry struggles to generate organic sales and traffic growth.

When an entrepreneur opens a new restaurant, he or she generally keeps all of its revenue to use for things like wages and benefits and rent and food and paper costs.

When an entrepreneur operates a franchise, that person pays a percentage of its revenue to the franchisor for the right to operate that brand.

Applebee’s operators, for instance, pay 4% of revenues for royalties. So an Applebee’s operator has to make a profit off of 96% of sales. And 3.5% of that is for the company’s national ad fund.

Subway operators, meanwhile, pay 8% for royalties, plus 4.5% for advertising.

Franchisors, because they rely on that sales-based royalty for their revenues, want to push the top line higher. Weak traffic and intense competition has led many of them to push value to get that top line higher.

But lower-cost items yield lower profits. At a time when many franchisees are paying higher and higher wages, either because of intense competition for workers or because of minimum wages, those profits are even weaker.

The concern Comma raised was the prospect of “training” customers to order cheaper items, which generate lower profits, rather than the more expensive, premium items that are more profitable.

Perhaps not surprisingly, in recent months we’ve seen evidence of this profit pressure on franchise systems’ operators. To wit:

A multiunit operator of Steak 'n Shake in Virginia sued the company over its national menu pricing strategy, blaming the strategy for its “substantial financial losses.”

Subway operators were in open revolt late last year when the company prepared an offer of five Footlong subs for $4.99 each.

Applebee’s second-largest franchisee, RMH Holdings, filed for bankruptcy protection. While the company didn’t specifically mention discounts, Applebee’s has been pushing $1 alcoholic drinks in recent months to help generate sales. And the brand has been a consistent discounter for years.

Again, value is important. But companies that are relying on their franchisees to operate units, especially those with weak unit volumes, need to be cognizant of the value they’re offering. Make sure your franchisees can operate that value profitably. Or you’ll have a smaller system pretty quickly.

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