5 forces chipping away at franchising

Salsarita’s CEO Phil Friedman doesn’t offer up data to back up his claim, but “the fact of the matter is, more restaurants are being built than are needed,” he says. In such a competitive environment, good sites are harder to discover and more expensive when you do, gripes Which Wich Franchise Adviser Frank Steed: “Finding good sites is a bear.” If only that were the worst of it.

For a moment this year, it seemed like franchised restaurants would finally have a powerful ally in a top government post with CKE Restaurants’ then-CEO Andrew Puzder up for Secretary of Labor. “We were excited that we had one of our own representing our industry, particularly the franchising aspect,” says Michael Mabry, COO at Mooyah Burgers, Fries & Shakes. “The hope was that there would be a better understanding of the franchisee-franchisor relationship.” Then Puzder withdrew his name. 

With competition increasing, even a labor secretary partial to restaurants’ concerns can’t solve the problems of overbuilding, rising rents and scarcity of workers. These headwinds are bedeviling the industry’s franchise community in 2017, giving the traditional model pause.

President Donald Trump has promised a still-vague deregulation agenda, likely to find favor in the Republican-controlled House and Senate. Many employers, including franchisors, have called for parental leave, overtime pay and minimum wage issues settled in their favor, though in many cases those issues will be decided by state legislatures. 

The most-anticipated federal change, however, is comprehensive tax reform, says the International Franchise Association. Topping franchises’ most-important list are accelerated depreciation, and changes to the Work Opportunity Tax Credit and the estate tax. To be sure, all three issues apply to business overall. But the recently revised Section 179 of the tax code, for instance, now permits franchisees to write off new equipment and remodeling costs over 15 years instead of 39—helping with cash-flow issues given the tax savings. 

“If the administration can move quickly on tax reform, that might prompt a business owner to execute on a transaction,” says David Stiles, director of Los Angeles-based Trinity Capital, an investment bank specializing in franchise financing. 

Meanwhile, there’s been good news on the joint-employer front. Jack in the Box recently won a summary judgment in Oregon’s district court after it ruled the franchisor was not a joint employer in a wage-and-hour dispute. The court based its judgment on the so-called economic reality test—a test that determines whether a parent company had power and control over employees. In this case, the franchisee had control over employment matters, according to state law, and therefore its workers were not employees of the franchisor.

Although this test may not necessarily be applied in other states, it’s a good practice for franchisors to ensure “franchise documents provide that all employment matters and day-to-day decisions are the sole responsibility of the franchisee,” noted labor lawyer Megan B. Center of Fox Rothschild LLP in a post-judgment recap on the firm’s website.

While a lot of new restaurant technology is supposed to relieve some of the administrative workload for managers, finding qualified help and training workers to use tech could also hinder some franchise businesses. The current unemployment rate makes it difficult for franchisees to find and keep workers. Economists say the rate won’t climb above 5% this year.

For franchises, back-of-house technology often boils down to managers immersed in often-complex reporting systems for labor and food. Zane Tankel, a 38-unit Applebee’s franchisee in New York City, says it takes three months of training to get new managers up to speed on its programs. To limit that, Mooyah’s Mabry notes, “We do our best to keep technology pieces to a one-input type of deal.”

The lifeblood of a franchise system is new unit development—or, at least, it used to be. For the past few years, many publicly traded franchisors have been selling restaurants to franchisees to spread around financial risk, a practice known as refranchising. Stiles predicts corporate activists will continue to push franchisors to unload company units to create a so-called asset-light model, and that bankers will remain eager to finance these deals, given the outlook for continued low interest rates. 

Meanwhile, despite the oversaturation in many markets, new store growth has taken a back seat for some operators. Recent closings among fast casuals such as Noodles & Co. and casual-dining chains like Ruby Tuesday have made executives—and their lenders and franchisees—think twice about building costly new units.

“[It’s] likely we will see some slowing of unit growth [in fast casual],” says Darren Tristano, chief insights officer for Winsight, the parent company of Restaurant Business and Technomic. “But not much, as unit expansion is still driving the growth in sales due to shifts in consumer spend from quick service and full service to fast casual.”

Applebee’s franchisee Tankel feels the pain. He isn’t planning on opening new units this year (he’s under no obligation to do so, per his contact). Instead, he’ll be trying to boost top-line sales in the face of increasing competition and labor costs. Will his efforts be hampered by the recent resignation of Julia Stewart, CEO of Applebee’s parent DineEquity, after nearly two years of negative systemwide same-store sales? “You just go back to the basics,” he says. “Vince Lombardi blocking and tackling got us here, and that will be the strategy.” Still, he’s hopeful the appointment of a new company president will provide leadership to make Applebee’s food and service a competitive point of difference again. 

Jeana Banks, director of development at A&W Restaurants, doesn’t need new dirt to grow the chain. She has travel plazas and convenience stores in her sights. For an investment of roughly $200,000 (for equipment and seating), an A&W restaurant can boost gas and store sales at both.   

Her approach, she adds, is “slow and strategic”—and mostly in the Midwest. Her target number of franchise agreements across the board, both for traditional and nontraditional outlets: 20 in 2017. 

C-stores and travel plazas aren’t new to A&W; there are about 60 in the system already. This year, however, it’s the franchise focus for the Lexington, Ky.-based chain. If all goes right, half of those 20 planned units will open in them. “I do about seven trade shows a year to sell franchises and only two are outside the gas and c-store market,” Banks says.

Travel plazas and c-stores, typically operated by companies with existing foodservice infrastructures, make ideal franchisee candidates, says Steed of Which Wich, another franchisor recruiting those sites. The Dallas-based chain began opening in nontraditional locations a few years ago, says Steed. “It gives us an alternative to waiting for a great spot to open on the street,” he explains, adding that it also solves the problem of lengthy development times. CEFCO, for example—a 226-unit Southern c-store chain—tested a Which Wich in late 2015, in White Oak, Texas. “It proved the model, and it’s led the franchisee to open more units in bigger towns,” Steed says.  

Like other franchise execs, Salsarita’s Friedman is aware of the industry’s supply and demand problem: “There are just too many restaurants.” To add to the challenge, getting one to open has become a waiting game—as long as a year and a half, in some cases, because of the increasing amounts of red tape. “Whether it’s a new site or a conversion, it takes a long time to find the location or to get the developers to build the center and then to turn it over for you to develop,” says Friedman, who is also a Salsarita’s franchisee. 

Developers themselves may be hampered by local governments concerned with environmental issues, traffic patterns and overbuilding. “Each step of finding sites and complying with regulations is taking longer,” Friedman says. 

“Development times have definitely lengthened in certain areas,” adds Sonic Drive-In’s SVP of Development Drew Ritger, blaming delays on regulations, site availability and financing. In areas of high demand—much of California and Florida, for instance—time horizons can stretch to two years.

Opening dates specified in franchise agreements thus become moving targets. Permitting recently forced Salsarita to extend a franchise agreement by two years for a new Nebraska franchise, Friedman recalls, because the developer of a strip center had been delayed in getting its approvals. “Sure, every franchise agreement has targeted dates for opening,” he explains. “But in this case, the developments themselves were not developing.”

Ritger says for markets where growth is less robust—in the South Central and Southeast regions, for his concept—development may move faster. Yet franchisees have to look carefully at certain redevelopment opportunities. “You have to have good, solid market plans,” he says.