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Why do struggling chains always turn to franchising?

Companies with steeply falling sales frequently turn to franchisees to turn stores around. RB’s The Bottom Line examines whether this is a good idea.
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the bottom line

Fuddruckers hasn’t exactly set the world on fire lately. Same-store sales in the burger chain’s fiscal second quarter declined 5.3%, parent company Luby’s Inc. reported this week.

And that was an improvement. Same-store sales in the first quarter declined by 11.2%.

Not surprisingly, the company is refranchising. Fuddruckers currently operates 54 company stores, following 14 closures over the past year and after the sale of five locations in San Antonio earlier this year. Franchisees operate another 102.

Refranchising has been a common strategy in the restaurant business for the past couple of decades, as executives embrace an investor-friendly and more profitable “asset light” business model.

But they’re really common when systems struggle, often coming across as a last-ditch rescue effort to keep chains afloat.

“They do it because they don’t have a better alternative,” said John Gordon, a restaurant consultant out of San Diego.

Famous Dave’s announced plans to refranchise its company stores in 2017, for instance. Those company stores had produced 13 straight quarterly same-store sales declines when it announced the plan.

Papa Murphy’s, which had employed a strategy of buying back struggling franchisees, after its 2014, began selling them back in 2017.

Steak ‘n Shake announced plans to refranchise all 415 of its company-owned restaurants last year, after its same-store sales turned south for the first time in nearly a decade. It has closed 31 locations this year to “prepare” those locations for incoming franchisees.

Refranchising isn’t necessarily a bad thing. Oftentimes, companies are simply bad at operating restaurants and better at franchising. And franchisees can do a better job of running the locations.

That was clearly the case when Burger King sold off all of its company restaurants to franchisees in 2012 and 2013. Many operators simply fixed up poorly operated restaurants and yielded improved profits.

“Just because you operate restaurants doesn’t mean you have an operating culture,” Kevin Burke, managing partner at Trinity Capital, told me.

Refranchising done right can inject some energy into restaurants while freeing up executives to concentrate on running the brand. The strategy can work, so long as the system focuses on ensuring franchisee profitability and operates the brand well.

When the brand is struggling, franchisees can frequently get stores at low prices because the franchisor is eager to let the restaurants go. The operators buying the units often pick off the best stores that can be more easily turned around, which can leave the franchisor closing weaker stores—Fuddruckers has been closing unprofitable stores for the past year, after all.

Still, such strategies can sap the credibility of the refranchising model when they’re done so frequently by companies desperate for a turnaround.

And just because franchisees are willing to take the risk of buying such stores doesn’t mean they are making a good decision.

Gordon pointed out that when an operator buys up a store that is losing money, it not only has to get that store to basic profitability, it has to generate enough profits to pay the royalty payment, which is typically about 5%.

And let’s not forget that many of these companies buying up stores are borrowing money to do so.

But the simple fact is that, if running stores were a more profitable venture, then more companies would seek to operate more stores.

And when restaurants are less profitable, companies seek to get out of it and hope someone else can do a better job. They often can, but sometimes they can’t.

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