Wanna Buy a Franchise? Maybe now is the time

With the global economy in turmoil and banks reluctant to lend to even the most well-heeled organizations—or even to other banks!—it looks like next year could be tough sledding for the franchising industry. And it could be even tougher for chains that have pinned their hopes on refranchising their existing company-owned restaurants to raise needed capital. Prior to the financial meltdown, bankers already regarded lending to restaurants as risky business; what are they thinking now?

Franchise information service provider FRANdata gave its industry outlook in late September (which is to say, just before the financial and credit markets fell off the cliff) at the Franchise Leadership & Development Conference in Chicago. Even without knowing about the massive shocks that loomed just around the corner, the company sensed that the overall economy was going to weaken dramatically and was unlikely to stabilize until 2010.

What was the tip-off? The unprecedented deleveraging then already under way. “The crisis of credit is becoming a crisis of confidence,” FRANdata president Darrell Johnson declared. He couldn’t have been more prescient.

Yet some franchisors will be winners, he said, with a few sectors staying hot and an increasing number of foreign brands entering the U.S. Alas, there will be losers, too. Which chains are most vulnerable? Johnson forecast that franchisors that rely on royalty fees to cover their G&A (general and administrative costs) could be in trouble. And brands that already have marginal performance will stand out, and not in a good way.

On the other side of the coin, Johnson foresaw that opportunities to buy underperforming units and opportunities to expand into other brands will abound for the better-performing franchisees. But given the chance, he’d probably want to insert the word “relatively” into his statement that “better performers will have better capital access” if we asked him his opinion today. Hey, even Fortune 500 companies with solid balance sheets struggle to find capital now.

Johnson declared that capital access will be a huge challenge for marginal performers, who will be exiting the business in greater numbers, followed upon almost immediately by increased litigation. In short, he foresaw a shakeout coming among franchisees, even before the worst of the financial and economic problems had become visible.

Which brings us to the refranchising issue. The concept—a chain sells off its company-owned stores to franchisees—has become a popular financial vehicle in the franchised restaurant world of late. It’s a key strategy on the fast food side of the business, where big companies like Sonic, Yum! Brands and Hardee’s have employed it to varying degrees. In full-service, the list of refranchisors includes DineEquity (owners of IHOP and Applebee’s), Denny’s and T.G.I. Friday’s.

There are many potential benefits to both franchisor and franchisee in a refranchising situation. One attraction for franchisors is that they get out of the business of running their own restaurants—which often significantly underperform franchised units—and further into the business of helping others do so, the better to build the brand. More importantly, they acquire significant funds to pay down corporate debt or invest in new ventures. It’s a tempting scenario: Companies acquire more capital just as their business becomes less capital-intensive.

In the case of DineEquity’s refranchising push for Applebee’s, the idea is to sell off 480 of its 511 company-owned stores in the 2008-2010 period. If successful, this will enable the Applebee’s brand to reduce its operating expenses and increase its operating margins. More importantly, it will enable DineEquity to reduce the large debt it took on to buy Applebee’s in the first place. So far, DineEquity reports it has “agreements” for 110 Applebee’s units.

It’s a savvy plan on paper. But ask yourself: Would you want to buy an Applebee’s, or an entire region’s worth of Applebee’s, right now? And if you did, who do you think would lend you the money to do so, and what sort of interest rate do you think they would charge? Restaurant industry lending giant GE Capital Solutions, Franchise Finance, has already announced that it will be cutting its loan activities significantly until the coast clears.

On the other hand, if you are somehow able to line up financing, what a time to buy. As speaker after speaker at Restaurant Hospitality’s Concepts of Tomorrow conference in Las Vegas this week pointed out, it’s a great time to get into attractive locations. And it’s an equally great time to negotiate with the landlords who control those locations. When both bankers and landlords are especially risk averse, their interest in dealing with proven brands and proven operators increases dramatically.

That’s exactly where we are right now. No one knows when the economy will turn around. But when it does, those who had the guts to go into strong brands and solid locations during the current downturn should be positioned to be the big winners. Maybe those who take the plunge on the Applebee’s refranchising offer will be among them.