As we have discussed elsewhere, the advantages of franchising for a fast-food company are substantial. For starters, franchising provides a means for rapidly expanding the store base without tying up capital building and operating new restaurants. This business model also typically results in a relatively consistent profit stream because risks associated with fluctuations in sales and operating costs (commodities, labor, etc) are largely borne by storeowners.

Not surprisingly, many of the largest quick-service chains rely heavily on franchisees to own and operate the stores. At McDonald’s (MCD - Free Analyst Report), over 80% of the burger chain’s locations are operated by franchisees or affiliates. Yum! Brands (YUM), which owns the KFC, Pizza Hut, and Taco Bell brands, is similarly situated, with roughly 75% of its stores franchise-owned. It is now in the process of a multi-year refranchising campaign to reduce company ownership in the U.S. to about 10% of the system. 

There are, however, potential downsides to the strategy that investors need to keep in mind when evaluating restaurant stocks. As in many relationships, potential flaws in the one between franchisor and franchisee frequently appear when times get tough. Addressing problems that may be eroding the value of a successful, but aging, brand can be a contentious exercise for any business. For a franchise-driven chain, this process can be something akin to turning around a large ship while hundreds of captains (i.e., store owners) offer different opinions on which direction to steer.
Instituting changes that involve investments in equipment, labor, or advertising can be particularly rancorous. And, since franchises typically don’t have the same resources as the chain’s owner, the latter will often need to provide financial support to the franchisees to execute the necessary initiatives. Disputes over strategy can even wind up in litigation, which creates added distractions and costs for both parties.

Burger King (BK) and Yum! Brands are two restaurant operators whose problems with franchisees have spilled over into the courtroom in the past year. One of the sore points with Burger King franchisees was a $1 double cheeseburger promotion that it claimed was a money-losing proposition. The consequences of this dispute will likely soon be the responsibility of the private-equity firm that recently made a successful buyout offer for the burger chain.

At Yum!, interestingly, financial results have been quite strong in recent years, with annual earnings growth usually exceeding 10%. These gains, though, have been driven largely by strong results overseas, especially in China. Back at home, Yum!’s recent performance has been much less satisfying, with its KFC chain, in particular, struggling through an extended period of lackluster sales. That brand’s leadership has instituted numerous measures to get trends moving in a favorable direction, but many franchisees have objected to some of the moves, most notably, the introduction and heavy promotion of grilled chicken.

One way to resolve a conflict short of, or in response to, legal action is for the company to buy back stores from franchisees. If this becomes necessary on a large scale, however, a restaurant operator would likely need to increase its financial leverage or divert capital from other uses, such as building new stores in promising locations, implementing or increasing dividends, or repurchasing stock. 

Problems in the franchise-driven business model are not limited to mature brands. Investors evaluating expanding and seemingly vibrant restaurant concepts also need to be on the lookout for potential problems. Perhaps the biggest concern in this respect is that franchising can reduce visibility about the profitability of the restaurant concept as a whole. In the not too distant past, for instance, there have been instances when companies applied questionable, or improper, accounting methods relating to franchisees that seemed to paint an incorrect picture of the financial health of the business. This has had painful consequences for shareholders. 

An extreme example of this was Boston Chicken. The casual chain expanded at an impressive clip in the early Nineties, but suffered a precipitous fall from grace as a public company, as the market digested the fact that its franchisees were mired in red ink.

Donut purveyor Krispy Kreme (KKD) also went through a significant upheaval (including restating earnings and replacing top executives) several years back due partly to the financial difficulties of its storeowners. The company has yet to turn a profit in any of the intervening years.

As demonstrated by many of the industry’s leaders, franchising is a valuable tool for restaurant companies. As suggested by the examples above, though, investors still need to keep a close watch on the fundamentals of the business, including a chain’s ability to generate and sustain attractive store-level returns, when evaluating restaurant stocks.

At the time of this article, the author did not have positions in any of the companies mentioned.