Ominous signs for Australian franchising

As the franchisor or the related entity gets tempted to boost its revenues by raising the prices of supplies, franchisees will immediately be challenged by the price rise. Franchisees may be forced to raise retail prices to ensure their survival or may need to take a profit hit which over time just reduces the viability of their franchised businesses even further.
March 9, 2010

Ominous signs for Australian franchising
Frank Zumbo

As 2010 gets well underway, there are ominous signs that not all is well with Australian franchising, with a number of key challenges and threats facing the sector. These include tight credit conditions; rising interest rates; greater competition for potential franchisees; increasingly saturated or “over franchised” sectors of the economy; and the threat of increased disputes.

As with 2009, franchise systems will continue to struggle as a result of the global financial crisis. The days of cheap finance to rapidly expand a franchise system are gone for the foreseeable future and those systems needing new finance or having to refinance existing debt will continue to be vulnerable. These franchise systems will struggle and some may even fail as banks look for greater security for loans and seek higher interest rates from SMEs.

Those franchise systems with a heavy debt burden are particularly at risk. This debt burden is particularly troubling for those systems where private equity bought in before the financial crisis hoping for quick and solid returns only to be caught out by the crisis.

More fundamentally, there are growing doubts surrounding the utility of the private equity model within franchising. Private equity runs on a very simple premise: buy as cheap as possible and sell as high as possible as quickly as possible. Typically, private equity operates on a 3-5 year turnaround. That's very short in franchising terms. Good franchise systems take years to build and develop into powerhouses. Good franchising is about building solid relationships with franchisees, suppliers and customers. This takes considerable time and delicate manoeuvring. This is time and patience that the private equity owners may not have given the tremendous pressure to show large returns for the investors in the private equity consortium.

For the private equity owners, the priority is to strip costs and raise profits for the franchisor. Stripping costs is very hard to do given that good and efficient franchisors typically run a very lean head office. Cutting back on training, franchisee selection and servicing of franchisees is very dangerous as that threatens the growth and success of the system. Unhappy or poorly selected and trained franchisees is a recipe for disaster for private equity owners.

If stripping costs doesn't deliver the necessary returns, then the private equity owners typically turn to raising revenue. This means trying to raise franchisee fees and royalties or, worse, trying to raise the prices at which the franchisor or related parties sell goods or services to franchisees. Both are again a recipe for disaster for the private equity owners as these “strategies” simply threaten the viability of franchisees and, in turn, the franchisor. As franchisees struggle and possibly fall over, the private equity owners come under increasing financial pressure as they are failing to make the returns they were expecting. The message for all franchise systems is simple: struggling franchisees mean a struggling franchisor.

The other possibility for private equity owners is to increase franchisee sales. This is easier said than done as the particular sector in which the franchise system operates may be saturated or highly competitive. Maintaining new and price competitive product offers are essential for all franchise systems and this applies equally to private equity owned franchises.

That brings us to one of the biggest challenges for the sector as a whole. Too often we hear that Australia is one of the most “franchised” countries per capita in the world. Yes, it's great to be first in any contest, but in franchising the contest should not be how many franchises a country has, but rather how financially viable and successful they all are. No point having lots of franchises if the bulk of them are not viable or undercapitalised. The very real danger is that there are just too many franchise systems in Australia and it's time for industry rationalisation.

This industry rationalisation is particularly pressing in those sectors that are “over” serviced or saturated by franchises. Food is one example. With the growing number of franchises operating in the food sector it is clear that those franchises need to be very sharp in their product offer. Tired old menus will struggle, as will products that don't satisfy Australians' evolving palates.

Clearly, food retailing is especially competitive and this means that food products need to be keenly priced. Of course, franchisees need to be able to purchase product supplies as competitively as possible. This is both a challenge and threat to franchise systems that require franchisees to purchase supplies from the franchisor or related parties.

As the franchisor or the related entity gets tempted to boost its revenues by raising the prices of supplies, franchisees will immediately be challenged by the price rise. Franchisees may be forced to raise retail prices to ensure their survival or may need to take a profit hit which over time just reduces the viability of their franchised businesses even further. In a saturated or very competitive market, as in the case of food, franchisees will not be able to raise prices without further eroding their customer base. Taking a profit hit is bad news for both the franchisee's and the franchisor's longer term survival. In short, it's very risky for franchisors or related companies to supply goods or services to franchisees.

Those dangers are equally or perhaps even more threatening to a private equity owned franchise system. For the private equity owners the temptation for “squeezing” more revenue through higher supply prices to franchisees to whom they or related companies sell goods or services is fairly obvious. Whether they resist that temptation is critical to the system's survival and the private equity owners getting the return they expect from the investment.

So what can be done by franchisors and franchisees to meet the challenges of 2010? Well, getting the fundamentals right remains essential and that's where it's important to establish a small working group so that the franchisor and long term franchisees can share ideas and resolve issues. While franchisee advisory councils may do this job, the danger is that such councils may not be sufficiently flexible or immediately responsive to growing threats to the system. In any event even franchisee advisory councils need to be regularly revamped to keep them “lean and mean.”

Establishing a small working group allows each of the franchisee members to be invited to be what can best be described as “CEO for the day.” This concept has already been well received by some elements in the sector and invites the franchisee members to suggest strategies that they would implement if they were CEO of the franchise system. The “CEO for the day” concept recognises that the “real life” CEO is not the fountain of all wisdom and there may be times where the franchisees may “know better.”

Associate Professor Frank Zumbo is with the Australian School of Business at the University of New South Wales.

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