Here is how a franchising works and 5 stocks with this business model

Should you invest in business with a franchising model? There’s plenty of companies out there, and you may be investing in one without giving consideration to it. You may think your company is for instance a fast food stock, but it may well be the franchisees selling the food, and the company just providing a brand for those franchisees to use. Let’s take a deeper look at how this business model works, the advantages and disadvantages for investors and a handful of stock with this model.

How does franchising work?

Franchise businesses operate on a model where a franchisor (the original business owner) grants the rights to a franchisee (an independent operator) to use the brand, business model, and operational support in exchange for fees and royalties. Here’s a breakdown of how it works:

A franchisor, for instance McDonalds or KFC, owns the original business, including its brand, business model, and intellectual property. They provide support and guidelines to franchisees. The franchisee is an independent operator who purchases the rights to operate under the franchisor’s brand and system.

Each individual franchisor will have its own deal terms and it is typically a ‘take it or leave it’ basis in the case of the world’s largest franchisees – in other words, it is not negotiable. McDonalds for example needs at least US$2m of a franchisee’s own money – no debt, but their own cash. Any deals inevitably involve a percentage of sales paid to a franchisor. They may also pay marketing fees to a national or regional advertising fund. Sometimes, a franchisor might franchise out the rights to an entire country to an individual country, and that franchisee will in turn franchise out individual outlets to their own franchisee (this is Dominos Pizza Enterprises’ business model).

Franchisees will need to adhere to the franchisor’s guidelines and standards to ensure a consistent customer experience across all franchise locations. To ensure this, Franchisors often provide training programs, operational support, marketing resources, and guidance on site selection, supply chain management, and customer service standards.

What are the advantages of investing in stocks with a franchisee model?

The key advantage is scalability and growth potential. Franchise models can scale more quickly compared to company-owned models because franchisees bear the cost of opening new locations but still bear the brand recognition and loyalty. This can lead to rapid revenue growth through higher customer traffic and sales.

Stocks that operate as Franchisors typically earn ongoing royalties from franchisees, usually as a percentage of revenue, which provides a stable and predictable income stream. Subject to the extent to which the franchisor is geographically spread out, the business may be less dependent on the performance of a single location or region.

What are the disadvantages of investing in stocks with a franchisee model?

This independence of the franchisees can also be a disadvantage for franchisors. Poor management or service by franchisees can harm the brand. If franchisees struggle financially, it can impact the franchisor’s royalty income and growth prospects. Larger companies can just axe poorly performing franchisees from the network with a minimal impact on the broader business.

But even when sales are going well, disputes between franchisors and franchisees over terms of the agreement or operational practices can lead to costly legal battles. This has haunted companies including Dominos (ASX:DMP) and Retail Food Group (ASX:RFG) in the past.

There is also the risk of market saturation. In mature markets (i.e. Australia and New Zealand for Dominos), expansion opportunities might be limited, leading to slower growth. Don’t take our word for it, Dominos has admitted that itself, hence its focus on markets like Europe, Japan and Taiwan. Ditto Collins Foods (ASX:CKF) in relation to KFC, although not necessarily with Taco Bell.

Moreover, opening too many franchises close to each other can lead to cannibalization, affecting sales at existing locations. This is a risk we see with Guzman y Gomez (ASX:GYG), because it has a strategy of having multiple locations close to each other. And as it goes without saying Franchises also compete with other franchises.

Finally, we observer that the sectors many franchise businesses operate in, especially in sectors like food service and retail, are sensitive to economic downturns as they rely on consumer discretionary spending.

Conclusion

Companies that offer a franchisee business model are in the franchising business before anything else. It is important to be aware of how each franchisor’s model works and the trouble that can occur at an individual franchisee level, but ‘trickle up’ to investors.

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