Franchise industry under pressure

One of the franchise industry’s favourite pitches to potential franchisees is that the failure rate in franchising is much lower than small business in general.

The argument goes something like this: Franchising, by virtue of offering an established business system and brand, is a safer bet than starting your own business.

But the recession is casting doubt on this argument. Franchised jeweller Kleins, franchised car care chain Midas and franchised DVD retailer EzyDVD have all fallen into administration. The latest casualty, kitchen and laundry appliance group Kleenmaid, looks likely to take at least 15 franchised retail stores down with it.

It’s certainly true that the boom in franchising has coincided with a long period of economic sunshine. Since 2002, the number of franchise systems operating in Australia has jumped from 700 to just over 1000. Franchising offered a fast way to grow, as new recruits brought capital and the enthusiasm that springs from having “skin in the game”.

But now, times have changed. Many franchisees are seeing their revenue fall. For franchisors whose model revolves around them taking a percentage of franchisee revenue as a royalty, earnings will also fall.

Whether franchisors can maintain profitability without fee gouging from struggling franchisees, or cutting and thereby compromising services to franchisees, is a question that must be asked by the industry – particularly with all the newly-unemployed likely to consider franchising as their next career move.

Some observers believe there is a strong risk that some franchisors won’t be able to resist the temptation to sell franchises to anybody with a purse and a pulse, just to raise cash and keep themselves afloat.

Most industry observers are expecting more casualties in the industry.

Jason Gehrke, franchise consultant and SmartCompany blogger, believes franchisors collecting royalties as a percentage of franchisee turnover are most vulnerable.

“If sales stagnate or decline, then royalties to the franchisor will be reduced, which can lead to cashflow problems for the franchisor. It could lead to a need to cut costs, including staff and services to franchisees – potentially when the franchisees need these services the most,” he says.

He believes the highly geared chains, those hit by a decrease in discretionary spending, and those failing to meet changing consumer tastes, will fail first. When EzyDVD went into receivership last December, the administrator David Kidman at Ferrier Hodgson, blamed the collapse on high levels of debt.

Other industry observers are arguing that it is the chains that have failed to reach critical mass that are most vulnerable.

“I’m concerned about franchising because there is a significant number of marginal operators that expanded too quickly on cheap credit,” says Frank Zumbo, associate professor of business law at the University of News South Wales, who has researched past franchising failures.

Zumbo says the franchising industry has been particularly susceptible to becoming over-geared because of the pressure to build critical mass quickly. The chains had a great incentive to get big quickly during boom times because with size comes better deals from suppliers, landlords and greater brand recognition.

But he says that the chains that didn’t make it to critical mass before the boom ended are most at risk of failure as demand falls away and credit is harder to get.

Not everyone is so gloomy. Adrian McFedries, managing director of franchise consultancy DC Strategy, argues that franchised businesses are no more vulnerable than those run on any other model. But he says franchises in some sectors are getting hit hard.

“The performance of franchises is driven by the performance of the sector they are in. The slowdown hasn’t hit all sectors equally,” he says. For example, he says bulky goods retailing, with whitegoods retailer Kleenmaid being the most obvious casualty, is doing it tougher than food retail.

McFedries acknowledges there will be more casualties of this recession, of both franchised and non-franchised businesses. Those that fail will be the weaker operators.

Despite the gloom, Gehrke actually believes there will be no fewer franchise chains when the recession is over. In fact there could still be growth of the industry overall as companies that currently do not have franchised operations try to start selling franchises to rid themselves of unprofitable assets and raise cash.

An example of this is mobile phone and electronics retailer Strathfield, which collapsed into administration earlier this year but emerged after a major shareholder injected fresh capital. Strathfield has announced it will pursue a franchise strategy as it attempts to turn its fortunes around.

These struggling would-be franchisors are likely to be joined by existing franchisors with cashflow problems in ramping up promotion of franchises for sale.

While rising unemployment will create a deeper pool of potential franchisees, the experts agree it is a short term strategy that will only prolong the agony for the struggling business.

“Franchisors who go out and sell more franchises as a response to a slowdown in sales may as well hand their administration papers in now,” DC Strategy’s McFedries warns.

“It has a devastating effect when a franchisor fails,” says Zumbo. From his study of the past collapses of Barbara’s House and Garden, Cut Price Deli, Traveland and Kleins, he has observed that once the franchisor fails there is a strong likelihood that the franchisee will lose everything.

He says that while some will pick up and continue operating as an independent business, or band together with other franchisees to keep trading, most will fail. Typically, franchisors in retail chains hold the head lease and an administrator will terminate this as one of their first actions. This means the franchisee loses their site unless they can come to terms with the landlord independently.

Zumbo says the 15 Kleenmaid franchisees running retail stores now have virtually no stock, the brand is next to worthless, and he says they can’t provide warranty back up. Most will lose their stores because the administrator has stopped paying rent. Many are also creditors of Kleenmaid and will get no return.

Customers caught up in a franchise collapse may lose out as well, as they have in the Kleenmaid disaster where $27 million in customer deposits are gone and up to 6000 customers, some of whom have paid as much as $40,000 on kitchen appliance orders, are unable to get a refund.

But Steve Wright, executive director of the Franchising Council of Australia, who believes it would be “over-optimistic” to think there were not a possibility of more failures this year, says franchise failure is not always the end of the line for franchisees or for a franchise chain.

He points out that EzyDVD, which went into receivership in December 2008 with $18 million in debts, was sold to entertainment chain Franchise Entertainment Group (which operates the Blockbuster chain in Australia) in January and its 25 franchisees are now part of a more robust chain.

On the upside, in a recession some of the problems of the boom for franchise chains are problems no longer. More franchise recruits are emerging – for chains that can afford to expand – and good sites for retail operations are becoming available again.

McFedries identifies another new market for franchisors – baby boomers who can no longer afford to retire. The big falls on the sharemarket have eroded retirement savings and mean a totally passive retirement is no longer an option. McFedries is expecting many of those in the 40 to 55 age bracket with accessible capital to move into franchising over the next 18 months.

Dirk Spence, co-founder and managing director of the 63-store strong retail chain Howards Storage World, says he has seen a “glimmer” of increased interest in the chain from middle-management types.

But like many franchisors, Spence won’t need as many recruits this year because the downturn has hit his franchisee sales and his expansion plans. “Instead of reaching 75 to 80 stores, we’ll be happy with 70 stores in 2009-10,” he says. Turnover in 2008-09 will be $105 million, slightly up on $102 million in 2007-08.

In 2009-10 he will be happy to avoid going backwards. “It would be silly to be over-optimistic for the coming year, but we’d like to grow slightly from where we are.”

Spence says it is certainly possible for franchised chains under pressure to maintain profitability – he says his chain will, despite softening franchisee sales. He hasn’t laid off staff, but says he hasn’t hired the new staff he would have needed had growth continued at the same pace.

He is telling franchisees to focus on what they can control – maximising sales from customers who walk in their doors. While franchisee sales hold up, so will Spence’s profitability.

FCA’s Wright says that despite reduced turnover, many franchisors are regarding the recession as an opportunity. He also argues there is a lot of incentive to try to maintain market position to be ready to take advantage when we come out of recession.

Bruce Myers, chief executive of franchised speciality meat retailer Lenards, says his 181-store chain is growing through an alliance with Metcash that will put 14 or 15 Lenards outlets in IGA supermarkets this year and add Lenards counters to butcher shops.

The retailer reported the average annual profit of a Lenards franchise rose 16% in the six months to 31 December 2008. Myers says the increase in profitability is due to increasing sales of high margin products, monitoring sales with a new technology package and sharing sales information among stores.

He says that a recession is an opportunity for Lenards to value-add to its chicken products, because people eat at home more, they have little time and they may not have the skills to cook. Myers expects revenue of $145 million to $150 million in 2008-09, up 2% to 3% on the previous year.

What can franchisors do to improve profitability without cutting services to franchisees, discounting and over-selling franchises to keep cash flowing?

Review pricing strategies and include value-add offers. Avoid discounting as much as possible (unless it is used as a tool, see below). Focus on up-selling and cross-selling to existing customers.

Manage cashflow by having sensible upfront discussions with creditors and debtors, and offer incentives, such as discounts, to pay faster and be paid faster.

Review product and service fit for the current market and be prepared to innovate.

For retailers, review staffing levels in store to ensure that they fit well with peak customer demand. Cut staff only where absolutely necessary because they are expensive to replace when conditions improve.

Review your own living costs and how much money is withdrawn from the business.

Franchisors should get a better understanding of business at ground level. This is particularly important for franchisors not operating stores themselves, because it can be easy to lose touch with the customer. Use the understanding to take out excess costs.

Focus on gross profit margin, not just sales. Discounting can be a serious miscalculation.

Maximise marketing effectiveness by reviewing the message medium, frequency and cost against returns generated.

Review your inventory management and logistics and supply chain, and look for savings.