Brands with Red Flags



Some franchisee turnover is to be expected, but there are definite inflection points when increased M&A occurs in the lifecycle of any brand. Know the red flags by watching Unbridled Capital’s insights here from Rick Ormsby.

The topic of today's episode is What Red Flags Should Investors Look for when a Chain's Franchisees are Consolidating or Getting Flipped? When I see a chain experiencing significant turnover in its franchise base, the first question I ask is, "Why is this happening?" Franchisee turnover of two to 4% is probably a healthy number on an ongoing basis. Life just happens. We get older, partners get in fights, people get divorces. Some brands fall out of favor geographically. Some owners want to monetize a big gain. Kids want to get into the business, et cetera, et cetera. But there are definite inflection points when M&A spikes. Here are a few to consider.

Number one, when prices are high, operators will sell opportunistically. This isn't a bad thing. However, when prices get abnormally high for a long time, there is concern about the long-term health of the acquiring franchisees at such high debt levels. For any brand that has been trading at seven-plus or higher times of EBITDA for a long time, the brand needs to have fantastic sales comps and a great product innovation platform, or there will likely be casualties in the franchise base at some point, especially for the newer entrance at the end of an up cycle.

Number two, when a brand is struggling, franchisees will generally want to sell or might be forced to sell by their lenders. If you see certain brands with a struggling market position or prolonged negative sales comps, and if there is a big exodus of the franchisees, this can be a worrisome sign. On the other hand, this transition can be healthy too if it replaces legacy franchisees with younger operators and fresher capital.

Number three M&A typically increases in brands that have near-term and significant remodeling costs, often when they are newly rolled out by the franchisor. Remodeling obligations are possibly the most notable indicator of the future financial health of a franchisee. Most legacy franchisees cannot afford to remodel many of their assets in a three to five-year period. And if most franchisors cannot produce a reasonably priced remodel that will drive additional revenue in the stores, we'll have problems.

Number four, if the brand is comprised mostly of mom and pop franchisees, then consolidation is happening rapidly right now. Smaller operators cannot juggle increasing labor costs, more regulations and thinning margins. The question here is, how is a brand like this going to maintain its franchisee base without losing unit count? And number five, be cognizant of brands that have high concentration of their stores on the West Coast or Northeast. These markets have huge minimum wage concerns and are likely to show increased M&A activity. Very few brands have an answer right now on how to handle this transformation in these areas. If you're looking to make an investment in a particular brand as a platform, please feel free to reach out to us anytime. Thank you so much.