Season 1 Episode 22: Understanding Franchisors' Motivations

Podcast

08.22.2019

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Pizza competition & the dropping 10-yr, commodity costs & fitness brand growth, and understanding franchisors' motivations

Welcome to the Restaurant Boiler Room, episode 22. I'm your host, Rick Ormsby, managing director at Unbridled Capital. The Restaurant Boiler Room is a one-stop shop for multi-million dollar merger and acquisition activity and financial complexities affecting the franchise restaurant industry. We talk money, deals, valuations, and risk, delivered to the front door of franchisees, private equity firms, family offices, large investors, and franchisors on an every-other-week basis. Please feel free to find our content at unbridled capital's website at www.unbridledcapital.com. Now let's enter the boiler room.

So, guys, I want to tell you that we're going to have a change in the way we do this podcast. For those of you who have been faithful listeners for the last, gosh, I guess 21 or so weeks, I just want to thank you for listening to the podcast. I hope it's been challenging for you, I hope you've learned, and it's been refreshing to learn a little bit more about the franchise M&A industry. Going forward, I've been doing it on a bi-monthly basis, and largely, you may or may not know this, have been doing the podcast based on finding articles and things that interest me about franchise M&A and then writing down my thoughts in a very cohesive manner and presenting them in this podcast in a short format.

I have some constraints, and our company is kicking butt, and because of that, my time is a little more limited. So I'm going to drop the podcast down to monthly and then I'm going to speak a little bit more from the hip a little bit. And so you're going to hear me tripping over words a little bit and maybe speaking from my mind with a little less preparation, but it may be actually more genuine and you may enjoy it more. So I'd ask you to have patience with a few episodes and hope you enjoy the change. A couple of things I want to say about today. There's an article that I found interesting recently from Jonathan Maze about Pizza Hut, and it talks about the pizza segment has changed a lot. Obviously, we all know this. Domino's was once the second or third largest competitor nationally in the pizza brands, and now they're clearly number one and Pizza Hut has given up control of the number one position pretty quickly and steadily over that time.

Jonathan Maze in a recent article has pointed out the reason why. And one of the reasons clearly, his reason, is that we as Pizza Hut have done a poor job of changing the asset model. Too many of the locations are dine-in locations and the business has turned into a delivery and carry-out business. You know, the Pizza Hut brand started in small-town America based out of Wichita, where people sat down and ate pizza inside restaurants, sometimes with their families, sometimes after ball games, sometimes with a pitcher of beer. And that model really worked for many, many years, but in the last 10 to 15 years, as technology has played a big role and as the pizza segment has really hovered towards bigger cities and there's been a bifurcation of franchise pizza that's fast on delivery and price point, and then mom and pop or craft type of restaurant pizza chains that instead focus on customer experience, Pizza Hut has been affected by this shifting landscape. Jonathan's not wrong about that.

He notes that about 40% of Pizza Hut's 7,500 locations are still dine-in or dine-in and carry-out locations. And he cites that about 10% of the business in Pizza Hut's US sales come from those locations when really they represent almost 40% of the total stores. And so it's clearly an issue, and the brand is underway as the franchisees are remodeling, relocating, and changing their asset types, there is a movement underway to slowly get out of dine-in assets that are underperforming and to replace them with delivery assets and delivery locations that are smaller in footprint, less remodeling for the future, lower lease costs, and can still serve the trade areas from a delivery and carry-out perspective.

And so the other thing that you've seen in the Pizza Hut space is that there's been an influx of young and well-capitalized franchisees over the last couple of years. Unbridled's brought most of them to the table, honestly, and these guys are well-capitalized and really have good plans for the brand. And so maybe with the changing asset model over time, Pizza Huts investing in better technology digitally, and with the new influx of young and well-capitalized franchisees, the hope is that Pizza Hut will regain some of its lost market shares over the next couple of years. Stay tuned for it.

The second article I wanted to talk about was, I saw Nicholas Upton of Franchise Times talk a little bit about Slim Chickens. And his article said ready to take over the world, and Slim Chickens is a chicken concept, kind of a fast-casual format that's really been growing over the last several years. And they're now flush with new capital. They found a financial partner and looking to hit a goal of potentially as many as 600 locations over the next 10 years. Their new partner is 10 Point Capital, which is also the owner of Tropical Smoothies Cafe, and they invest in Phoenix Salon Suites. It's interesting to me, because coming from the KFC perspective many, many years ago, I can just tell you there has been such an influx of competition in the chicken segment. There is a chicken fast casual or QSR competitor basically on every street corner.

And the segment has really grown nicely, often at the expense of some of the traditional players like KFC, which has dropped its unit count by over 1,000 units in the last 10 years. Just watch and see. It's maybe a testament to the popularity of chicken as a second option to burgers in the QSR world. But also, I think we have to be a little careful as we look at new unit development. There are a lot of new concepts that continue to pop up. A lot of them are great ideas, but there are going to be winners and losers in this segment as the economy slows down. And entrants that are trying to grow really at an expansive and quick pace towards the end of a good cycle may be caught in a little bit of no man's land as we move forward. So keep an eye on it.

The third article I wanted to talk about is more of a point. Look at the 10-year treasury. My goodness, it has cratered and is now down in the 1.55% range, really close to an all-time low over the near term here. And there's a couple of things that I'd say. If you are refinancing or are buying something, my goodness, you've got low-interest rates. So take advantage of it. Your real estate is pretty much predicated by cap rates, and cap rates are predicated by interest rates, which basically means that your real estate is more valuable as the 10-year continues to drop, these things are good for the marketplace. But it may also signal as the 10-year has cratered here that we may be in for a few economic headwinds going forward.

A couple of franchise lenders that are common in the marketplace have closed their doors or are contemplating closing their doors. And so I think you're seeing a little bit of pain in the industry that's really been beset with rising wage costs, lack of employment options. It's hard to hire people, a lot of competition. Just be careful that the dropping 10-year, while on one hand may be awesome for refinancing or borrowing money or looking at increased real estate values, may also signal that we may be in for a little bit of a financial headwind ahead of us in the next 12 to 18 months.

Unbridled has a couple of deal closings that I wanted to announce. One of them is a three-unit KFC business that we sold in Michigan to KBP Foods, which is one of the country's largest franchisees. I'll read a quick release here.

"We're seeing a progressive shift in the franchise landscape as large consolidators acquire legacy franchisees at an amazing pace. KFC franchisees are near to my heart," and this message is from me. "And I'm extremely thankful to our Unbridled team and our unwavering support of KFC franchisees across the world. In this case, the Masters family and NJM Holdings, LLC have been a mainstay within KFC for many decades, and their legacy will be missed. Many congratulations to the family on this closing, and we hope that the next stage of their lives is filled with many years of joys and blessings." And that comes from me as managing director. And as a condition of the closing, we'll make a charitable contribution to the KFC Foundation, because at Unbridled we want to give back to the employees that are so important to the success of the KFC brand, and we want to be a blessing because we've been blessed. We do that in all the deals and all the brands where we close transactions.

We also recently closed a four-unit Taco Bell sale in Alabama. The stores were sold to Cala, LLC, one of the country's largest franchisees with over 300 locations. And the seller was BBG Specialty Foods. The area of the country was in Dothan, which is in the southeast corner of Alabama, and the franchisee, Charles Neyland, says that "We were very thankful to Unbridled Capital for representing us in the sale of our Taco Bell business. Their relationships, expertise, professionalism, and constant availability were big difference makers in getting our business sold efficiently and for the best price. Not only do I trust them, but I would highly endorse their work to all of my colleagues, franchisees, and friends." And so thank you for that nice endorsement, many best wishes both to Cala and to the exiting franchisee, Charles Neyland in that transaction too. Taco Bell businesses continue to sell at crazy prices. The brand has just hit a home run in terms of its appeal and its demographic, its new products, its speed of service, and the management of the company. And so kudos to that brand as it continues to grow.

We had recent Q2 earnings releases. There are a bunch of restaurant companies that have reported. I'll just quickly talk about three, Taco Bell, KFC, and Pizza Hut through the Yum brand system. Taco Bell posted a +7%, unbelievable same-store sales growth. KFC was at +2%. By the way, +7%s are just ridiculous in a mature brand. You don't hear of numbers that high. KFC had a respectable +2% same-store sales with the introduction of some new products over the last quarter. And then Pizza Hut was actually at a +2% as well. Pizza Hut announced that they were going to close up to or potentially could see the closure of up to 500 stores over the next umpteen years, I don't know, months of time. David Gibbs was recently announced as the new CEO to replace Greg Creed, who's been with Yum for many, many years. And so we wish David Gibbs, both he and Greg, the best of luck in their new endeavors.

The next article that I found interesting was about commodity cost pricing which might drop precipitously due to a potential trade war with China. In the franchise business, your food costs are typically around 30% of your total cost of doing business as a percentage of sales. And obviously, we watch the commodity costs fairly closely because year to year they change. And in some cases, as in wing prices, you see massive swings in commodities. I saw an article here by CNBC that was kind of interesting, and it said that if Beijing imposed a 10% tariff on US soybeans that the total American soybean exports could drop by 18%, according to one study. And soybean futures for July delivery dropped more than 7%. And if we do have that amount of drop in sales to China, that is going to affect obviously the supply and demand curve here in the United States. It could mean that we have too much. And when we have too much soybeans and too much of a commodity, the price drops when there's more supply than demand. So it's something to watch out for in upcoming months as we watch the commodity cost changes with the threat of a trade war with China and the United States.

Okay, what else do we have here? Interesting article that I saw recently talked about the city of Minneapolis issuing a ban on all new drive-throughs. Evidently, this is not just a ban on restaurant drive-throughs, but all establishments in the city limits that have drive-throughs, be it banks or whatever, laundromats or dry cleaning services, and restaurants. So check that article out. But I think what it potentially means is it's a hindrance to some of these places for new unit development on the franchise side. Certainly, it appears that the existing drive-throughs will continue to operate in Minneapolis, but when you constrict and take away new drive-through opportunities, you're really putting a damper on franchise activity from a unit development perspective and you're probably hurting the franchisees that are looking to grow in these markets. So I hope this is not a trend for other cities and other progressive cities throughout the country, but it's something to keep an eye on for sure.

In July, our next article, TDN2K, which does a comprehensive monthly study across the restaurant industry of sales and traffic declines and accelerations, came out in July and said that comp sales and traffic were down 1% and 4% respectively. And this represents the lowest monthly comp sales performance since September 2017. If not for the growth, and this is a comment from me, if not for the growth and delivery and carry-out portion of the business, this picture would clearly look a lot bleaker than it does. As delivery and carry-out, especially through third-party delivery, continues to roll and it's seen fairly decent penetration, you're seeing, I think, a little bit of hopeful or misleading sales and traffic comps in the industry. Because yeah, they're getting sales, and yeah, they're getting more traffic, but the sales and traffic are not profitable in many cases. You've probably heard that in a lot of the third-party delivery platforms, the business that's coming from them is marginally profitable if not profitable at all. So this is a bleak outlook. I'm hopeful for a turnaround, but I don't think it's coming.

So we're in a position now where sales have turned negative on a comp basis this summer, and traffic at -4% in July is just horrific. It's really horrific. So watch the trend. We may be ending or coming to the end of a cycle. And if that's the case, watch for a little bit of contraction both in unit counts, optimism, and potentially EBITDA and sales for franchise companies going forward.

Another article that caught my mind was about fitness brands. Now, there are quite a few franchise boutique fitness brands, small franchises, and then the larger consolidators too. You'd know them by name. Obviously, it's not a boutique anymore, but Planet Fitness and Orange Theory and Snap, and a lot of these places have grown and have been growing really, really quickly. In an article today, which is, today the 19th of August, by CNBC, it's interesting that they point out that the profit in the industry has grown by 8% in the last year, but that boutique brands make up a market share of 40% of the overall industry. And the small brands have really been popping up. You've seen them in strip centers all over the country, really, a lot of them in suburban and urban locations.

The comment in this article is, though, that these boutique brands in the fitness space typically charge pretty high rates relative to the larger big-box fitness brands, and fitness in a recession is one of the first things to go when people start tightening their belt and looking at cutting expenses when they're hurting a little bit. The other piece of it is that people typically are fickle with their workouts. So the pace of new unit growth in this business has indeed been incredible, and fitness has been just an amazing growth story, both in the public and private markets. But if we do hit a recession or a slowdown, be watchful of what happens not only to these boutique brands, as CNBC points out, but to the overall business in the fitness space in general.

In closing, I'd just like to thank you so much for entering the Restaurant Boiler Room today. You can find our podcasts on iTunes, Google Play, Stitcher, TuneIn, and Spotify. If you like these podcasts, please listen, rate, and review them. I also encourage you to visit our website at www.unbridledcapital.com for the best franchise M&A and financial resources in our industry. Our website includes podcasts, videos, white papers, and a list of our M&A transactions. Please note that neither Rick Ormsby nor Unbridled Capital, LLC give legal, financial, or tax advice. These podcasts represent opinions that have been prepared for informational purposes only. We expressively disclaim any and all liabilities that may be based on such information, errors therein, or emissions therefrom.