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Why Franchises Are Good for Investors

BOSTON (TheStreet) -- For investors searching for growth stocks, they need look no further than companies that franchise, such as McDonald's (MCD) and DineEquity (DIN).

Whether its shoes or automobile parts or burgers and fries, many stocks of companies that have more franchised locations than company-owned stores are outpacing the return on the S&P 500 this year. Krispy Kreme Doughnuts (KKD), for example, has seen its stock surge 20% as the business recovers following the Great Recession.

It's likely most people have a friend or relative who has talked about buying that McDonald's franchise and opening their own store. That entrepreneurial dream supplies these public companies with a reliable cash stream and lowers expenses. In terms of growth, that makes these stocks attractive to investors hunting for opportunities.

"The benefit of franchising is that, if you have a system that can be replicated well, then franchising is a good growth strategy," says Lorne Fisher, chief executive and founder of Fish Consulting, a public relations and consulting firm that counts AFC Enterprise's (AFCE) Popeyes and Dunkin' Donuts, which will soon hold its initial public offering, as clients.

"That's really what it is, a growth strategy," Fisher continues. "Companies look to grow their brand and system with reduced capital needs. They look to have low capital expenditures and still grow the brands and reap the benefits, which are in the form of royalty fees."

Companies that move from company-owned and operated stores to a franchise business model also reap rewards from the transition. While revenue will slump, as they aren't getting sales totals they enjoyed previously, many reduce expenses in the process -- increasing profit margins, Fisher says. In industries such as the restaurant business, where margins are already razor thin, this becomes even more important.

Jack in the Box (JACK), for example, saw company restaurant sales drop 17% in its most recent quarter and nearly 16% this year alone due to the decline in the number of company-operated restaurants. But Jack in the Box says this is part of its refranchising strategy and notes that the sales decline has already been partially offset by increases in same-store sales at its restaurants.

Franchising is not without its hurdles. It's a federally regulated business model, watched by the Federal Trade Commission and individual states. Companies see upfront costs related to legal paperwork and filings, although they benefit from eliminating the costs of starting stores from scratch, then running and maintaining them.

The companies themselves talk up the benefits of the business model. McDonald's says the company views itself primarily as a franchisor and believes franchising "is important to delivering great, locally relevant customer experiences and driving profitability."

AFC Enterprises says the model provides "diverse and reliable earnings with steady cash flow, and relatively low capital spending requirements." The company says that, over the past five years, cash flow produced by its model has primarily been used to pay down debt and buy back stock.

The future looks bright for franchisors and franchisees alike. The International Franchise Association, the oldest and largest organization representing franchising worldwide, estimates that the number of franchise establishments will grow 2.5% this year. Economic output, which is the gross value of goods and services produced, is projected to grow 4.7%, to $739.9 billion.

"The forecast of stronger growth in 2011 for franchise businesses is good news for our country," IFA CEO Stephen Caldeira says. "When franchise businesses are stronger, so is our economy as a whole."

For investors, navigating the land of franchises can be daunting and confusing. Fisher points out that the common misperception is that franchises are an industry, but many types of industries have companies that franchise.

It is also easy to make the mistake of confusing which companies do and don't. Starbucks (SBUX), for example, franchises internationally, but all U.S. stores are company-owned. For that reason, less than 10% of the revenue generated in the most recent quarter comes from franchising.

TheStreet looked at publicly traded companies that derive a substantial portion of their revenue from franchise operations, starting with costs collected from potential franchisees:

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