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:

Sonic Corp. ( SONC)
Company Profile: Sonic operates and franchises a chain of quick-service drive-in restaurants in the U.S.
Share price return: 12.7% this year
Franchise locations: As of Aug. 31, Sonic had 3,572 drive-in restaurants, of which 3,117 were franchises.
Revenue from franchises: Franchise revenue accounted for 23% of Sonic's total revenue last quarter. Sonic reported first-quarter revenue of $26.5 million from franchise drive-ins, compared with $86.4 from company-owned locations.
Franchise costs: Sonic says the franchise fee for a restaurant is $45,000, with a total initial investment ranging from $710,000 to $3 million. There are also royalty fees that run between 4% and 5%, and advertising fees of nearly 6%. Depending on the number of locations owned, franchisees are required to have liquidity of $1 million and net worth of $1 million.
Analyst view: Five research firms have a "buy" rating on Sonic, including RBC Capital Markets and Piper Jaffray. Another seven analysts say investors should hold the stock, while four researchers suggest dumping shares.

Denny's ( DENN)
Company Profile: Denny's operates a family-style restaurant chain in America with the Denny's brand name.
Share price return: 12.9% this year
Franchise locations: As of March 30, Denny's counted 1,665 restaurants, with 1,439 franchised or licensed and the other 226 company-owned and operated.
Revenue from franchises: Franchise revenue accounted for 23% of Denny's $135.8 million in total revenue last quarter. Company sales totaled $104.5 million in the most recent quarter, compared with $31.2 million from franchise and license revenue.
Franchise costs: Denny's says franchisees must meet a minimum financial requirement of $350,000 liquid capital to invest and a net worth of $1 million. Denny's estimates that the total initial investment is between $1.2 million and $2.6 million. There is a royalty fee of 4% of gross sales and an advertising fee of 3% to 4% of gross sales, the company says. For new restaurants, there is an opening training fee.
Analyst view: Five of six analysts covering Denny's say investors should buy the stock. CL King analysts even have a "strong buy" rating. Only one firm -- EVA Dimensions -- has a "sell" rating on Denny's.

Tim Hortons ( THI)
Company Profile: Tim Hortons develops and franchises quick-service restaurants that serve food, including coffee and other hot and cold beverages, baked goods, sandwiches and soups. Earlier this week, Tim Hortons abruptly announced that CEO Donald Schroeder is leaving after three years. Executive Chairman Paul House was named interim CEO while the company conducts a search for a permanent replacement.
Share price return: 10.6% this year
Franchise locations: As of April 3, Tim Hortons counted 3,169 restaurants in Canada and 613 in the U.S. Almost all of the company's restaurants are franchised. The company also has 274 self-serve licensed locations in Ireland and the U.K.
Revenue from franchises: Franchise-related revenue accounted for about 29% of Tim Horton's $643.5 million in total revenue last quarter. Franchise revenue totaled $189 million, with nearly $168 million from rents and royalties and $21 million from franchise fees. That compares with $454.5 million from company-owned locations.
Franchise costs: Tim Hortons estimates that the total initial investment for a U.S. franchise will vary between $337,000 to $439,800 for the equipment cost; $2,400 to $34,000 for real property cost; and a franchise fee of $35,000. There are also required pre-opening expenses that range between $47,000 to $88,400. Tim Hortons says there are also several ongoing fees, including a weekly royalty of 4.5% of a restaurant's gross sales, a rent fee equal to 8.5% of monthly gross sales and a monthly advertising fee of 4% of gross sales.
Analyst view: Scotia Capital is one of five research firms with a "buy" rating on Tim Hortons. Thirteen firms, including Canaccord Genuity and RBC Capital, say investors should hold the stock. No analyst has a "sell" rating on Tim Hortons.

Krispy Kreme Doughnuts ( KKD)
Company Profile: Krispy Kreme is a retailer and wholesaler of doughnuts and packaged sweets. The company owns and franchises locations in the U.S. and internationally.
Share price return: 23% this year
Franchise locations: Krispy Kreme ended the first quarter with a total of 652 stores. As of May 1, there were 86 company-owned stores and 566 franchises.
Revenue from franchises: Franchise-related revenue accounted for 31% of Krispy Kreme's $104.6 million in total revenue last quarter. Domestic franchise revenue totaled $2.4 million in the first quarter, and international franchise revenue was $5.6 million. External supply chain revenue, which does include sales to company-owned stores, totaled $27.1 million in the first quarter. By comparison, company-owned Krispy Kreme locations had revenue of $69.5 million last quarter. Krispy Kreme noted that international franchise revenue in the first quarter benefited from a recognition of $375,000 related to Krispy Kreme Mexico. This revenue was accrued in prior quarters but not recognized because collection was uncertain. On May 5, the company said it sold its equity interest in Krispy Kreme Mexico.
Franchise costs: Brian Little, director of corporate communications for Krispy Kreme, didn't immediate reply to a request for franchise cost information.
Analyst view: Four analysts, or 50% of those following Krispy Kreme, rate the stock "buy." Among them are analysts from CL King and Sidoti & Co. Another three firms recommend investors hold shares, while a lone analyst has a "sell" rating.

McDonald's ( MCD)
Company Profile: McDonald's franchises and operates McDonald's restaurants in the food-service industry. The company and its franchisees buy food, packaging, equipment and other goods from numerous independent suppliers.
Share price return: 7.5% this year
Franchise locations: As of March 31, McDonald's had 32,805 restaurants, 26,398 of which were licensed to franchisees.
Revenue from franchises: Franchises accounted for 32% of McDonald's $6.1 billion in total revenue last quarter, or $1.96 billion. Company-owned restaurants pulled in about $4.2 billion in revenue.
Franchise costs: For a new McDonald's restaurant, the initial fee paid to McDonald's is $45,000, and the company estimates that equipment and pre-opening costs range from $1 million to $1.8 million. Franchisees also must pay a monthly service fee equal to 4% of monthly sales and a monthly base rent. McDonald's notes that relatively few first-time owner/operators get a new restaurant. McDonald's requires an initial down payment of 40% of the total cost for a new restaurant or 25% of the total cost for an existing restaurant. The company also requires a minimum of $500,000 of nonborrowed personal resources.
Analyst view: As a component of the Dow Jones Industrial Average, McDonald's has a large analyst following. Fifteen analysts, or nearly 58% of those covering the stock, say McDonald's is a "buy." Credit Suisse, Sanford C. Bernstein and Stifel Nicolaus are among those bullish analysts. The other 11 analysts following the stock rate it "hold."

Jack in the Box ( JACK)
Company Profile: Jack in the Box operates and franchises Jack in the Box and Qdoba Mexican Grill quick-service restaurants.
Share price return: 3.2% this year
Franchise locations: N/A
Revenue from franchises: Franchise-related revenue accounted for 36.4% of Jack in the Box's $505 million in total revenue last quarter. Franchise revenue totaled $62.5 million in the company's fiscal second quarter, while distribution sales to franchisees was $121.4 million. Company restaurant sales were $321.2 million in the fiscal second quarter.
Franchise costs: Jack in the Box franchisees pay an initial franchise fee of $50,000 per location, which carries a 20-year term. There is also a $25,000 area-development fee per location. The company charges a royalty fee of 5% of gross sales and a separate marketing fund contribution of 5% of gross sales.
Analyst view: Morgan Keegan is one of four research firms rating the stock "buy." Another nine say investors should hold shares, while two recommend selling.

DineEquity ( DIN)
Company Profile: DineEquity focuses on franchising IHOP restaurants as well as Applebee's, which the company acquired in November 2007.
Share price return: 10.2% this year
Franchise locations: As of March 31, DineEquity reported 1,738 franchised Applebees, compared with 271 company-owned restaurants. The company said there were also 1,329 franchise IHOP restaurants at the end of the first quarter, compared with only 10 company-owned locations.
Revenue from franchises: Franchise-related revenue accounted for 49% of DineEquity's $300.2 million in total revenue last quarter. The company had $104.5 million in franchise revenue, $32.2 million in rental revenue and $8.7 million in financing revenue. That compares with about $155 million in revenue from company-owned restaurants.
Franchise costs: According to Applebee's international franchising requirements, the company generally requires a minimum $1 million net worth for each restaurant. There is also a $40,000 franchise fee per restaurant, a royalty fee of 4% of gross sales, as well as an advertising fee that is not less than 3.5% of gross sales.

For IHOP franchises, the company has minimum financial requirements of a $1.5 million net worth and $500,000 in liquid assets. IHOP doesn't publish franchise fees on its website, but the company notes that the cost of construction for a standard prototype IHOP restaurant is approximately $960,000 to $1.2 million. Additional cost of equipment, seating and point of sale system are about $480,000, the company says.
Analyst view: Three research firms recommend buying shares of DineEquity. One of those first -- Raymond James -- has a "strong buy" rating on the stock. The other five analysts following DineEquity rate it a "hold."

AFC Enterprises ( AFCE)
Company Profile: AFC Enterprises operates and franchises quick-service restaurants under the brand names Popeyes Chicken & Biscuits and Popeyes Louisiana Kitchen.
Share price return: 10.3% this year
Franchise locations: As of Dec. 26, the company had 1,542 domestic franchised restaurants, 397 international franchised restaurants and 38 company-operated shops.
Revenue from franchises: Franchise revenue accounted for 62% of AFC's $46.8 million in total revenue last quarter. Sales at company-owned locations was $17.6 million, compared with $27.9 million in revenue from franchises and $1.3 million in rental and other revenue.
Franchise costs: The basic requirements for owning a Popeyes franchise is a net worth of $500,000, of which $250,000 must be liquid. After that requirement is met, AFC Enterprises has several franchise fees, including a $7,500 development fee per restaurant, a $30,000 franchise fee per restaurant, a royalty fee of 5% of gross sales and an ad fund that takes 4% of gross sales. These fees don't address other project costs, such as the $330,000 to $420,000 required for a building, $150,000 to $170,000 in equipment costs, and signage, which can run from $15,000 to $30,000.
Analyst view: Of the six analysts covering AFC Enterprises, half rate it a "buy" and the other half say investors should hold onto shares. BGB Securities is among the bullish firms, while Cowen & Co. say investors should sit tight.

Winmark Corp. ( WINA)
Company Profile: Winmark franchises retail locations under the brands Plato's Closet, Play it Again Sports, Once Upon a Child and Music Go Round across North America.
Share price return: 9.5% this year
Franchise locations: Winmark had 902 as of March 26. The company also has a leasing portfolio of $30.4 million.
Revenue from franchises: Franchise revenue accounted for 70% of Winmark's $11.1 million in total revenue last quarter. The company says its most profitable source of franchising revenue is royalties from franchise partners. In the first-quarter, royalties jumped nearly 11% from a year ago, to $7.1 million. Total franchising-related revenue totaled $7.8 million, compared with about $3.3 million from leasing activities.
Franchise costs: A Play It Again Sports franchise requires an initial investment of $235,800 to $402,300, according to Winmark's estimates, although the actual investment depends on store size and other market factors. The initial investment for Once Upon a Child stores ranges from $193,900 to $291,700. The Initial investment requirements for Plato's Closet shops range from $178,500 to $354,000. Lastly, the initial investment requirements for Music Go Round locations range from $253,450 to $325,100.
Analyst view: EVA Dimensions is the only research company following Winmark. Analysts at the shop rate the stock a "buy."

Pizza Inn ( PZZI)
Company Profile: Pizza Inn is primarily a franchisor and food and supply distributor to restaurants operating as Pizza Inn. In addition to buffet and delivery/carryout stores, Pizza Inns are found in convenience stores, college campus buildings and airport terminals.
Share price return: 20% this year
Franchise locations: As of March 27, Pizza Inn had 298 domestic and international restaurants. The company owned only five domestic restaurants, though. The other 216 domestic locations and 77 international restaurants are franchise-owned.
Revenue from franchises: Franchise revenue accounted for 89.4% of Pizza Inn's total revenue last quarter. In the first quarter, franchise revenue totaled $937,000 and food and supply sales to franchisees rose to $8.7 million. Sales at company-owned restaurants rose in the first quarter to $1.1 million.
Franchise costs: Pizza Inn offers different franchise opportunities by concept, each with different financial criteria owners must meet. Buffet locations have a liquid asset requirement of $150,000 and for buyers to have a minimum net worth of $500,000. Delivery/carryout shops have a liquidity requirement of $100,000 and for buyers to have a minimum net worth of $150,000. Lastly, the nontraditional express locations require liquid assets of $30,000 and a minimum net worth of $80,000.

The company's franchise fee also varies by the type of location. The buffet location is the most expensive at $25,000; the delivery/carryout shops have a fee of $10,000; and the express locations fee totals only $5,000. In addition, there is an ongoing royalty fee of 4% of weekly gross sales for buffet and delivery/carryout stores and 5% of monthly gross sales for express shops.
Analyst view: Pizza Inn is not covered by any Wall Street research firm.

-- Written by Robert Holmes in Boston.

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Disclosure: TheStreet's editorial policy prohibits staff editors, reporters and analysts from holding positions in any individual stocks.

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