John Gordon - August 2019

Restaurant Franchising: It Takes Money to Make Money

The Current US Pizza Hut Example

by John A. Gordon, Principal and Founder of Pacific Management Consulting Group

For years, the common perception of restaurant franchising in the United States is that it is a “goldmine”, that it is a way to supercharge brand unit growth and the sure pathway to wealth and value generation for restaurant franchisor investors, the restaurant franchisor itself and franchisees. Nothing is easy anymore, everything takes effort.

For example, franchise investments are not the endless “annuity” that deliver year after year returns with no care or attention required as some investors might hope; franchisors have found that they have to inject funds to move the brand forward; and franchisees know that they deal with operating losses and capital spending (CAPEX) to develop and maintain their units.

What underpins the restaurant franchise world is care and attention to brand stewardship and maintaining proper store economics.

A useful illustration is the journey that YUM /Pizza Hut has undergone the last several quarters, particularly with regards to their US Pizza Hut brand. Pizza Hut US has lost market share for decades. Since 2013, Pizza Hut system sales fell about $500 million, while Dominos rose almost $3 billion. <1> Pizza Hut concentrated on price point marketing. In addition, about 40% of its US stores remained to be the dated “dine in” stores, some also known as “Red Roofs”.  These are lower volume stores—analysts estimate the dine in stores had only 10% of US sales but had 40% of US unit locations, implying lower AUVs. <2>

In 2015, I had a meeting in central New Jersey and had the opportunity to quickly shop a Red Roof Pizza Hut. It was an immense unit and no doubt had some pickup business but the dining room was totally empty at 545p on a winter Tuesday. Empty dining rooms do not draw customers. If it delivered, that POP messaging was lost to me. I can only imagine how difficult it was to service a pizza buffet given such low volume.

Franchisors have to spend money

In 2017, YUM agreed to invest $130M in a Pizza Hut US “Transformation Agreement” which included corporate spending in improving operations, accelerating, technology, E commerce, and a $25M media fund boost in 2017 and$13M in 2018. At the same time, franchisees agreed to up their advertising contribution. <3>

On their recent Quarter 2 call, YUM noted the urgency to fix US Pizza Hut store base more quickly and called out that US same store sales and unit counts would be impacted as app. 500 US dine in units are closed and hopefully replaced by the same number of delivery units over time. It was noted:

…But as we get into the specific situations and sort them out, there may be some situations where we deploy a little capital in the short term to flip a market and get it in the hands of someone else and then take our capital back out. So, we will update you…. <4>

Note that this comment relates to the franchisor’s capital, not the affected franchisees. We can reasonably assume they will be in bad shape.

Franchisees Have to Spend Money

Pizza Hut has many kinds of unit types that vary in size and cost. The problem for a franchisee of course, is once their unit is built years earlier, it becomes a permanent investment, as fixed of an investment as it gets. Often there is debt service to start with and there is a continual need to remodel, repair, maintain and keep up with brand mandates. If the brand is weak, if the store EBITDA before CAPEX, debt service and taxes is low, it is very difficult situation for the franchisee to be in.<5> My best sense of a blended 2018 US Pizza Hut franchisee EBITDA rate is app. 7-9%, which is very low.

A special note is that the largest Pizza Hut US franchisee, NPC, one of the largest franchisees in the world, is itself extremely stressed currently. In April 2019, Standard and Poor’s downgraded NPC debt to CCC plus, based on very weak credit metrics, negative free cash flow exacerbated by high capital spending for remodels and modest new unit growth. Poor unit level sales and financial results thus trickle down. NPC has traded hands and is now privately held. This demonstrates the store level economics problems and also may restrain NPC as a possible solution to capturing the closed red roofs.

Pizza Hut had been trying to get franchisees to convert to delivery only units for some time. But as I was reminded this week, via a return tweet from a franchisee, the Pizza Hut remodel standards can be costly<6>, especially if the franchisee has no money.

Recommendations to get through the trickiest of minefields

Of course, maintaining the brand at a high level is everyone’s common goal especially at the 30,000-foot level. But common goals may break down at the 1000-foot level where day to day tactics are put in place.

Both the franchisor and the franchisee have demands upon it: demands for after tax free cash flow. The franchisor has demands for funds for some amount of capital spending to sustain the brand but also almost really unlimited demands for share buybacks funds and for dividends for investors. The franchisees have demands also: to live on the after-tax free cash flow generated by the business, but also to live up to store development agreements, remodel stores and make strategic acquisitions if they are in the position to do so.

On the balance sheet, both the franchisor and franchisee need to make better use of restricted cash accounts, even if just as a memorandum entry…. to show what funds it would need…if it had funds…for remodeling or IT, or new initiatives. It becomes a signal to management that if funds become available, funds should be socked away.

Both franchisors and franchisees should avoid promises it really should not make: activist investors press franchisors to commit to levels of franchised restaurants and levels of G&A, and cash returned to share holders that cannot be absolute. For example, three years ago, no PE activist could have foreseen how delivery could have developed and the fact that active levels of franchisor CAPEX investment would be required. There should be some natural give and take. And so, on the franchise side. If store level economics collapse, how properly can a brand require franchisee x produce the same number of stores under an SDA that was written eight years ago?

Finally, franchisors just simply must operate some amount of company stores every year. In my experience, without it, there is just not the vibrancy of opinion in corporate to be focused on solving store issues quickly.

About the author: John A. Gordon is a long-time restaurant industry veteran and works complex restaurant operations, financial analysis and strategy engagements via his consulting firm, Pacific Management Consulting Group. He will be present at the Restaurant Finance and Development Conference in November 2019, helping moderate a panel about…. restaurant franchising issues. Contact him at jgordon@pacificmanagementconsultinggroup.com, office (858)874-6626.

<1>   Technomic Top 500 Chain Restaurant Report. See:  https://www.restaurantbusinessonline.com/financing/pizza-hut-works-fix-its-asset-problem

<2>   Sell side restaurant analyst conversation with author, August 2019.

<3>   Nation’s Restaurant News, https://www.nrn.com/operations/yum/invest-130m-pizza-hut May 3 2017

<4>  https://www.seekingalpha.com/article/4280203-yum-brands-inc-yum-ceo-greg-creed-q2-2019-results-earnings-call-transcript

<5>   Hence the phrase: “the franchisor gets paid off the top line and the franchisee gets paid off the bottom line.”

<6>   Numbers are all over the board, from dine in remodel levels of app. $200K and lower.