Franchising feels the pain

It’s not going to be a rosy year for any business model, but franchising’s crystal ball is especially foggy. We delve into the likely scenarios to get a better view.

Even the most optimistic franchisor has to accept that 2009 is likely to be a tough year for the $161 billion sector.

In the past three years, revenue for the 1000 franchise chains and nearly 70,000 outlets has increased by more than 16% or $27 billion, according to research company IBISWorld.

But that was before the global financial crisis hit.

In 2009, growth will be harder to come by. Disputes will rise as profitability becomes a problem and more franchised businesses will follow Midas, Kleins and EzyDVD into failure.

On top of this, the sector could be facing more federal regulation in response to the last Parliamentary inquiry into franchising.

But there will be some bright spots. Recruitment of new franchisees could get easier, and for those with franchise systems with strong balance sheets there are likely to be opportunities to expand.

Smart franchises with the right strategies will survive.

Recruits will come, but franchisors still desperate

The looming surge in unemployment has many in the franchise sector hoping that it will get easier to recruit new franchisees as laid off workers look to invest their super and redundancy packages in a franchise.

Steve Wright, chief executive of the Franchise Council of Australia (FCA), says there are already signs that this is happening, particularly for the service franchise chains with lower initial franchise fees, such as cleaning franchises, pool maintenance and dog washers.

The more expensive franchises are expecting the increased interest from people with payouts to come later.

“Not enough people have lost their jobs yet to cause the gold rush to franchising,” says Jason Gehrke, director of Franchise Advisory Centre. “The redundancies only started happening in late November. And franchising will not be the first option for many. But they’ll look at it after they have exhausted other options and it will be something completely different to what they are used to.”

But despite the predictions of a recruiting boom, there is evidence that franchisors are still finding it tough to expand and arguably they are getting more desperate.

Jumping castle franchise Jumping J-Jays has given away a free franchise in Melbourne worth $50,000, and is preparing to give another away in Canberra this year. And franchises Beauty Spa Group and Hire-A-Hubby have been reported as giving discounts for franchises.

“It’s not a good idea,” says Frank Zumbo, an associate professor at the University of New South Wales who has studied Australia’s franchising sector closely.

He says it devalues the brand and damages the resale value of other franchises in the chain. Now more than ever franchisors need to be recruiting wisely.

“It’s irresponsible. It shows the franchisor is treating the franchisee as a moneybag to be exploited. It’s important that franchisors don’t throw out good franchise selection criteria simply to raise cash,” he says.

Profitability under pressure

Will sales be strong enough to support increased numbers of franchisees?

The real issue for many chains in 2009 will be profitability. As consumer confidence has plummeted, sales are slowing. Franchisees are likely to find the going tougher and franchisees – many of which earn the lion’s share of their revenue from taking a percentage of the franchisee’s turnover – will be hit.

The good news is that the Government’s stimulus package that handed $10.4 billion to consumers before Christmas had a positive effect, and the further Government fiscal stimulus is expected to offer another boost to the sector.

Falling petrol prices have cut costs for many chains, especially mobile fleets of lawn mowers, car washers, cleaners and the rest. But on the other hand, many are coping with rents locked in during boom times.

FCA’s Wright says franchisors are reporting that franchisees haven’t suffered the crash that some had predicted, but they are still very cautious.

“They are doing all they can to cut costs and trim fat and reduce exposure.”

Who is in debt?

No one knows for sure what kind of debt the franchise sector is carrying. Most are private companies, and Frank Zumbo says that in many cases not even the franchisees know how leveraged their franchisor is, since they are not required under the franchising code to disclose their balance sheets to franchisor – just an auditor’s statement

But it is reasonable to assume that with the easy credit that has been available to franchisors looking to grow, and prospective franchisees looking to get into franchising, there is a significant amount of debt underpinning the sector.

With cashflows tightening these are the chains – and franchisees within chains – that could get into trouble.

Banks tighten the screws

Franchisors expecting their banks will help them out of a hole are likely to be disappointed – there are reports the banks are tightening their lending criteria for franchising.

SmartCompany understands that at least one bank has increased its risk rating on franchisors, and at least one chain has lost its accreditation with its bank.

This has big implications for prospective franchisees, because buying a franchise in an accredited chain gives access to more favourable interest rates and lower security requirements.

As for tapping capital from private equity – forget it. It’s generally accepted in the industry that there will be no more acquisitions funded by private equity firms in the foreseeable future.

More failures are likely, and consolidation

Last year EzyDVD, Kleins and Midas hit the skids. This year more chains are likely to fail.

Experts have been saying for years that Australia has too many franchise chains, and if your franchise system couldn’t reach critical mass in the boom times, you won’t in a recession.

“There will be a day of reckoning,” says Zumbo. “And it’s coming very quickly.”

Well-capitalised big chains will be able to pick up bargains. Chains in particularly vulnerable sectors like mortgage broking are likely to be first. The coffee sector is also a strong candidate for consolidation. It has boomed in the last 10 years, but coffee is a discretionary expense vulnerable to a downturn.

FCA’s Wright, perhaps optimistically, says it’s not clear yet whether it will be a zero-sum game or whether there will be growth of the sector as a whole. “Hopefully it’s the latter.”

New regulations – more red tape?

Further franchisor failures are likely to ratchet up pressure for more regulation of the sector. The Federal Parliamentary inquiry into the industry reported to Government in December, and the industry awaits Government’s response.

SmartCompany attempted to contact Small Business Minister Craig Emerson several times for an update, without success.

FCA’s Wright says he spoke to the Emerson last week, and he did not detect any indication of action likely right away. Wright speculates that change to the laws is unlikely this year because of other Government priorities and the fact that the previous round of reform following the Matthews review is not even 12 months old.

If this is the case, there are many in the industry who will be very upset. Zumbo says the recommendations to Government, including one to introduce a good faith obligation, are not designed to increase costs, but to create a more balanced relationship between franchisors and franchisees.

“There are problems that need to be addressed, and if they are not there will be an increase in disputation in the sector,” he says.

More disputes are likely

Falling profitability is bound to lead to conflict between franchisor and franchisee. As franchisors make their operations leaner to keep costs down, they are likely to be stretched to address franchisee concerns and give them the extra support they need.

Zumbo says that disputes happen typically when desperate franchisors try to shift the pain on to franchisees. The better franchisors will work co-operatively with franchisees and see how they can help. “If franchisors have a siege mentality and try to bully their way out of trouble, it is a recipe for more disputes and disaster,” Zumbo says.

Given the more difficult conditions ahead, prospective franchisees are being urged to do extensive research before buying into a chain.

Franchise Advisory Centre’s Gehrke recommends that for every $1000 to be invested in a franchise, the prospective buyer must spend at least one hour in due diligence. He suggests working in the business and get a feel for the culture, doing a small business or franchise course, reading every single document provided, getting advice from professionals, and verifying every statement made by the franchisor. And finally, go to the shopping centre and count the customers for yourself.

New opportunities

Despite the gloomy environment, the optimism of some in the sector is irrepressible. Wright reports that he processed 25 new applications for the FCA at the last board meeting, and these usually represent new entrants to the sector. He says he’d be surprised if there were not new franchises started in the coming year.

‘The switch from hospitality-related services in franchising to personal, health, home services, with a wellbeing and environmental focus as the areas of growth, has been quite substantial, and I think it has further to run.”