The remarkable thing about the franchise industry is that in theory it shouldn’t work, but in practice it does. For instance, there’s very little that can’t be copied in the restaurant sector: there’s hardly any legal protection against a competitor imitating designs, menus and themes. Yet Subway, McDonald’s, 7-Eleven, Dunkin’ Donuts and Domino’s Pizza are obviously successful franchise businesses.
The way franchising works is that the franchisor licenses the brand and intellectual property to the franchisee, who trades as a small business. The franchisee operates using the back-office systems that the franchisor has set up and enjoys support in the form of training and mentoring.
The question is whether the benefits accrue to the franchisee, who works hard dealing with the day-to-day problems of running a small business, or the franchisor, who has developed the concept and is earning abundant fees while putting little capital at risk.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Some franchisors report strong revenue growth, while experiencing “churn” – recruiting new franchisees to replace disillusioned ones who have failed to earn a living. This model eventually becomes unsustainable, as word gets out that the economics are unfavourable to franchisees.
But when everything goes well, you have a Domino’s Pizza. Shares of Domino’s Pizza Group (DPG), the UK master franchise, have increased in value 44-fold in the last 20 years. The US founding company, Domino’s Pizza, is up 28-fold since it listed in 2004.
A different kind of franchise
While Domino’s is hugely successful, it’s unlikely that either the US or UK pizza restaurant will repeat that kind of share-price performance in the next 20 years. Instead, the former DPG management team (Stephen Hemsley, Nigel Wray, Colin Rees, Andrew Mallows, Robin Auld and Rob Bellhouse) left and set out to repeat their success with franchising.
Franchise Brands (Aim: FRAN) was founded by Stephen Hemsley and Nigel Wray and listed on Aim in 2016 at 40p per share. Since 2016 revenue has more than doubled, from £21m to £58m in 2021.
Franchise Brands’ strategy has been to acquire a variety of franchise businesses and then put them on the same common platform for administration, marketing and IT functions. It has focused on less glamorous areas than pizza restaurants. Two commercial-plumbing businesses together make up the bulk of group revenues: Metro Rod was 63% of 2021 revenues and Willow Pumps was 26% of revenues.
Metro Rod, which Franchise Brands bought from a private equity seller in 2017 for £28m, grew at 23% last year. The division was resilient in the lockdown because it focuses on drain clearing and maintenance. Around 90% of Metro Rod’s £28m revenues come from management services fees, which are paid to it by franchisees (the calculation is 18.6% of the franchisees’ turnover).
Willow Pumps is around half the size of Metro Rod and has been less resilient. Willow installs pump stations, which are typically long-term projects often for the housebuilding sector, where labour shortages and rising raw materials prices have delayed building projects.
Recovering from the pandemic
Franchise Brands’ other operations include services to consumers, such as oven cleaning (Ovenclean), car-chips repairs (ChipsAway) and dog sitting (Barking Mad). These amounted to 11% of group revenues last year. For these businesses, Franchise Brands charges franchisees an upfront fee, rather than a percentage of the franchisees’ revenue.
The pandemic restrictions have meant that all these brands have struggled. Lockdowns meant less driving, hence drivers not chipping their car paintwork, which affected ChipsAway. Fewer people took foreign holidays and had less need for someone to look after their dog, which affected Barking Mad.
Management took the decision to mitigate the impact on franchisees, so fees were reduced and other charges suspended. That meant a short-term hit to revenue, but hopefully stronger relationships with franchisees in future.
The businesses are now recovering. Factor in the opportune acquisition of another franchise that has been battered by lockdowns (see below) and brokers’ forecasts that revenues could double by 2023 look achievable.
More room for rapid growth
In February, Franchise Brands’ management announced a deal to buy Filta, another franchise business. Filta recycles used cooking fat at commercial restaurants. Filta has struggled through the pandemic, as commercial kitchens have been affected by various lockdowns.
The all-share offer values Filta at £50m, which translates to a forecast price/earnings (p/e) ratio of 20 times forecast 2022 earnings. Before the deal was announced, Franchise Brands’ own shares were trading on almost 30 times forecast earnings, and a price/sales ratio of 2.8. That premium rating means that the acquirer can use its own paper as a valuable acquisition currency. The deal is set to close on 6 May, but Franchise Brands has already announced that it has received over 90% acceptances, so the offer will go through.
Franchise Brands also hopes to benefit from “the great resignation” as wage slaves reassess their lives and decide to quit their jobs in favour of more entrepreneurial activities. Allenby Capital, the firm’s broker, is forecasting that revenues will rise from £58m in 2021 to £110m in 2023, producing earnings of 8.4p in 2023. This includes the uplift from the acquisition of Filta. That puts the shares on a forecast p/e of just under 20. That may seem pricey in this market, but it has a good record of growth since it listed in 2016 and management that seems to know how to make franchising work.
Bruce is a self-invested, low-frequency, buy-and-hold investor focused on quality. A former equity analyst, specialising in UK banks, Bruce now writes for MoneyWeek and Sharepad. He also does his own investing, and enjoy beach volleyball in my spare time. Bruce co-hosts the Investors' Roundtable Podcast with Roland Head, Mark Simpson and Maynard Paton.
Contributions to Tax-Free Childcare accounts rise but many parents aren't using the scheme
News Fewer than 60% of open Tax-Free Childcare accounts are used - could you be missing out?
By Marc Shoffman Published
Pensioners to receive up to £600 in winter support - who is eligible and how to claim
Up to £600 in cost-of-living payments is starting to land in pensioners’ bank accounts. We explain who qualifies and what to do if you don’t receive the cash.
By Ruth Emery Published
M&S shares shift from frumpy to fabulous as pre-tax profits are up by 56%
M&S is performing strongly and has announced it will pay a dividend for the first time since the pandemic.
By Dr Matthew Partridge Published
The rise and fall of Sam Bankman-Fried – the “boy wonder of crypto”
Why the fate of Sam Bankman-Fried reminds us to be wary of digital tokens and unregulated financial intermediaries.
By Jane Lewis Published
Three defence stocks set to flourish in an era of instability
A professional investor tells MoneyWeek where he’d put his money. Tom Bailey highlights three defence stocks that look promising.
By Tom Bailey Published
EasyJet shares are volatile but enticingly cheap
The EasyJet group has shrugged off the cost-of-living crisis, restarted dividends and shares look good value.
By Dr Matthew Partridge Published
The fallout from the war on landlords
Investors fleeing the market and the rise in rents are affecting us all.
By Charlie Ellingworth Published
Eight small-cap trusts to bet on
Funds investing in market minnows are out of favour, but the cycle will turn. Here are the best bets.
By Max King Published
Trust in US TIPS to beat inflation
In an inflationary market TIPS, the US Treasury Inflation-Protected Securities are most compelling says Cris Sholto Heaton.
By Cris Sholto Heaton Published
What is Vix – the fear index?
What is Vix? We explain how the fear index could guide your investment decisions.
By Dr Matthew Partridge Published