Consolidation - this has arguably been one of the largest and most important trends in the franchised sector over the past few years, and it’s not hard to see why. One definition of consolidation is “a solidification and strengthening”; terms that also describe two of the most critical aspects of running a successful multi-unit operating company today. While we expect this trend to continue in the restaurant industry, we also believe that consolidation will have a significant impact on other franchised brands in new and exciting ways.
The consolidation trend in franchising has historically been driven by traditional, restaurant industry tier 1 and tier 2 brands in the QSR and Casual Dining segments. The economic reality of declining traffic, heavy discounting and prime cost pressure, combined with heavy governmental regulation, has created a much more complex business model for our industry. Smaller operators have taken the brunt of these changes, and in many cases, the answer has been to sell to a “consolidator” in the same franchised system. These consolidators typically have an established organization and infrastructure that allows them to deliver a level of professional management and leverage fixed overhead costs in a way smaller franchisees simply can’t match.
The traditional consolidation model witnessed in recent years will remain prevalent as we move forward, but this activity is likely to slow down as the seller pool of small companies, whom operate top tier restaurant brands, shrinks. To be sure, we believe that this specific archetype will maintain its strong momentum for the foreseeable future; with large absolute numbers, a significant number of aging franchisees, and a new era of sophisticated buyers looking to achieve rapid growth, this form of consolidation is not going anywhere soon. Tier 1 and 2 brands have been the frontrunners in attracting buyers seeking growth through mergers and acquisitions due to the sheer number of restaurants in their respective systems, large geographic footprints, and simply a greater number of available opportunities to consider.
Eventually, there will come a time where these massive consolidated operators, will reach a critical mass and no longer have the desire or ability to acquire more stores. We have already started seeing certain franchisors implement size limits on their franchisees, creating incentive in these large scale operating companies to seek opportunities in new franchised brands. Although mega-franchisees benefit from their immense size due to the greater predictability of operational results and returns through economies of scale, implementation of modern technology, market control, and fixed cost leverage, there is still a point at which big becomes too big, and benefits turn into inefficiencies.
Now the question is, once top tier consolidation slows, where will this leave the franchise industry? First and foremost, we suspect that strategic buyers will turn their attention to tier 3 and 4 restaurant brands, as well as regionally specific brands. It is within these smaller brands that the greatest untapped potential for consolidation lies. The opportunity in this segment will additionally attract a greater number of interested purchasers due to the inherently lower valuations these brands receive. Also meaningful is the risk and reward tradeoff a buyer would encounter upon entering a less mature brand’s system with high growth opportunity. In turn, this leads to another appealing aspect of consolidating brands smaller in scale: the buyer’s greater ability to control a larger portion of a system’s franchised universe. This is especially desirable when purchasers are seeking “the next greatest thing”, with the intention to enter a system at the ground level into order to obtain superior control within a brand.
We are already seeing this consolidation trend follow suit in the non-restaurant franchise world. While it remains true that restaurant franchising is the most widespread use of the business model, the industry will inevitably become overpopulated in the future. This saturation in the restaurant realm will make franchisees seek outside opportunities that have a less competitive purchasing process. The industries that are likely to see an uptick in attractiveness include auto services and repair, service businesses such as house cleaning, day spas, health centers, fitness centers, senior care, pet care, dry cleaning, and early childhood development. The opportunity for franchising consolidation in the future is immense, as transactions in these industries are desirable for the same reasons as the smaller restaurant brands: purchasers are typically working with lower valuations and have a greater chance of controlling a significant portion of the franchised system.
The bottom line is that the franchising business model works. It enables entrepreneurs to run their own businesses without falling prey to the fundamental risks of creating a new and unique concept. Operating a franchised brand gives buyers a sense of safety and security, having stemmed from the existing familiarity with the concept. We will continue to see the application of the basic, time honored concept of franchising push itself into other non-food industries; this is clearly the free market at work, with the survival of the strongest business models, like franchising, reigning supreme. It is because franchising has proven itself time after time that it’s an incredibly successful way in which to run a large, multi-unit company that we believe there are no upper bounds in what can be achieved in operating businesses in this domain.