Investing in the Profitable Franchise Model
Matthew is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
As one of the great American business innovations of the nineteenth century, franchising has proven itself over the decades to be an extremely successful and profitable business model. The Coca-Cola Company (NYSE: KO) was one of the first companies to put franchising into use, which they still do to this very day. Operating under a type of franchising known as the ‘bottler system,’ The Coca-Cola Company enters into franchise agreements with independent bottling groups around the world.
Under this bottler system, Coca-Cola itself does not actually produce the final product you find on store shelves. For Coke, their only product is syrup concentrate. The company produces syrup concentrate and sells that syrup directly to the independent bottlers. It is these bottlers who are responsible for mixing the syrup into soda, sweetening it, bottling it, selling it, transporting it and delivering it to grocery stores, convenience stores, restaurants and vending machines. PepsiCo (NYSE: PEP) also operated a similar bottler system before they acquired their major independent bottlers in 2009.
While The Coca-Cola Company’s bottler system is one of the oldest forms of franchising, most readers are probably much more familiar with the system employed by much of the fast food industry, McDonald’s Corporation (NYSE: MCD) being the best such example. McDonald’s has used franchising to great effect, with over 27,000 of its 33,000 global restaurants being operated by franchisees.
For McDonald’s, the typical franchise agreement is fairly similar among all of its individual franchisees. To become a McDonald’s franchisee, an individual has to pay McDonald’s an initial, one-time, franchisee fee of currently around half-a-million dollars per restaurant. Monthly on-going fees must also be paid during the duration of the franchise agreement and include royalty fees of around 12% of total revenue and advertising fees of 4%. Additionally, the majority of McDonald’s restaurants and the land underneath those restaurants are owned directly by McDonald’s. Franchisees are required to also pay monthly rent payments for use of McDonald’s buildings and real estate property. For these fees a franchisee is allowed to operate a McDonald’s restaurant under a typically 20-year franchise agreement. Those are royalty fees, advertising fees and rent that McDonald’s can predictably expect from its 27,000 worldwide franchisee every month for 20-years. And once that 20-year contract expires, McDonald’s can then renegotiate the contract under new favorable terms and start the whole process over again. A great business to have if you can get it.
This form of franchising is not limited to the fast food industry. In the convenience store space, the Japanese retail conglomerate Seven & I Holdings Co. (NASDAQOTH: SVNDY) and its 7-Eleven brand operates a similar franchise model. 7-Eleven has used franchising to build-out its over 45,000 convenience stores in 16 countries (more stories than any other company on the planet). Like McDonald’s, 7-Eleven owns the building and land of its franchises stores. This essentially makes McDonald’s and Seven & I Holdings more of a real estate company than a play on actual restaurant and convenience store retail.
The fees The Coca-Cola Company, McDonald’s and 7-Eleven receive from their franchisees are reinvested back into the overall business. Fees collected by these three go toward regional, national and international advertising campaigns to further expand the brand. Further expansion of the brand will in turn result in high fees these companies will be able to demand from their franchisees once the contracts have expired. Fees are also used to fund expansion of the McDonald’s and 7-Eleven’s global stores count--expansion that happens much faster than with company-operated business models. And with faster expansion comes greater scale, which is used to lower operating costs and further boost the company’s balance sheet.
The franchise concept has worked very well for these three companies, making each of them the undisputed leaders in their respective retail spaces. Looking for similar industry leading franchise buinesses models could be the key for investors. Their marketplace leadership creates significant barriers for entry, leaving individuals with the choice of competing with a global leader or joining forces through franchising. If you can't beat them, join them. For these individuals, the benefits of buying-in and joining-up with a well-run company are well worth the franchise costs. And it is these costs that have made these three companies some of the most successful, profitable and shareholder friendly companies in the world.
WhichStocksWork owns shares of McDonald's and Seven & I Holdings Co. The Motley Fool owns shares of The Coca-Cola Company, McDonald's, and PepsiCo. Motley Fool newsletter services recommend McDonald's, PepsiCo, and The Coca-Cola Company. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.