The successful franchise restaurant model

In the last part of this series, we learned about restaurants that use the company-operated model. The second model widely used by restaurants includes franchise and licensing.

Restaurants have successfully expanded locally and globally, and very quickly, using the franchise model. For example, restaurants such as KFC, Taco Bell, and Pizza Hut under Yum! Brands (YUM); McDonald’s (MCD) and IHOP under DineEquity (DIN); and Buffalo Wild Wing (BWLD) have opted to use the franchise model.

In a franchise business model, the franchisor (McDonald’s, for example) and the franchisee enter into a contractual agreement to sell the franchisor’s (McDonald’s) branded products. The franchisee takes on the burden of developing the restaurant, staffing, overseeing day-to-day operations, and managing costs for running the restaurant. The franchisor (McDonald’s) may own the location of the restaurant and lease it to a franchisee. Usually, the franchisee pays an initial fee as well as royalties from the restaurant’s sales to the franchisor. If the franchisee leases the place from the franchisor, then the franchisee pays rent as well. The franchisor reports these incomes as revenue. Due to eliminated operational costs, the margins are higher for the franchisor.

The benefits of using this model include the opportunity for the company to grow faster because the franchisee provides the capital for making the restaurant ready for operation. The franchisor faces lower risk if the store underperforms.

The franchisor also has more time to focus on product and operation research and less on execution. Since the restaurant is owned by the franchisee, who’s highly motivated to make the restaurant a success, it also eliminates the agency issue. The franchise is only as good as the restaurant boss, whose capital is employed in the restaurant.

The downside of this model is that the company has less control over management.

Burger King (BKW) and Dunkin’ Donuts (DNKN) are almost all franchised restaurants, but many restaurants such as Brinker International (EAT), Texas Roadhouse (TXRH), and those included in the exchange-traded fund (or ETF) Consumer Discretionary Select Sector Standard and Poors depositary receipt (or SPDR) (XLY) operate under both models.

Whichever model a restaurant follows, it is increasingly targeting the Milennial Generation, which we will discuss next.