Franchising under pressure

One of the franchise industry’s favourite pitches to potential franchisees is that the failure rate in franchising is much lower than small business in general.

The argument goes something like this: Franchising, by virtue of offering an established business system and brand, is a safer bet than starting your own business.

But the recession is casting doubt on this argument. Franchised jeweller Kleins, franchised car care chain Midas and franchised DVD retailer EzyDVD have all fallen into administration. The latest casualty, kitchen and laundry appliance group Kleenmaid, looks likely to take at least 15 franchised retail stores down with it.

Can the franchising model survive the recession, or was franchising just a sign of the good times?

It’s certainly true that the boom in franchising has coincided with a long period of economic sunshine. Since 2002, the number of franchise systems operating in Australia has jumped from 700 to just over 1000.  Franchising offered a fast way to grow, as new recruits brought capital and the enthusiasm that springs from having “skin in the game”.

But now, times have changed. Many franchisees are seeing their revenue fall. For franchisors whose model revolves around them taking a percentage of franchisee revenue as a royalty, earnings will also fall.

Whether franchisors can maintain profitability without fee gouging from struggling franchisees, or cutting and thereby compromising services to franchisees, is a question that must be asked by the industry – particularly with all the newly-unemployed likely to consider franchising as their next career move.

Some observers believe there is a strong risk that some franchisors won’t be able to resist the temptation to sell franchises to anybody with a purse and a pulse, just to raise cash and keep themselves afloat.

Who will survive?

Most industry observers are expecting more casualties in the industry.

Jason Gehrke, franchise consultant and SmartCompany blogger, believes franchisors collecting royalties as a percentage of franchisee turnover are most vulnerable.

“If sales stagnate or decline, then royalties to the franchisor will be reduced, which can lead to cashflow problems for the franchisor. It could lead to a need to cut costs, including staff and services to franchisees – potentially when the franchisees need these services the most,” he says.

He believes the highly geared chains, those hit by a decrease in discretionary spending, and those failing to meet changing consumer tastes, will fail first.  When EzyDVD went into receivership last December, the administrator David Kidman at Ferrier Hodgson, blamed the collapse on high levels of debt.

Other industry observers are arguing that it is the chains that have failed to reach critical mass that are most vulnerable.

“I’m concerned about franchising because there is a significant number of marginal operators that expanded too quickly on cheap credit,” says Frank Zumbo, associate professor of business law at the University of News South Wales, who has researched past franchising failures.

Zumbo says the franchising industry has been particularly susceptible to becoming over-geared because of the pressure to build critical mass quickly. The chains had a great incentive to get big quickly during boom times because with size comes better deals from suppliers, landlords and greater brand recognition.

But he says that the chains that didn’t make it to critical mass before the boom ended are most at risk of failure as demand falls away and credit is harder to get.

Not everyone is so gloomy. Adrian McFedries, managing director of franchise consultancy DC Strategy, argues that franchised businesses are no more vulnerable than those run on any other model. But he says franchises in some sectors are getting hit hard. 

 “The performance of franchises is driven by the performance of the sector they are in. The slowdown hasn’t hit all sectors equally,” he says. For example, he says bulky goods retailing, with whitegoods retailer Kleenmaid being the most obvious casualty, is doing it tougher than food retail.

McFedries acknowledges there will be more casualties of this recession, of both franchised and non-franchised businesses. Those that fail will be the weaker operators.

Despite the gloom, Gehrke actually believes there will be no fewer franchise chains when the recession is over. In fact there could still be growth of the industry overall as companies that currently do not have franchised operations try to start selling franchises to rid themselves of unprofitable assets and raise cash.

An example of this is mobile phone and electronics retailer Strathfield, which collapsed into administration earlier this year but emerged after a major shareholder injected fresh capital. Strathfield has announced it will pursue a franchise strategy as it attempts to turn its fortunes around.

These struggling would-be franchisors are likely to be joined by existing franchisors with cashflow problems in ramping up promotion of franchises for sale.