Companies with franchise business models have often been very good investments over the years. Many have been able to pay generous dividends as well as deliver capital growth for shareholders.

Well-run franchises provide investors with defensive characteristics as well as growth opportunities, and therefore can be a valuable addition to a balanced investment portfolio.

Franchise models can take various forms, but what connects them all is their ‘capital light’ characteristics. That is to say, each franchisee is expected to provide the capital investment and manage the operations in return for the legal right to use a brand or business process.

The main advantage of such an arrangement is that the master franchise owner can expand quickly and without the need to raise equity or bank debt in order to facilitate growth. It is therefore comes with lower financial risk.

HOW DO THEY EARN MONEY?

There are multiple revenue streams available for the franchisor, including royalties for using a brand, a share of revenues, fees for providing training, supplying products on long term contracts and fees for arranging financing.

In return for taking risk, franchisees have an opportunity to become their own boss, run a business and potentially own multiple franchises, enriching themselves in the process.

The opportunity has to first demonstrate clear business merit, with potential for good returns and growth, in order to attract talented entrepreneurs.

BRANDED FRANCHISE MODELS

Cake Box (CBOX:AIM) is a good example of a branded franchise model. It listed on the stock market a year ago and sells egg-free freshly made cakes which are sponge-based and use fresh cream.

Sukh Chamdal and Pardip Dass co-foundered the Cake Box franchise business in 2008, addressing an underserved market of people who either had an egg allergy or observed a lacto-vegetarian diet.

As Cake Box has grown, its products have increasingly appealed to a broader customer base who purchase the group’s cakes despite not requiring egg-free products, thus reducing the company’s reliance on a narrower demographic.

The company has grown predominantly through franchise expansion and does not directly own or operate any Cake Box stores. Today it has 113 outlets and is on course to open around 24 new stores every year. The target is 250 sites in the UK.

The appeal of the stores has been so strong that Cake Box receives over 100 applications every month. These prospects are whittled down to two per month, on average.

Each applicant is responsible for identifying an appropriate site, which is then reviewed by the company for its feasibility. Once approved, the franchisee is required to invest £125,000 to open a store.

A minimum equity contribution of £35,000 (including the deposit) is required, and the rest is usually funded by bank debt.

The company has banking arrangements in place to offer its franchisees, subject to credit approval. Cake Box is not responsible for paying off  the debt.

A lease and franchise agreement are signed (usually for a five-year term) under which the company has a right to terminate the agreement at any time if the franchisee commits any infractions of the rules.

The franchisees are required to purchase all of their ingredients through Cake Box, no substitutions or unauthorised products are allowed.

WHAT’S IN IT FOR FRANCHISEES?

Cake Box has developed an attractive proposition offering a simple and affordable package for new store owners. The hours are reasonably sociable, from 11am to 7pm and 99% of stores are profitable.

The company doesn’t charge any ongoing management fees or marketing levies, unlike many other franchise operators. The brand and distinctive proposition provides the franchisees with the opportunity to grow revenues and on average the stores have seen double-digit like-for-like annual revenue growth.

On average, a store that has been open for at least 12 months will generate £94,000 earnings before interest, tax, depreciation and amortisation (EBITDA) a year. A store has an average payback of 18 months.

This is a very attractive return on investment giving the more enterprising franchisees an opportunity to own multiple outlets. Currently over 20 managers own multiple stores.

HIGH RETURNS ON CAPITAL FOR THE FRANCHISOR

The franchise model has allowed Cake Box to grow its stores rapidly, grabbing market share in a very short space of time, without incurring the financing costs and associated credit risks.

The returns on capital and cash generation are very attractive. For example, Cake Box converts all of its net profits into cash, and generates a very attractive 45% return on equity.

Cake Box is arguably still in the early stages of its expansion phase. It floated on the stock market at 108p in June 2018 and its shares now trade at 171.5p, equal to a 59% capital gain in just over a year. It has also paid out 2.4p in dividends.

OTHER FRANCHISED BUSINESSES IN THE UK MARKET

The best-known franchise company on the UK stock market is Domino’s Pizza (DOM) which holds the master franchise rights for the brand in the UK, Ireland, Switzerland, Liechtenstein and Luxembourg.

It makes money by selling its franchisees ingredients and fresh dough bread as well as charging royalties. It passes on some of the royalty payments to the ultimate owner, Domino’s Pizza International Franchising.

Investors had enjoyed decent gains for a long time until a few years ago. Its international operations have been struggling to deliver the expected levels of growth and UK franchisees have become troublesome for the company by lobbying for a greater share of profits.

This goes to show that franchise companies are not a guaranteed way to make money from investing.

Among the small caps, Filta (FLTA:AIM) offers its franchisees proprietary mobile cooking filtration units (MFUs), with specially designed filters for the sole use with the MFU’s.

The growth in the trend of eating out has led to an increasing number of professional kitchens. These have become subject to more stringent regulations due to the environmental impact of disposing of used oil.

Filtering can double the life of cooking oil, thus lowering costs, while also saving time and removing a potentially dangerous job for the staff. Filta isn’t a pure franchised business as it runs a few other businesses directly.

PORTFOLIO OF FRANCHISES

One of the downsides for investors in franchised businesses is that they are locked into one product, or brand, so have concentration risk. One alternative is to consider investing in a company which has multiple franchises.

A relevant example is Franchise Brands (FRAN:AIM), run by Stephen Hemsley who is considered to be one of the UK’s experts on franchise businesses.

The company earns fees though start-up charges, license fees and product sales. Its franchise portfolio includes car repair firm ChipsAway and Metro Rod, which provides drains clearing and maintenance services across the UK.

PREMIUM PRICE FOR FRANCHISE STOCKS

Franchise companies often trade on high equity valuations. This is partially to reflect their capital-light model and the fact that most are highly cash-generative businesses. Investors are happy to pay a premium price to access the potential capital gains and hopefully generous dividends over time.

The accompanying table illustrates the range of price-to-earnings ratios for UK-quoted franchise stocks.

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