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Steven Chen
Steven Chen
Articles (206)  | Author's Website |

Urbem's 'Quality Strategy' Series: The Franchisor

What could be better than using others' money for free to grow your business?

At Urbem, we love to find opportunities among franchisors. In the end, what could be better than using others’ money for free to grow your business? Thanks to this unique feature, the franchise model offers a few benefits to shareholders, including a high quality of revenue (e.g., high margin, strong cash flow), predictability, scalability, shared business risk, asset-light operations and motivated unit managers.

However, not all franchisors are created equal. From an investor’s perspective, we have to look for a high return on capital with an enduring competitive advantage, commonly via brand, scale or switching costs. Besides, the company preferably has a sizable runway to deliver secular growth for years to come through both regional expansion and same-store sales growth.

Over the past several years, our favorite franchisor businesses have been Domino’s Pizza (NYSE:DPZ) and Choice Hotels International (NYSE:CHH). Both companies have delivered tremendous shareholder value through a robust franchise model with attractive unit economics in a lucrative industry.

Michigan-based Domino’s Pizza is the world’s largest pizza company based on retail sales and the recognized leader in pizza delivery, operating a global network of 16,300 stores in more than 85 markets. The company has been benefiting from increasing consumer (mainly millennials) preference for pizza and Mexican food over the more traditional burger and chicken joints. As of the third quarter, there are nearly 800 Domino’s franchisees in the U.S., owning 94% of the almost 6,000 domestic stores, while the vast majority of the over 10,000 international stores are operated by master franchise companies, including Jubilant Foodworks (NSE:JUBLFOOD) in India, Domino’s Pizza Group (LSE:DOM) in the U.K., Alsea SAB de CV (MEX:ALSEA) in Mexico, Domino’s Pizza Enterprises (ASX:DMP) in Australia, Japan, France and Germany, as well as DP Eurasia (LSE:DPEU) in Turkey.

Compared with its peers, Domino’s has favorable unit economics for its franchisees, including low initial capital expenditures, smaller space requirement and remarkable same-store growth (3% to 12% domestically and 3% to 8% internationally over the past several years). We believe that a globally-recognized brand and fortressing network build a substantial competitive moat around the highly profitable restaurant franchise business. The return on assets has improved from 17% to over 35% over the past decade. The company only needs to invest 2% to 3% of total sales in sustaining operations in a typical year. Looking at a still fragmented market, the management at Domino’s sees a room for additional 5,600 stores in the top 15 markets alone, including China (25% penetration), Germany (30% penetration) and Brazil (35% penetration).

Maryland-based Choice Hotels International is one of the largest hotel franchisors in the world, owning proprietary "Choice Brands" such as Comfort Inn, Quality Inn and Econo Lodge. Being the first hotel chain in the U.S., the company possesses a rich history of innovations, including the first 24/7 toll-free reservation hotline, the first global marketing and reservations system and the first real-time rate and availability information platform. As of fiscal 2018, the franchisor had 7,021 hotels (or 569,108 rooms) opened and an additional 1,082 hotels (or 87,061 rooms) under construction, awaiting conversion or approved for development across more than 40 markets worldwide. Choice Hotels typically conducts its domestic franchising through direct relationships and its international franchise operations through a combination of direct and master franchising relationships.

The Choice Brands mainly target the lucrative niche market of business and leisure travelers with a conservative budget and, therefore, avoid more intense competition from the “crowded” premium segment. In addition to the growing brand awareness, the majority of Choice's franchise partnerships are over a decade in duration and embedded with so-called "liquidated damages provisions," which "protect" the franchisor from early terminations. The resulting switching cost further widens the economic moat. At the same time, the company utilizes a significant number of hotels and members to reduce supply costs and enhances operational efficiency for its franchisees. Over the last decade, the return on assets ranged from 12% to 29% and capital expenditure as a percentage of sales from 2% to 6%. It is estimated that by 2030, approximately 1.8 billion tourists will cross borders annually, in contrast with the less than 0.6 million available rooms in Choice’s global network at the moment. We believe that a strong pipeline, continuous overseas expansion and recent development into the higher-end category should fuel healthy growth at Choice Hotels.

Disclosure: The mention of any stock in this article does not constitute an investment recommendation; investors should always conduct careful analysis themselves or consult with their investment advisors before acting in the stock market; we own shares of Domino’s Pizza.

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About the author:

Steven Chen
Steven CHEN is a quality-focused, business-perspective investor (with bottom-up opportunistic approaches), an ex-hedge fund analyst on Wall Street, a serial entrepreneur, computer scientist, and free-market capitalist.

Steven is the Managing Partner of Urbem Partnership, a value/quality-focused investment partnership fund (www.urbem.capital).

Steven can be reached at [email protected], LinkedIn, or WeChat (ID: LSCHEN2005).

Also, check out his column at Smartkarma on the Asian market - www.smartkarma.com/profiles/steven-chen

Visit Steven Chen's Website

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