We demonstrated in the past how much we fancy capital-light businesses. In this sense, what can be better for us than a company that not only consumes little capital itself but also can leverage others’ capital for free to grow its own business? Does this sound too good to be true? Well, that is essentially what franchising is all about.
Just as when Ray Kroc convinced the McDonald brothers to “franchise the damn thing” a few decades ago, the concept is by no means novel. It has actually been a proven helping hand for a few restaurant incumbents like McDonald’s (MCD, Financial) and Yum! Brand (YUM, Financial) as well as rising stars such as Domino’s Pizza (DPZ, Financial) and Wingstop (WING, Financial) to generate tremendous wealth for their shareholders.
The business model is simple – the franchisor provides the rights to use its assets (e.g., brand, technology, real estate), know-how and supports (e.g., advertising, supply chain, financing) in exchange for franchise fees, royalties and/or other relevant payments (e.g. supply, lease). The franchisee would be responsible for the on-the-ground operations as well as, most importantly, the initial and ongoing investments. The latest 10-K of Yum! Brand describes that “franchisees supply capital by purchasing or leasing the land, building, equipment, signs, seating, inventories and supplies and, over the longer term, by reinvesting in the business.”
The revenue stream for franchisors is not only scalable and high-margin but also recurring and predictable, as the franchise agreement is typically long-term and franchisees would share the business risk (more on the downside). Having that said, we do not see all franchisors as equal and, as always, are quite selective in terms of picking the next long-term outperformer.
Snack Empire (HKSE:01843, Financial) is one of the franchisors that we like from the investment perspective and has just become our portfolio company this year. You may have never heard of the company name, but the brand that it operates, "Shihlin," is especially well-known over many places in the Far East. Originating in Taiwan (as a form of night market), the street-snack type of food/beverage concept appears to have traveled well across borders – from Singapore to Malaysia, Indonesia, the U.S. and, even places like Egypt and Cambodia. In its fiscal year 2020 (which ended in March 2020), Snack Empire had nearly 250 units globally, almost 90% of which were run through franchise partnerships. Our calculation indicates that the business earns an over 50% return on reinvested/incremental capital. Unlike many of its western peers, the company has a much sounder balance sheet with minimal debt and plenty of liquidity.
In contrast to what the "Empire" portion of the name may imply, the Singapore-based, Hong Kong-listed business merely has a market cap of 350 million Hong Kong dollars ($45 million). Most shares are owned by its two founders, who are still in charge of the day-to-day management. Given the company's differentiated offerings and its tiny market share per our estimate, we think that Snack Empire has a massive runway ahead and would not be surprised if the stock turns out to be a multi-bagger for investors.
Lastly, it is worth noting that franchising is not a privilege for restaurants. Some high-quality examples include convenience-store giant Alimentation Couche-Tard (TSX:ATD.A, Financial) (TSX:ATD.B, Financial), used-goods retailer Winmark (WINA, Financial) and hotel franchisor Choice Hotels International (CHH, Financial). We own the first one and keep our close eyes on the latter two in our Investable Universe. All three possess the track record of delivering superior returns on capital consistently for a long time.
Disclosure: The mention of any security 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. I/We have position(s) in any of the securities referenced in this article.
This article was written by the author and first appeared in Hillside's monthly newsletter.
