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This month's Master Investor article took a look at restaurant franchisors. McDonalds Corp and Domino's Pizza Inc have been outstanding investments.
Fund Hunter seeks to identify funds that own good stocks. This requires an understanding of what constitutes a good stock. I therefore look at investment sectors and individual companies.
In September 2019's issue of Master Investor Magazine I covered Restaurant Franchisors.
In the Master Investor article I stated that:
Franchisors enjoy the fruits of business success and avoid much of the downside risk.
Two of the largest restaurant master franchisors are McDonald's Corp and Domino's Pizza Inc.
Restaurant franchisors have more often than not been good investments. Their success depends on the durability and growth potential of their restaurant concept.
Franchise the damn thing
The movie The Founder (2016) offers a good insight into McDonald's and franchising. The trailer on IMDB is available here.
Quotes from the trailer:
Franchise the damn thing
There should be McDonald's everywhere...franchise, franchise, franchise.
Are restaurant franchisors stock compounders?
Stock compounders are durable businesses that can 1) generate high returns 2) sustain high returns and 3) realize high-return growth.
This results in free cash flow per share. Share prices move in-line with free cash flow per share over the long-term.
Restaurant master franchisors appear to qualify as stock compounders. This does depend, though, on the durability of their restaurant concept and the remaining growth prospects.
Looking at each factor in turn -
Restaurant franchisors are durable from a financial perspective. They receive franchisee royalty and other payments as long as franchisees remain in business.
Franchisors are compensated on the basis of franchisee activity rather than profitability. McDonald's Corp, for example, saw free cash flow per share increase during the global financial crisis.
The key issue is whether the restaurant concept will remain durable over the long-term.
McDonald's and Domino's Pizza both hit stumbling blocks with like-for-like sales under pressure. However, both companies have since recovered and managed to remain relevant.
The types of restaurants that are franchised tend to be fast food outlets. A general shift away from fast food would undermine the investment case for restaurant franchisors.
McDonald's Corp free cash flow per share and share price
Generate high returns
If restaurant franchisors can franchise the majority of their outlets they have the scope to generate high returns. To attract and keep franchisees the underlying concept needs to be profitable.
Both the franchisee and the franchisor need to earn an attractive return. A number of restaurant groups have struggled to attract franchisees with DP Poland (Domino's Pizza in Poland) a case in point.
High returns depend on the growth potential of the restaurant concept. Larger businesses generate economies of scale.
Sustain high returns
Like-for-like sales are the engine of franchisee profitability. It is a measure of whether existing stores are becoming busier and/or able to increase prices.
Restaurant franchisors are marginally impacted by a decline in franchisee profitability in the short-term. Over the long-term it can have a major impact.
Franchisees are less profitable than franchisors and can come under pressure. Domino's Pizza franchisees in the UK are currently suffering in large part due to increasing costs.
The restaurant sector is competitive and prone to fads. Burgers and pizzas, though, appear to have passed the test of time.
Domino's Pizza Inc earns high returns
Realize high-return growth
This depends on the "white space" for a restaurant concept. McDonald's and Domino's Pizza are both expanding in emerging markets.
The growth prospects for both brands in developed markets is hotly debated. Domino's Pizza Group, for example, is currently splitting store territories in the UK.
Restaurant franchisors can be stock compounders. They need to have a durable and profitable brand that has scope for growth.
Master franchisors can make for excellent investments.