March 2009 Franchising World

By Reginald Heard
       
We set sail for the New Year with a focus on a new horizon and with great relief that the turbulent storms that hammered our economy last year finally had ended. In one calendar year, our economy was hit hard and fully consumed by a historical political horse race season, a national housing crisis, high-fuel energy prices, extraordinary job losses, significant devaluations in personal savings and retirement plans, investment banks and bank failures, a systemic national meltdown in the capital and secondary markets, a sizable insurance company failure, and unprecedented multi-billion bailout programs for the banking system and automotive industry.
  
What appears to have started with a collapse in our housing markets rapidly transcended into a global credit-market crisis which led to a financial crisis of both Fannie Mae and Freddie Mac, the largest quasi government and publicly-owned residential lending agencies in the country. Then what followed was the failure of some of the country’s oldest and biggest investment banks such as Bear Sterns, Lehman Brothers and Merrill Lynch. The systemic problems within the capital markets were further precipitated with the failure of AIG, one of the country’s largest insurance companies that ended under the receivership of the federal government. The economy had to weather another tsunami with a series of reported bank failures and displaced national lenders. By the close of the year many banks’ priorities became to raise liquidity rather than making new loans. The estimated 25 banks closures that were reported last year compare with only three bank failures that were reported in the previous year, and none reported in 2006 and 2005. In fact, not since 1993 have bank failures been this high, when 42 banks failed, according to the FDIC.  
  
The Lifeblood of Franchise Systems 
As access to reliable capital has always been the engine that stimulates economic growth and expansion, the continuous access to capital is also the lifeblood of mostly all franchise system models. In one single year––many national SBA and conventional lenders simply stopped funding deals without much warning. In fact, many that issued commitment letters were rescinded and not honored. New development pipelines dried up almost overnight. The lending environment became highly selective on the types of loans that would be considered. The credit underwriting standards to qualify for a loan also tightened considerably igniting a full-blown national credit crunch leaving many investment projects under-funded and many without alternative funding options.  
  
The Bush administration, Federal Reserve and Congress orchestrated an emergency mega-billion dollar “bailout” package plan tailored to recapitalize the banking industry, restore confidence in the global capital markets, stabilize the housing and employment markets, and to starve off the ailing economy from falling any further into a deepening recession. Throughout the year, the Federal Reserve implemented an offensive monetary policy strategy by authorizing a series of targeted rate cuts ending the year at historically-low interest rates with a .25 percent Fed Funds Rate and a .50 percent Federal Discount Rate. The prime rate, which is the most-widely used benchmark in setting small-business loan rates and home equity lines of credit, concurrently declined, ending at 3.25   percent, historically-low levels. By year end, our federal policymakers authorized another multi-billion “bailout” plan, this one targeted to the Big Three automotive manufacturers as direct benefactors and with the ultimate goal to alleviate any additional waves of massive job losses during the current state of the economy.
  
If any one of the above mentioned events were isolated and had occurred in one single calendar year, then any one of those events would have had significant relevance to the overall health of the economy. Fortunately, we have all experienced and survived these unprecedented market conditions of last year which may now to be described as the perfect storm.  
  
Glimmers of Hope 
We are beginning to stem the tide with some signs of unthawing capital markets and with some cautiously-renewed optimism by banks to restart lending once again. Banks have shored up their balance sheets with a fresh infusion of taxpayers capital and the “risk rated” adjusted pricing spread in the secondary markets started its descent from its highs during the peak of the capital-market crisis. The credit crunch that was national in scale and had inversely impacted every segment of our economy from consumers (home, auto, and credit cards), college students, domestic and international investors, state and local municipalities, and large to small businesses, is showing slow signs of a recovery with lending commencing again to credit worthy and resourceful borrowers. Banks and non-bank finance companies that are now recapitalized remain cautious, but have interest to extend credit once again to those viable projects with sound underwriting fundamentals. For most of this year, our banking system, consumers and businesses will continue to de-leverage nonstrategic debt as the economy continues to produce both great personal and business investment opportunities. The barriers to entry for marginal deals such as highleverage transactions (such as 90 percent financing for non-real-estate start-ups and under collateralized loans) will remain subdued for awhile, thus, creating considerable opportunities for the many cash empowered and resourceful business investors.  
  
The series of events that transpired last year forced many of us to take drastic actions in modifying our current business models, operating budgets and growth development strategies. However, now that we have begun our new tack and set our sails to navigate in this new economy there still lie ahead some headwinds. Some upside opportunities worth noting now also exist and that should be capitalized on while the window of opportunity still remains available. They include low cost of capital––historical and favorable lowinterest rates, purchase power market shift to franchise operators––below market rents and access to higher barrier to entry   site locations, lower project development cost––labor and material cost, and business acquisitions in undervalued business assets––merger and acquisitions, to name a few.  
  
Historical Low Cost of Capital 
Interest rates at these historically-low levels are optimum market conditions for franchise-unit operators and investors in business systems to secure very attractive debt capital on both short term and long term. Unit transfers and business acquisitions with a stabilized cash-flow history will underwrite more favorably in a lowerinterest rate environment to yield higher-net loan proceeds than net-loan proceeds that would yield in a market of higher-market interest rates. Similarly, the credit underwriting on cash-flow proformabased franchise start-up units will  underwrite with less stress in a lowerinterest-rate market, thus yielding higher probability of approvals and potentially a lower initial equity-injection requirement. It is also the optimum time, if not already done, to refinance any existing higherfixed-rate loans and lock into a lower-borrowing cost. Most SBA loans have been pegged to the prime rate and adjusted quarterly, as a result, many small-business operators over the past year have been enjoying the reductions in their loan payment. For example: Let’s assume there is a $1,000,000 business loan structured on a 10-year term and priced at the prime. A year ago, loan payments would have been calculated at a 7.25 percent rate with $11,740.10 monthly payments. However, based at the 3.25 percent current prime rate level, the loan monthly payments would be lowered to $9,771.90. In this example, the substantial decline in the prime rate over this past year would have reduced the cost of debt capital by over 16.8 percent and an increase to the bottom line net income equal to $1,968.10 per month or $23,617.20 annually.   
  
Purchase Power Shift to Franchise Operators 
In an expanding economy, it’s a daunting challenge for many smaller franchise-unit owners to hold much leverage power when it comes to securing a highly-desirable site location or in having the advantage in landlord-lease negotiations. Typically the smaller-business operators lack the economy of scale or the capital resources to directly compete with the more seasoned and well-capitalized operators to obtain control of the more highly-desirable site locations or to leverage favored lease terms in a market that has high demand for lease space and the landlord has multiple-tenant selection options.
  
As a direct result of the credit crunch and economic recession, landlords are preparing to face an increase in the number of store closings, defaulted leases and unit vacancies in their retail properties. Already many large anchor retailers such as Circuit City, Linens ‘n Things and Sharper Image have sought bankruptcy protection as the credit crunch and economic recession directly affect store performances. 
  
In these uncertain times it is ideal for franchise operators to negotiate some very attractive below-market lease rates and favorable landlord concessions. With some research these market conditions may also create an opportunity for franchise operators to land one of those most desirable site locations that would have not been available under normal conditions.  
  
Lower Project Development Cost 
In downward economic cycles it is very common for the pipeline of new development projects still in the planning phases to get either substantially delayed or to get completely cancelled. However, for those new development projects that have been well planned and properly funded, developing in a downward economic cycle has many benefits. Foremost, labor cost and material cost will typically be less than in an expanding market with high demand for labor and raw materials. Secondly, having a project developed during the downward phase of the cycle will have you well positioned with new product online during the recovery cycle. This now presents a potential competitive advantage over your direct competition more than during the downward cycle when it was more focused on downsizing and is now in an unfortunate situation of needing significant renovations to remain competitive.  
  
Business Acquisition Opportunities in Undervalued Units and Franchise Systems 
This tight credit market and faltering economy has produced a sub-market of many existing businesses now priced at very attractive business valuations not seen in many years. This year should produce an increase in business-acquisition transactions and merger and acquisition activity for both single-unit franchises and complete franchise systems with established infrastructure. Both declining revenue and net operating income performances will continue downward pressures on business valuation resale multiples. Additionally, a prolonged credit crunch and a cycle of higher commercial vacancy levels will equally put upward pressures on market real estate cap rate valuations. Again, these current market conditions may be an optimum time to maximize investment and purchase existing franchise units during the downward economic cycle.
  
These market conditions may also be ripe for some well-established and capitalized franchise systems to become active buyers in the market to acquire other smaller franchise systems to execute an expansion strategy and develop operating efficiencies with an economy of scale. Mergers and acquisitions and strategic partnership alliances may dominate most of the transaction activity this year.  

Reginald Heard is president of Bankers One Capital. He can be reached at 203-791-9998 or  rheard@bankers1capital.com  . 

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