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The concept of franchising goes back to the middle ages, when landowners and local leaders granted rights to citizens in order to conduct fairs and other business. While it has since been used by different enterprises in various countries, Singer Sewing Machine Company is credited for being the first to utilize the model in the corporate setting. Short of money and a distribution network during the early 1850s, the company sold licenses to consumers in return for training and the right to sell sewing machines. Singer’s eventual success encouraged many others to pursue growth through franchising. 

Two subsequent events accelerated the spread of franchisees: the growth of A&W Root Beer in the 1930s as the first restaurant franchise, and the development of the U.S. Interstate Highway system. The latter encouraged hotel owners and restaurateurs to establish operations wherever highways were laid. Since then, the total value of franchising has grown exponentially, recently reaching $1.5 trillion in sales annually in the United States alone.

While many industries have adopted an asset-light business strategy, fast-food restaurants are among those that have utilized it most frequently. Under a franchise model, a company gives owners (franchisees) access to proven corporate strategies, training, advertising, and trademarks, in return for an initial fee and monthly royalty payments (which are typically a portion of sales). Franchising has proven to be the most efficient means of expansion, since franchisers are not responsible for much of the development costs or operating expenses, once properties open. All told, franchisers are required to commit less capital operating under a franchise business model. Too, in spite of the fact that revenue growth potential is limited, operating efficiencies are typically far greater.

The fast-food sector has been “refranchising” thousands of its U.S. properties by selling them to franchise owners.  Led by giants McDonald's (MCD – Free Analyst Report) and YUM Brands (YUM), the fast-food sector has trimmed the number of owned restaurants, in order to focus resources on international markets. In fact, “refranchising” has enabled them to establish distribution networks, partnerships, and a healthy slate of franchisees in various foreign countries. YUM Brands decided to trim the number of company owned restaurants by 50% several years ago. Similarly, Jack In The Box (JACK) was entirely company owned until the 1980s, when it was finally swayed by the potential benefits of franchising. McDonald's, too, started scaling back its restaurant ownership a few years ago, with the goal of selling a quarter of its owned base. Besides the fact that asset sales instantly boosted efficiency and lowered the amount of required capital, they also netted these companies a tidy sum. The sale of each property, with each unit’s value being determined by customer base and location, boosted financial wherewithal.

Note that growth in overseas markets is also being pursued through franchisees. Owners in other countries are more aware of local laws, trends, and cultures. Therefore, by pursuing partnerships, companies are mitigating the risk that consumers may not embrace particular products and brands.

More than its competition, McDonald’s recognizes the financial benefits of franchising. Most of the franchisees pay a monthly rent, which is determined by restaurant sales. There is also a 5% royalty, or service fee, on top of the contributions they are obligated to make toward the company’s marketing efforts. By the same token, the business model has enabled stockholders to benefit through share-price appreciation, an industry-leading dividend yield, and share buybacks.

According to McDonald’s, maintaining a certain number of owned properties is pivotal to developing a healthy system. In particular, directly operating restaurants is paramount to being a credible franchiser and imperative to providing personnel with restaurant operations experience. Therefore, it will continue to own a portion of its portfolio (currently 80%, or 25,972 of its properties are owned by franchisees). At company-operated properties, and in collaboration with franchisees, management develops and refines operating standards, product and pricing strategy, and marketing concepts. Moreover, the company has established an environment that is conducive to identifying and exploiting key products and/or areas. This joint effort is highlighted by the fact that McDonalds’ most iconic product, the Big Mac, was created by a franchisee. The confluence of these factors enables McDonald’s to attract 40 million customers each day to nearly 33,000 branches in 120 countries. Needless to say, these numbers generate considerable economies of scale.

A proven franchise model, together with a stellar track record for making the right decisions, has enabled McDonald’s to outpace its competitors. When the company felt its menu was getting stale, it refreshed it. Management kept its classic menu favorites such as the Big Mac, and added a slew of new products, including Angus burgers.  Too, a decision to boost business during the highly profitable breakfast period, with McCafe coffees and value-oriented beverage promotions, has been a tremendous success. In fact, McDonald’s history of successfully adding new products (including value offerings and healthier options) easily outpaces that of its peers in the quick-service restaurant space.

The ongoing transition to an asset-light, franchise-rich business model is owed to a desire to grow in a more stable, yet lucrative environment. Even during the now-ended recession, during which consumers cut back in dining, McDonald’s generated profit growth. Through franchising and refranchising, McDonald’s has expanded into existing and new markets at a blistering pace. McDonald’s Corporation founder, Ray Kroc, believed in the principle of a three-legged stool: with each leg representing the company, franchisees, and suppliers. Success during the recent recession, and expectations of a bright future is proving that each leg is more secure now than ever before.

YUM Brands, the world’s largest restaurant company and whose portfolio includes KFC, Pizza Hut, and Taco Bell, among others, is also utilizing the franchise model. After years of selling restaurants, more than 70% of its 37,000 store portfolio (in 110 countries) is franchise owned. Moreover, the company undertook this strategy in order to pursue international growth.

Many foreign companies saw the vast potential in China, and moved to plant their flags there. Faced with moderating U.S. sales, YUM initiated a massive expansion program into the world’s most populous nation. In fact, the company’s KFC concept was the first foreign fast-food business to open a property there in 1987. Two decades later, YUM has become the country’s biggest restaurant chain with over 2,500 locations (predominantly KFC and Pizza Hut restaurants). Much of the blistering growth is owed to an ability to attract and retain young customers. Too, the company has benefited from the fact that chicken is the main source of protein for many Chinese, and the primary item sold by KFC—formerly Kentucky Fried Chicken.

China’s long-term potential is highlighted by the fact that its middle class (which is a key source of sales for the fast-food industry) is comparable in size to the U.S. population, and growing. In order to capture as much of the lucrative market, YUM CEO David Novak intends to establish 20,000 units there. Supported mainly by an aggressive franchise model, China’s contribution to YUM’s profits is paced to eventually exceed the level generated in the U.S.

Jack In The Box owns and operates more than 2,200 restaurants primarily in the western and southwestern United States markets. While it is a pioneer in the quick-service industry, ushering in drive-through services for consumers seeking “fast food,” the company initially resisted the industry-wide trend toward franchising. The company’s strategy changed in the 1970s, though, when its management chose a more aggressive growth path. Through the sale of owned properties, and dependence on franchisees for growth, the proportion of owned restaurants has since dwindled to 40%. Moreover, an asset-light model, together with an innovative menu, is enabling the company to compete with bigger and wealthier competitors. In particular, JACK’s strategy to launch a new product each quarter and introduction of value products together with premium products have resonated with consumers.

The company’s namesake brand is expanding in existing U.S. markets and growing into new ones by utilizing the strength of its ever-growing franchise network. Moreover, the California-based restaurateur intends to increase franchise ownership to 70%-80% by 2013. Too, it will likely spend a considerable amount of capital to expand Qdoba, a so far successful Mexican restaurant chain competing in one of the fastest-growing food categories.

The franchising model is likely to ensure continued growth because of its underlying benefits: it offers lucrative returns to companies and entrepreneurs, with a relatively minimal amount of risk. Although predominantly associated with large companies like McDonalds in the United States, other companies are set to use the franchise model to spur top- and bottom-line growth. Savvy investors willing to look beyond the obvious players and markets should be able to benefit along with these companies.
 
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.