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Refranchising Gets Hot Again in the Restaurant Industry

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Once-struggling restaurant chains like Arby's and Sizzler are building a new face for customers and pitching a new opportunity to successful franchisees through a process called refranchising.

As franchisors look to expand while slashing expenses and paying off debt, several brands in the restaurant industry are resorting to selling off corporate-owned stores to franchisees with the capital to give the neglected stores a boost.

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"Refranchising is not a trend or fad. It's been happening for a long time," says Steve Caldeira, CEO of the International Franchise Association. "It's an excellent way to free up working capital for franchisors to focus on growth markets or new products and deliver value back to shareholders. Generally these stores perform better because franchisees tend to focus on operationsfull time as opposed to corporate owned stores."

While the trend may not be new, industry observers say it is picking up as a strategy in the restaurant sector, another byproduct of the recession.

Dine Equity's (NYSE:DIN) Applebee's Neighborhood Grill& Bar and IHOP Restaurants, Roark Capital's Arby's, Sizzler, Yum Brands (NYSE:YUM) -- owner of Taco Bell, KFC ,and Pizza Hut -- Jamba Juice (NASDAQ:JMBA), and Burger King (NYSE:BKW) are just a few of the names that are selling off company-owned stores and becoming primarily franchise models.

"I think a lot of brands are looking to bring capital in because they've been hurt by the recession. It's an asset that they can convert to liquid," says Darren Tristano, executive vice president of Technomic, a food and restaurant research and consulting firm.

Restaurants have struggled for years -- and particularly in recent times -- to build profitability.

"They've taken on debt and increased capital expenditures because of remodeling restaurants, enhancing risk efficiencies, adding equipment," to be able to create new and more appealing items, Tristano says. Refranchising takes the burden of running the restaurant off the company. "They're basically running the brand and not the restaurants," Tristano adds.

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When DineEquity announced in July the sale of 65 company-owned Applebee's in Michigan to TSFR Apple Venture LLC, the company noted that its "increasingly franchised business model is less capital intensive and experiences less volatility in cash flow performance compared to the operation of company-operated restaurants."

As of July, the company had sold or entered into agreements for all of the 510 domestic Applebees restaurants, leaving just 23 units as test markets for the parent company.

Refranchising is becoming increasingly attractive for both sides of the transaction.

"Independents have been struggling. As a result, chains continue to dominate in the restaurant industry," he says. "It's a good opportunity to be refranchising."

Company-owned stores tend to be in markets close to headquarters so they're easier to manage. Depending on the strategy, if stores are updated, parent companies could maximize the sale price, but more than likely they want to offload underperforming units as fast as possible. Franchisees can acquire locations for cheap and get an immediate return on their investment once they update the stores, Tristano says.

But the strategy isn't something that individual franchisees are likely to get in on. In many cases, companies will approach existing franchisees with the offer, then ideally take it to a franchise group that is managing other non-competitive brands. Beyond that, perhaps they will turn to individual franchisees in the market, Tristano says.

"Restaurant organizations, in general, like to work with fewer franchisees" and those who have better infrastructure because "the individual franchisee is going to be very needy," Tristano says. "The multi-unit franchisee is going to have an infrastructure in place to deal with issues that come up."

Tom Kelley, principal of AccessPoint Media Group, and a brand consultant for restaurants, suppliers, retail, and hospitality, offers a less rosy picture of the process of refranchising.

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"A lot of times unfortunately it's not part of a strategic plan; it's a knee-jerk reaction of having to raise cash or wanting to focus on a new concept," he says.

Many times the locations that chains are looking to get rid of are undesirable or those that have not been updated. While franchisees are likely to get a good deal on the purchase of locations, they also take a big risk, Kelley says.

"Those really don't attract the best franchisees so if the company can't save them it's somewhat unlikely that the franchisee can" without resources to update them, he says.

Guillermo Perales, the largest Latino franchisee and CEO of Sun Holdings, is one multi-brand franchisee with the resources to take advantage of buying company-owned stores. His group acquired 51 company-owned Arby's locations in July. That brings his roster of Popeye's, Golden Corral, Burger King, CiCi's, and Del Taco locations to 390, mainly in Dallas.

Earlier this year, Perales' group purchased 96 Burger King stores.

While Perales was able to acquire the Arby's restaurants at a discount, he says they were appealing for several other reasons including: location (most are in Dallas), an exclusivity agreement to develop 15 more stores in the area, confidence in Arby's management (it was bought by Roark Capital in 2011), as well as the fact that it was a concept that didn't compete with his existing brands.

"They had brought in leadership that I had known from the past and they're going to overhaul the concept by giving it a new look and new products so I'm betting on the upside," he says. "We're always looking for concepts to expand. I think we would do a much better job here than they can."

Of course, Perales will need to do more investment including some closures, moves, and updating of restaurants, but he is optimistic of the potential for returns.

"We've done it before. It's not as easy as it looks. It's like a marriage. The brand has to have a lot of faith in you as franchisee to run the stores right, to remodel and to rebuild. They're looking for the franchisee to be the right partner," he says. "You're required to put a lot of cash back into stores ... to keep the operations running better."

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To be sure, franchisors are not looking to sell all of their corporate stores. Having a small test market is still needed to test new products and stay relevant to what's happening in the trenches. Experts say that franchisors that don't "have skin in the game" should for the most part be a red flag for franchisees. (Two exceptions are Subway and McDonald's (NYSE:MCD), he says.)

Sizzler is one such brand.

Once with 600 stores, new management in 2008 halted Sizzler's franchising program. Of the remaining 170 currently, 19 are company-owned.

After nearly four years of initiatives to breathe new life into the 54-year-old brand, which included bringing in new management, paying off the company's debt, and overhauling the menu and pricing, the final piece that was needed to complete the revamp was updating its locations -- and for that they needed help.

"The difference between a remodeled and non-remodeled restaurant was 6%-8% more sales and positive guest count versus flat. The remodeled look changes the whole perspective of what people thought about Sizzler," Sizzler USA CEO Kerry Kramp says. "We're confident we can move outside of California and continue to develop the brand."

This past February, Sizzler signed its first deal with venerated multi-franchisee Tony Lutfi since its revamp began in 2008, agreeing to sell five locations in California and allow Lutfi to open five new Sizzler's in the San Francisco Bay area. Lutfi's portfolio includes Jack in the Box (NASDAQ:JACK) locations, Church's Chicken, Arby's, and Little Caesars.

The company is looking to sell more stores to franchisee heavyweights to essentially endorse its new look as it moves towards expansion again, but that doesn't mean it plans to move entirely away from corporate-owned stores.

The cash gained from selling off some stores would be used to accelerate more remodels and build more company-owned restaurants, Kramp says.

"We intend to develop more company restaurants. We don't know the exact ratio but we like the thought of having company-owned restaurants," Kramp adds.

Sizzler plans to announce a second multi-unit deal. Kramp declined to offer more specifics.

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