Mergers and acquisitions in franchising

Executive Summary

Franchising is a form of cooperation between entrepreneurs that originates from the United States and now is also growing rapidly in the Netherlands. Franchising provides the opportunity for rapid expansion with many advantages: the franchise organization can grow with a minimum equity investment, while the self-employed franchisee directly has a famous name, a proven formula and the related know-how.

Franchising is a growth strategy with many benefits for as well as the franchisee as the franchisor. It gives both parties an efficient division of labor. In fact, for the franchisor, franchising makes a rapid expansion possible, with minimum investments. These are largely borne by the franchise holders that are entrepreneurs. The franchise organization offers the franchisees facilities in the area of market research, marketing, advertising, administration, automation. But also inventory control and distribution range.

Purchasing and distribution may also be cheaper and more efficiently through economies of scale for both parties. The franchisee also makes use of a proven formula and has immediately the famous name, experience and expertise of the organization. Another advantage for franchisees is that investments are usually easier to be funded by the success and any financial guarantees from the franchisor.

As always, there is a back side. Due to rapid growth in combination with a weak franchise organization, a number of franchise organizations fail. Even with a well-organized organization and a proven success formula, expansion that has been implemented too rapidly leads to a rapid collapse. The adverse effects are incalculable, not only for the organization but for the starting small entrepreneur (the franchisee) who does not get a return on his investment.

To see how well organized these organizations are, I decided to do research on the topic of mergers and acquisitions within franchising. This led me to the Yum organization. Yum is the largest restaurant company worldwide. This claim concerns the management and control over 35,000 system restaurants. It is managing and controlling over 35,000 restaurants in over a hundred countries and territories. The brands of KFC, The Pizza Hut, Mexican food restaurant Taco Bell, Long John Silver’s or the A&W outlets are the brands that are exploited by all these restaurants owners.

In the past decade Yum has done many mergers and acquisitions. The mergers and acquisitions within franchising have never been researched before. For this reason I have chosen for this pioneering role, which I will express in this exploratory study to the causes and effects of M&A in franchising.

The reason that I chose for the organization of Yum is that it is a large global organization. This makes it possible to build a broader and global perspective to examine how causes and effects of mergers and acquisitions within franchising are linked. It was also an opportunity to research several organizations with different services or products to a wider picture. This would be much more time, so I have not chosen for this research design. In the introduction of the case study in section two of chapter three, I also added a brief description of Yum.

The findings of my exploratory study are based on investigating the causes and effects of mergers and acquisitions in franchise businesses. Therefore, I first looked at the causes by using the available data from the annual reports followed by the effects in terms of an event study. After the event study I was able to make a link between the strategy (causes) and the events (effects) that has taken place in the last decade for the business of Yum. Yum and the franchisees are constantly seeking for optimization in their supply chain and the service they deliver to their customers. Successful mergers and acquisitions consist of a number of critical business principles that have to be implemented in the core processes of the franchise stores. In chapter five I will briefly discuss these principles and what they mean for the business of Yum. These findings may also be interpreted as recommendations towards my subject of research.

1 Introduction

In the past decade Yum has done many mergers and acquisitions. The mergers and acquisitions within franchising have never been researched before. For this reason I have chosen for this pioneering role, which I will express in this ‘exploratory’ study to the causes and effects of M&A in franchising.

My research objective is to say something useful about the key factors in franchising that lead to a successful business model. Thus, my conclusion will be based on these key factors that lead to a successful business model. When a franchisor is buying or selling a store, it is important to know where failure can be prevented and success can be enhanced.

The figure below is a visual representation of my research model.

Figure 1 A visual overview of the research model

1.1 Literature

To do the exploratory study in a correct way, it is important to identify the main components of both growth mechanisms to understand what I am actually going to do research on. I will do a thorough literature study to the main concepts and previous studies to understand both of these mechanisms.

Businesses associate mergers and acquisitions mainly with economic benefits as synergy benefits, reduce costs and a way to grow. These expected benefits are also the basis of the decision for a merger or acquisition.

Franchising means that a company (the franchisor) sells the rights for using its brand and business principles to another second company (the franchisee). But this still is not an answer on the question why a firm initiates franchising and how franchising impact different types of organizational performance.

Therefore the literature section will give a brief summary about the main concepts of M&A activities as well as a broad overview of the franchising literature that has been published.

1.2 Research Question

In this section I will further clarify my research objective. Here, I want to make a distinction between the causes and effects of the acquisition in franchise. If I can identify the causes or motives behind an acquisition, I will be able to compare the effects per category per company as described below.

Looking at causes it is clear that companies can grow more rapidly through mergers and acquisitions, rather than expand their production capacity. This is one of the main reasons why many companies get the majority of their growth from mergers and acquisitions get. In addition to this growth pattern, creating shareholder value is another main motif. This shareholder value is achieved by exploiting the opportunities arising from a merger or acquisition such as economies of scale, access to new technologies, products and services and markets. These cost motifs often have a dominant position. Through acquisitions, production efficiency and lower costs can take place. If average costs decrease with larger production is known as economies of scale. In addition, companies can realize cost savings as cheaper products together than in individual companies (economies of scope). In addition to the causes or motives which form the basis of most mergers and acquisitions, also the effects have been described in the used literature.

Looking at the effects it is clear that companies have many reasons for dealing with mergers and acquisitions but that practice has shown that not all mergers succeed. There is much literature devoted, in which success rates often are not greater than fifty percent and the performance of the companies after the merger has become worse than before. There are roughly two different methods used for determining the success of a merger or acquisition. The most commonly used method is quantitative; the performance of the share of the merged company is compared with the performance of the shares of comparable companies. Another method is qualitative, where the leaders of the companies are asked in interviews if the merger has been proved successful.

If any successful or non-successful effects have been detected there could probably be a cause for this effect. Therefore, my research question is:

“What are the causes and effects of mergers and acquisitions in franchising?”

When I separate the causes and effects, I can compare any success of another. This way I can identify motives and choices can lead to the most positive effects. Based on these conclusions, I can make recommendations to further research.

Also, I will give an introduction of the case study that will take place in the next section. Also my expectations regarding the outcomes of the case study will be given further explanation. Therefore I will identify the main parameters on which I will compare the two mechanisms with each other.

1.3 My approach and the structure of the thesis

After the introduction in chapter one, my thesis really starts with the subject of mergers and acquisitions in franchising. Because the main idea is to do research on the causes and effects, I studied lots of literature on this subject.

In the second chapter I will describe the literature I used for this thesis. I distinguish 2 types of literature. The first part of the literature is about the main concepts of mergers and acquisitions. The second part is about the franchising literature. For both M & A as well as franchising there has been a lot of research published. The interesting thing of my exploratory research is that both areas have never been combined previously. In this chapter, I will give a summary of the main concepts of both mechanisms.

The third chapter I will describe the data and sources that I used for the case study in the fourth chapter. Since not everyone is familiar with this type of study, I will quickly describe the main concepts of it. Readers that are familiar with the concepts of a case study could skip this section and head forward to chapter four.

Further reading to the fourth chapter will give a description of the actual research. Here, I will deal with a case study of the company Yum that have businesses in franchising. In order to do this I will use data obtained by using the software from Thomson ONE Banker. The fourth section will give an overview of all the mergers and acquisitions that Yum has done in the past decade. I calculate the abnormal return of the share and compare this return with the market and the industry.

As I indicated I will do research on the company Yum on the basis of a case study of their mergers and acquisition. I will separate the causes and effects and use four steps to progress to a conclusion. For this research design I used the annual reports of Yum, and analyzed them. This company owns fast food restaurants of the franchise labels A&W, Kentucky Fried Chicken, Long John Silver, Pizza Hut and Taco Bell. First I will look at the causes in the sections 1 and 2.

1. The strategy of the company

The strategy of the company in the annual report can be found in the notes to the financial statements. In the annual report of Yum, The formulation of the strategy is reflected in the section entitled “Letter to shareholders” on page 2 of the annual report of 1998. Also, I looked at the annual report of 2007 to point out the development of the strategy. Thus, I will point out the company’s strategy in section three of chapter four.

2. The growth of the company

In this step, I will analyze how the company grew. I will analyze what part of the growth is autonomous (do more of what the company already did) and what part of the growth caused by acquisitions (growth purchase). This information I gather through the software from Thomson ONE Banker. With this software it is possible to see what acquisitions are made by Yum in the past decade. This software also discloses the status and value of the deals. I will link this information with information from the annual reports. In this way I can gain deeper understanding of the growth. I will develop and process the data into tables and graphics in order to display the business growth.

Because I separated the causes and effects in my research design, section 3 and 4 will deal with the effects.

3. Financing growth

There are several ways to finance a merger or acquisition. In this step, on the basis of the report, I will describe how the various mergers and acquisitions have been financed. Thomson ONE Banker discloses the value of the deal. The explanation of the funding of the deals can be found in the section “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the heading “Consolidated Cash Flows”. The financing of these deals in numbers is included in the “Consolidated Statements of Cash Flows”. I will process the data into tables and graphics in order to display the financing of the growth.

4. The performance of the company

Finally, I will use an event study to see what the performance of the company has been. This is very important to see how the above steps have effect. I will start with an analysis of the share value. Also, the event study shows the performance of Yum in the market and in the industry. For the last one, not all the data was available. All the data is reflected in the annual reports. I will this process these data in tables and graphics. With the event study I linked the data from Thomson ONE Banker and DataStream.

Chapter 5 will give the conclusions of my research. In a three page summary I will give the outcomes and recommendations of my research. My conclusion will be based on the key factors of successful franchising. When a franchisor is buying or selling a store, it is important to know where failure can be prevented and success can be enhanced. With this thesis both franchisee as franchisor could be able to benefit from the sources I analyzed.

2 Literature Review

For both M & A as well as franchising there has been a lot of research published. The interesting thing of my exploratory research is that both areas have never been combined previously. In this chapter, I will give a summary of the main concepts of both mechanisms. In the final thesis I will further go into literature study to identify the different parameters that I want to work with to de the exploratory research.

2.1 M&A literature

During the 20th century, the United States had five waves of mergers and respective acquisitions. Each of these five periods was associated with economic growth, followed by a period of recession. The European history of mergers and acquisitions is remarkably shorter than that of the United States. For Europe they can only speak of two waves that are parallel to the last two periods in the United States. But in order to understand these waves, one must identify possible motives for these mergers and acquisitions. Most of the literature distinguishes the following causes for M&A activities;

2.1.1 Synergy

Synergy is one of the most cited reasons for companies to engage in a merger or acquisition. Synergy means that the combined company is more profitable than the sum of the two individual companies. When a merger or acquisition has a positive acquisition value (NAV), it is supposed to be economically. The NAV is defined as:

NAV = VAB – (VA + VB) – P – E

VAB – (VA + VB) stands for the synergetic effect. If this term is positive, then the merged company is worth more than the sum of the value of the two individual companies. P symbolizes the buyer pays the premium and E the costs related to the acquisition or merger.

Synergy effects can be defined broadly as well as narrowly. The broad definition also takes into account the effect of bad management to be replaced through better management in a merger or acquisition. However, the more narrow definitions do not take into account this management effects. Synergy can be divided into operational synergies and financial synergies.

2.1.1.1 Operational synergy

The main source of operational synergy is the cost reductions arising from merging two or more companies. This cost reduction may result the existence of economies of scale or economies of scope. Economies of scale are the benefits that large companies have experienced since their fixed costs spread over more units and thus they have lower production cost per unit than small companies. Companies can both internally and externally grow to an optimum size for which the cost per unit is minimal. Through mergers acquisitions companies can grow externally. Economies of scope are the possibility for a company to create a set of input factors to a wider range of products to be offer. When a company is too small, this is not possible and therefore companies can grow through mergers and acquisitions to become a company that can enjoy these benefits.

2.1.1.2 Financial synergy

Financial synergy occurs when the cost of capital of a company drops by merge or by taking over another company. The cost of capital can be reduced after a merger or acquisition. This is the case if the cash flows of businesses are not perfectly correlated and the volatility of cash flows of the company has narrowed. A lower volatility makes the company less risky for investors and hence a lower premium is questioned. This effect is also known as “debt coinsurance” (Higgins and Shall, 1975). These authors argue that there is no additional value created by financial power, but that just different distribution among the creditors and shareholders. In other words creditors get more and the shareholders less. There have been some empirical studies that confirm this hypothesis, but others contradict this. In addition to debt coinsurance, there are other benefits that large companies experienced in financial markets. For example, large companies are seen less risky than small firms, making it easier to them to access financial markets and having a lower cost of raising capital.

Finally, the fixed costs associated with the collection of capital are equal to large and small companies, but the cost per unit of capital is lower for the large companies.

2.1.2 Diversification

Companies diversify through mergers or acquisitions. In this way they are able to lower the risk to investors and thus reduce the cost of capital. The reduction of this risk was explained by financial synergy.

Another reason why companies want to diversify through mergers and acquisitions is to enter more profitable industries. But there are two major drawbacks linked to expand in this way. First, the acquired or merged company which is now operating in a profitable industry has no guarantee that this industry will retain its abnormally high profits. Secondly, the abnormally high profits can only continue to the long term if it is difficult for other companies to enter this industry. Since firms are only able to buy companies from sectors which can be accessed easily, such merger will not have abnormally high profits.

Companies can diversify both a related and an unrelated merger or acquisition. The last option is called conglomerate. Rutherford (1992) defines conglomerate mergers or acquisitions as transactions in which two or more companies from different industries and that not belong in the same production do merge. In the third merger wave in the 60s conglomerate mergers and acquisitions were very popular for several reasons.

2.1.3 Increasing the market share

The most important goal when companies integrate horizontal, is an increase of the market share. They speak of a horizontal merger or acquisition when the concerned companies all belong to the same industry (Rutherford, 1992). Companies want to increase their market share because together with product differentiation and market barriers to entry for a company, it provides market power. The stronger the market powers of an enterprise, the more its ability to self-determinate the price and keeps it above the competitive price. The market power of an enterprise is determined by the structure of the market in which it is active. If there are many companies are operating, then this is called a competitive structure and all firms are called price takers. The other extreme is only one company and therefore there is a monopoly. Forms in between are monopolistic competition and oligopoly. Horizontal mergers and acquisitions can be transferred to a pure competition monopoly. This phenomenon was clearly visible at the end 19th century in the first merger wave.

2.1.4 Geographic expansion

When a company does no longer see growth opportunities in the region its active, it may be a solution to expand the activities to a new region. This expansion can be done in two different ways. The first possibility is to start a company from scratch in the selected region. However the expansion to a new region could also take place through an acquisition of a similar company that is already active in that region. This last possibility is again a horizontal merger or acquisition.

2.1.5 Supply chain forms

A supply chain is created through vertical integration. They speak of a vertical integration where the companies do not belong to the same industry, but several steps are within the same production chain (Rutherford, 1992). First, a backward merge or take over can take place. This means that a company closer to the supply of inputs, is taken over. The security in relation to the supply is the main motivation for such mergers or acquisitions. If the company does not own its supplier, then the relationship with its supplier suddenly ends. This brings additional costs. An example of this is that prices for the inputs of the future supplies can be higher than current prices. A second reason for a company to vertically integrate with its supplier is the need for specialized input factors of production. The company is totally dependent on the suppliers for specialized input factors. When the relationship with the supplier ends, the company faces high costs to adapt the production to new input factors. Companies can also forward merge or take over to get closer to their customers. Since companies often better compete after a merger to better compete, the consumer can also benefit from it.

2.1.6 The hubris hypothesis

Roll (1986) argued that mergers and acquisitions not only be based on economic founded reasons, but also personal motives of managers often play a role. This hypothesis of Roll explains why managers sometimes pay a premium for a company that really is correctly valued. The reason why these premiums paid at least is the fact that these managers estimate their own valuation higher than the valuation of the market.

If these are the causes or motives for M&A activities then these causes must have some consequences or effects. Since franchising has become more visible in the current business landscape (Combs, 2004), it became easier to compare several parameters within the mechanism franchising in order to draw some conclusions.

2.2 Franchising literature

Equity joint ventures and strategic alliances do differ from franchising. They can distinguish two characteristics in which franchising differ from them. The First typical characteristic of franchising is clear feature. Franchising occurs in businesses where the service needs to be done near the actual customers. This is the case for example for a hairdresser. This leads to replication and geographic spread of the service-providing outlets. Another key feature is that the business contract between a centralized principal (the franchisor) and decentralized agents (franchisees) contains a unique equilibrium of responsibilities, decision rights, and profits. It is the franchisor that has to set and implement standards for performance in the whole chain. The franchisor also has to select and approve its current and future franchisees, approve outlet locations, manage brand image, and coordinate activities such as purchasing where scale economies are available (Caves & Murphy, 1976).

The attention of a spectrum of researchers has been captured by the phenomenon franchising. For this reason it has been researched several times from different perspectives. It can be seen for example from the perspective of entrepreneurship. From this perspective franchising is a vehicle for entering business ownership (Shane & Hoy, 1996). Another example is the perspective of marketing. From this perspective franchising is defined as an important distribution channel (Kaufmann & Rangan, 1990). Other research has been done from the perspective of economics. The economic perspective says that franchising is a leading venue for understanding the structure of contracts (Lafontaine, 1992). Franchising has also been researched from the perspective of strategic management. In this light, franchising is an important organizational form (Combs & Ketchen, 1999)

The mainstream of published research about franchising finds is basis in either resource scarcity or agency theory. The first perspective is the perspective of resource scarcity. Viewing from this perspective towards the phenomenon, franchising is seen as a mechanism to ease financial and managerial constraints on growth. The agency theory perspective is different. This perspective defines franchising as a mechanism for improving the alignment between rewarding fees or incentives on a chain wide level.

2.2.1 Resource scarcity

The researchers Oxenfeldt and Kelly (1969) published a scientific article about resource scarcity. They conclude that firms franchise with the goal to gain access to scarce resources. In particular the financial and managerial resources (local decisions and market knowledge) are popular. This is done with the underlying thought of rapid expansion. A younger firm has more difficulties in raising capital for growth by the traditional financial markets for example with public stock offerings. Raising capital for growth from existing operations is also very difficult. Other difficulties are the development of necessary managerial talent and knowledge of the local market (Katz & Otheyn, 1992). According to some other researchers rapid expansion may also be essential to build the economies of scale in purchasing and advertising necessary to effectively compete with more established firms (Caves & Murphy, 1976, Castro Giovanni & Combs, 1994). For this reason, firms are looking for access to the capital and managerial resources that are provide by franchisees when they build and manage outlets. This is even the case when returns might be higher for the outlets owned by the firm (Oxenfeldt & Kelly, 1969). The resource scarcity model that has been proposed by Oxenfeldt and Kelly (1969) is very clear. The firms turn to franchising because of the urgent need to benefit from economies of scale. This pushes the firms to expand at a higher rate than if they would only use internal resources. With the achievement of the economies of scale, expansion slows down. This leads to the fact that franchisors shift their focus on maximization of the returns. Since firm ownership seems more profitable, the franchisor will buy back its franchised outlets with the highest profits. A mature chain would slow down franchising and become primarily owned firm in the end, according to Oxenfeldt and Kelly (1969). Future studies have used franchisor age, chain size, growth rate and to measure resource scarcity, like Oxenfeldt and Kelly (1969). These studies looked at how the variables affect the proportion of franchised outlets. Some of the other studies have focused on resources like capital. However, there was a question that different researchers asked themselves. This question was if capital scarcity could be an independent factor for franchising. The assumption here is that franchisee capital is not as expensive as passive capital from sources such as for example stockholders and lenders (Norton, 1995; Rubin, 1978). Franchisees are not able to diversify their risk, they have to put their entire capital in one, or just a few outlets. For this reason capital from franchisees is considered too costly. The result of this is that franchisees that rationalize, ask for a premium on their capital above regular expectations, for the risk they take (Norton, 1995; Rubin, 1978). Since franchisees invest in their own capital, there has been a strong financial incentive (Minkler & Park, 1994). The motivational difference might be spot by passive investor