We are deep enough into the pandemic to more clearly see consumer patterns. The initial brunt of inflation has been absorbed and its implications are better understood. Labor shortages and supply chain issues coursing through the economy are revealing their impact.
We’re far enough into 2022 to start seeing a picture of how franchise development is being affected, in part based on our compiling recent unit activity across thousands of brands. Understanding how all these negative economic influences are affecting franchising will help us gain some insights into franchise development in 2023. Of course, we also must factor in the next likely wave about to crash ashore in the form of a recession (and/or the newest Covid variants).
The foundation of franchise development is built on consumer behavior trends. However, Covid has forced noticeable changes in consumer preferences, the permanency of which are becoming increasingly clear. The pandemic has altered not only how and where consumers shop, but also what they buy, why they bought it, what influenced their purchasing decision, and how they have adjusted their long-term comfort with these modifications to traditional consumer activities.
Across franchising we’re seeing business models adapt to customer shifts. Determining which parts of the customer experience can be automated with greater impact on fast delivery and turnaround, as well as which customer interactions are best handled by a human touch, is an ongoing challenge for brands that cuts across almost all sectors. The impact on retail brands is obvious, but even in personal services technology is being integrated more and more into their delivery. This has been a silver lining for many brands struggling with labor challenges as today’s consumers are much more willing to embrace the integration of technology than they were pre-pandemic.
Effects on franchise development
How does all this affect franchise development? Prospective franchisees are also consumers and have their own insights and concerns. Based on some of our franchisee survey work, we’ve heard that many want to know that models have adjusted and are asking how brands are staying ahead of these accelerated consumer behavior changes. One consequence is that new brands have an advantage in how they show themselves to prospects. A challenge for many mature brands is showing a new look with existing units projecting a pre-pandemic look.
As we are being reminded, inflation is very disruptive. We spent the past dozen years in constant cost-reduction mode as price flexibility was almost nonexistent. Now the world we live in is the exact opposite. Supply chain disruptions, low unemployment, rising interest rates, and so forth have raised the cost of being in business. While consumers are psychologically accepting rising prices for almost everything, value judgments are more influential now, affecting which brands can actually make higher prices stick.
Two important keys to being able to raise prices lie in maintaining quality expectations and delivery reliability. Without raising prices, can brands demonstrate to prospective franchisees that their units have the ability to absorb rising costs and still show good unit economics? They’d better be able to do so, because prospects will want to see proof.
Consolidation on the rise
Another consequence of the pandemic and now inflationary pressures is a rise in unit consolidation. Franchise unit consolidation usually accelerates in times when economic uncertainty increases. We saw it in 2008–2010, and we’re seeing it now. Covid, shifting consumer preferences, labor shortages, supply chain woes, inflation, and now possibly a recession are driving less efficient single-unit and smaller multi-unit operators to seek exits to a much greater degree.
To prevent the negative consequences of closed units and failed franchisees, history shows us that the trend toward consolidation is further accelerated as franchisors work to address underperforming units facing stronger headwinds—which often means larger multi-unit operators buying smaller operators’ units. We’re seeing this happen now.
This has important implications because multi-unit operators represent the main source of new unit expansion. However, during periods of consolidation, multi-unit operators invest in existing unit transactions to a much greater extent, reducing their appetite (and capacity) for new unit growth.
The money factor
Financing will likely be another bottleneck slowing down both new unit and transfer deal flow. Many of our lender clients are telling us they are insisting on unit economics information to even consider loans. Underwriting teams are factoring in as much as a 2% increase in loan interest costs for business plans.
Finally, the belief that a recession is on its way has permeated business decisions, including those of franchisee prospects. At this point, whether it happens or not is less important than people believing it will. History shows that in the early stages of a recession franchise development drops. In the latter stage of a recession, when layoffs have become a concern for many, franchise development becomes a leading engine of recovery.
The shadows of the pandemic and inflation, combined with anticipation of recession, will slow development activity in the second half of the year and, as history shows, probably well into 2023 as well.
Our advice to franchisors? To be successful in the next 24 months, focus on specific operational activities that will allow you to show attractive transparency in key attributes tailored in different ways to two key audiences: prospective franchisees (both candidates and multi-unit operators) and lenders.
*This article originally appeared in Franchise Update Magazine Issue 3 of 2022. You can view it online here.