The unemployment rate hit 9.4% last week, the highest number of people out of work since 1984. With the recession dragging on, many laid-off workers are seriously contemplating franchising as a possible solution to their employment dilemma. Unfortunately, this presents a Catch-22 for the franchise industry. While it's great to have so many prospective buyers, even if they do decide to go ahead with the purchase, financing is hard to come by. Alisa Harrison of the International Franchise Association recently said that "credit and lending is still the issue that is holding back franchise sales." Let's take a look at this problem through the eyes of some franchising competitors.
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A Tough Go
A Snap-On Tools (NYSE:SNA) truck passed me the other day and it got me wondering about its franchise business and that of its major competitor, Matco Tools, also a franchisor. Matco itself is a subsidiary of Danaher Corp. (NYSE:DHR), makers of Sears Holdings' (Nasdaq:SHLD) Craftsman tools. Both have been supplying the professional mechanic trade for an awfully long time and both are struggling in this economy. Snap-on saw first-quarter sales drop 20% year-over-year from $721.6 million to $572.6 million, including 7% related to currency exchange. Danaher's were off 13% year-over-year to $2.63 billion from $3.03 billion. In terms of earnings, Snap-on's dropped 38.5% to $34.8 million and Danaher's 13% to $237.7 million. Both companies still made money, but it was nowhere near what they're accustomed to making. (Internal return on investment helps determine a stock's ability to propel shareholder returns, read Earnings Power Drives Stocks.)
Snap-on Franchise Operations
Snap-on derives approximately 38% of its total revenue from franchisees who purchase mobile tool vans from the company in order to provide sales and service to auto repair shops. Franchisees are on the front lines, building the brand. Without their success, the company doesn't do as well financially. For instance, in the first quarter, its Snap-on tools group segment generated $21.1 million in operating earnings from $242.4 million in revenue, while the commercial and industrial division's operating earnings were $18.0 million on $259.8 million in revenue. In addition to a higher operating margin, franchisees deliver additional revenue through Snap-on Credit, its 50%-owned joint venture with CIT Group (NYSE:CIT). Snap-on Credit provides customers with extended credit and equipment leasing as well as financing for franchisees.
In Q1, despite a 21.2% drop in financial services revenue (less big-ticket purchases by shop owners) the Snap-on Credit still generated $10 million in operating income. That's an operating margin of 50% compared to less than 10% for the company's operating divisions, including the tools group. With only $20 million in revenue, its financial services division delivered 15.6% of its total operating income in the first quarter. I'd say franchisees are a very important part of its business. (Find out how to put this important component of equity analysis to work for you Analyzing Operating Margins.)
Matco Franchise Operations
In the first quarter, Matco and the rest of the tools group contributed $250.2 million in revenue, less than 10% of overall sales. Operating margins were 6.6%, 210 basis points lower than its rival. Not to worry, franchisees are a happy bunch despite being such a small piece of Danaher's pie. In a recent satisfaction survey by Franchise Business Review, Matco franchisees gave the company a four-star rating placing it among FBR's list of the 50 best franchises in terms of franchisee satisfaction. Its revenues are almost identical to Snap-on's franchise operations ($250.2 million to $242.4 million in Q1) placing 39th on Entreprenuer.com's 2009 Franchise 500 ranking. Snap-on was 37th. You can't get much closer than that.
While financing is a legitimate concern for franchisors, I doubt top-ranked franchises like McDonald's (NYSE:MCD) are having difficulties getting prospective owners. From what I can tell, both franchise programs seem to provide true opportunity for its franchisees. As for which stock I'd buy, Snap-on holds bigger appeal for me because it's more of a franchise play than Danaher. Long-term, they both look good. (Learn more in Is Buying A Franchise Wise?)