
Alicia Miller
One of the most compelling things about franchising is that lagging or failing brands CAN be reinvigorated. Franchising is incredibly resilient in that way.
Franchise turnarounds, however, are also among the toughest assignments in business. Franchisees must believe in and underwrite the turnaround for it to take hold.
There are three clear themes visible in successful franchise turnarounds.
Leadership has significant operating experience, often as franchisees themselves. There are interesting second or third career options for former multi-unit franchisees and corporate leaders with strong operating and also turnaround experience. It’s a unique skillset.
Sponsors are patient but also provide a clear mandate for change. There is a big difference between patience and passiveness. There must be a clear mandate for change, reinvestment in the business at the brand level and strategic support.
Focus on recreating the value proposition for both customers and franchisees. It’s back to the drawing board. What is differentiated and special? A complete rethink about unit-level profitability is also needed. Franchisees will be understandably skeptical, so communication and collaboration with them is key.
Stall-outs that remain stuck are missing these elements. Scale brands held by “long-hold” investors are at the greatest risk. The temptation is for the sponsor to milk cash flow for far too long.
Learning from legacy pizza
Let’s look at a notable turnaround example: Sbarro. Fifty-year-old franchise brand Sbarro was acquired by MidOcean Partners and Ares Management in January 2007 for $450 million ($208 million was debt, according to Buyouts magazine). At the time, there were 1,000 Sbarro locations in 34 countries and 11,000 employees. Sbarro reported EBITDA of $49 million prior to the transaction.
The timing turned out to be terrible. Changing consumer tastes, higher ingredient prices and competition in pizza/QSR created enormous pressure. Planned expansions in Brazil and Japan fell flat. The recession of 2007 to 2009 hit Sbarro’s shopping mall locations hard.
But heavy debt also reduced optionality. In January 2011, S&P downgraded Sbarro to “CC,” a low “junk” status. Sbarro notified lenders and the U.S. Securities and Exchange Commission about the potential of default. Despite the company’s eroding position, more debt was added, climbing to a total of $404.3 million by November 2011. What could possibly go wrong?
Sbarro declared Chapter 11 bankruptcy. After wiping out 70 percent of the existing debt, Sbarro’s remaining debt (held by Guggenheim and Apollo) was still high. MidOcean’s and Ares’ equity stakes were wiped out.
Sbarro continued to struggle. EBITDA declined to $21 million in 2011 and $15 million in 2012. What the brand really needed was a proven operational leader at the helm with a well-conceived turnaround plan and partners patient enough to give management time to execute on that plan.
It was at this point that J. David Karam entered as CEO. Karam was an experienced multi-unit franchisee of Wendy’s (at one time owning more than 350 stores), and later tried to buy the parent company. When the Wendy’s board opted instead to accept a competing bid from Nelson Peltz and his Trian Partners in 2008, Karam came in as president to run the business under Trian for several years.
Karam took over as CEO of Sbarro in early 2013. EBITDA that year was only $4 million. Karam recalled the major steps in the reboot process and the results:
“The prior restructuring wasn’t as effective as it could have been. There was still too much debt relative to EBITDA, and they didn’t take the opportunity to abrogate bad lease deals. I started in March 2013. By November we had aligned around a restructuring plan. We filed for bankruptcy again in April 2014. It was a lot to get through—of course franchisees, landlords and vendors were alarmed about the second bankruptcy. But we explained how we planned to turn the brand around. Apollo and Guggenheim remain invested in the brand today, and I am now the majority owner along with my sons. We repositioned the brand around New York-style pizza by the slice and built out the team. It took time to heal from a decade of misdirection and the bankruptcies, but we’re back on a solid path.”
Karam said he sees a “huge opportunity” ahead. “Pizza is the second or third largest QSR category. What we provide is unique, high-quality pizza by the slice. We defined and now dominate the impulse pizza category,” he said. “Our offering is differentiated by its quality. For example, we make our own dough and shred our own cheese daily in our stores. We know that if we put our locations in high foot traffic areas, our beautiful displays of food and our crave-able offerings will get their share of that customer traffic. Five years ago, we also added third-party delivery and it’s grown to be a significant part of our business.”
The momentum is “tremendous,” Karam continued, and Sbarro recently opened its 700th location. It opened 103 new stores last year alone and should open 110 this year, he said.
“EBITDA has grown significantly, and we’ve reduced our leverage … we should be debt free in 36 months. There are 1,000 malls in the U.S. but we’re only in 250. There are 150,000 convenience stores and 20,000 travel centers in the U.S. alone. We also target colleges, airports, casinos and other high-traffic locations,” he said. “There is plenty of greenspace. International markets are high growth, now more than half of our development.”
Once a franchise system is in distress, only the hard work of investing back into the brand, rebuilding or reinventing both the customer and franchisee value propositions, consolidating what’s left of the system under the best possible operators, and rebuilding franchisee trust will turn the brand around. That’s a massive, expensive, multi-year undertaking with one big unknown—whether franchisees will ever get on board. But if franchisees see value in changes made and believe that the future is bright, they will invest again.
There’s always a place for skilled turnaround artists and teams to do good work. But following best practices, making investments along the way to keep the brand and offerings current, and avoiding over-leverage is the easier path.
This column's author bio has been updated: Alicia Miller is the founder and managing director of Emergent Growth Advisors. Her Development Savvy column covers smart ways to market and grow a franchise. She is also the author of the forthcoming book, “Big Money in Franchising: Scaling Your Enterprise in the Era of Private Equity.” Reach her at [email protected].