Despite being one of the largest stocks on Aim, Franchise Brands is not covered by many analysts and attracts virtually no media attention. This is not particularly surprising: the group spends its time unblocking drains, fixing hydraulic hoses, and draining grease from industrial ovens. It also has a small business-to-consumer (B2C) arm offering dog-sitting, minor car repairs and – you guessed it – more oven cleaning.

The key point, however, is that it provides most of these services via a franchise model. The group has a combined network of 648 franchisees across seven brands in 10 countries, covering the UK, North America and Europe. While Franchise Brands HQ provides marketing, training and IT support, as well as help with invoicing and logistics, the individual operators are responsible for getting out there and making money.

In return for the help they receive, franchisees pay a monthly “management service fee” which is either a cut of their invoiced revenue or set at a fixed rate. 

The WS Gresham House UK Micro Cap fund counts Franchise Brands as its third biggest holding, a fact that manager Ken Wotton attributes largely to its corporate structure. “The model of effectively devolving the profit and loss exposure and responsibility to the underlying franchisees, and supporting them from the centre, is very scalable,” he says. “It’s a low capital intensity, high return on capital business model which should be high margin and convert profits to cash quite strongly.”

 

 

We touched on the power of franchising in the Ideas section last week, when we discussed the estate agency group Belvoir (BLV). That business appears to be thriving in a highly cyclical industry. In some ways, however, Franchise Brands has a far cushier deal. Unlike the property sector, the markets it operates in are not particularly sensitive to economic conditions. Most plumbing problems need to be dealt with urgently, and clients are unlikely to quibble too much over price. Therefore, while management did report “some softening of demand” in the summer months due to equipment not being used as intensively, demand is unlikely to fluctuate too wildly in the medium term. 

It helps that its businesses operate in very fragmented markets, and all have a market share of less than 5 per cent. This means there should be an abundance of organic growth and cross-selling opportunities. “The ability to serve customers through a one-stop range of services is becoming more of a competitive advantage,” management suggests.

The scale of this task, and the execution risks involved, could set off alarm bells – but Franchise Brands has a secret weapon. The group was co-founded in 2008 by Stephen Hemsley, who was previously finance director, chief executive and chair of franchise giant Domino’s Pizza (DOM) and took the chain from private ownership to a market capitalisation of almost £1.5bn. While many small caps are slightly under-managed, therefore, Franchise Brands seems to be in an extremely capable pair of hands and has its eyes firmly set on growth. 

Hemsley certainly has plenty of skin in the game, given he owns about 12 per cent of the company. His stake is matched by that of fellow co-founder and former Domino’s investor Nigel Wray, who is now a non-executive director.

 

Deal dilemma 

In theory, therefore, Franchise Brands is on the path to success. But what about the reality? 

Its growth trajectory has been impressive since its IPO in 2016. System-wide sales – the total aggregate sales of franchisees plus a small contribution from direct labour operations – have shot up as the franchisee base has grown and become more successful, and the group has consistently achieved double-digit adjusted profit growth as a result. Meanwhile, its average operating margin sits at a comfortable 10 per cent, and – historically – it has turned the lion’s share of profits into cash. 

Changes in the last 18 months, however, have radically altered the corporate dynamic. In March 2022, Franchise Brands announced a £50mn all-share merger with Filta, a kitchen services company.Earlier this year, it bought hydraulic equipment specialist Pirtek for £200mn, effectively doubling the size of the organisation.

 

 

 

These deals – particularly the second – have had a major effect on the group’s income statement. Margins contracted in the first half of 2023 as Franchise Brands wrestled with big amortisation charges, one-off acquisition costs and an increase in administrative expenses, which were pumped up by Pirtek’s and Filta’s overheads.

More important was the effect on Franchise Brands’ balance sheet. While Filta was paid for with new shares, management relied on both an equity fundraising and debt to fund the Pirtek acquisition. As such, the balance sheet is now highly leveraged, with net debt sitting at 2.5 times Ebitda at the half-year mark.

Several red flags seem to have started fluttering, therefore. Interest rates are high and investors are very nervous about companies – particularly small companies – burdened with borrowings. (The group’s interest charge is averaging 8 per cent on gross debt.) The two big acquisitions will also need to be integrated and there is no certainty as to whether management will pull it off. 

On the flip side, however, there are huge opportunities. The TB Amati UK Smaller Companies Fund added Franchise Brands to its portfolio after the Pirtek acquisition, and manager David Stevenson said the impressive scale of the group means “there is real scope to grow organically from here”. 

Stevenson is also so confident in Franchise Brands’ cash generation that he believes debt will not be an issue for long. This chimes with management’s plan to repay the acquisition facilities within five years, while abstaining from other major deals in the meantime.

Management is also keen to shift the B2C part of the business, as it is more exposed to economic downturns and is struggling to attract new franchisees in the current market. So far, though, it has not liked any of the offers it has received and has suspended marketing activity until further notice.

If it can sell these businesses – and Stevenson believes they could fetch a price equal to their combined turnover of £25mn – this would also help the deleveraging effort.

There are a lot of ‘ifs’ right now, and the struggles of the B2C brands will make some investors nervous. However, Franchise Brands’ valuation reflects this uncertainty. A business of this sort would typically trade on a premium compared with more capital-intensive companies. For example, the enterprise value (market capitalisation plus net debt) of the most famous franchise business in the world, McDonald’s (US:MCD), is now nine times sales. The comparable multiple for Franchise Brands – which uses similar leverage, albeit at a higher cost – is around three, while its forward price/earnings multiple of 14 compares favourably to a five-year average above 20.

Worries about debt and unproven expansion plans could transform into something far more positive, however, if Pirtek and Filta start to pull their weight, borrowings are paid off and demand holds steady. All three targets looks achievable.

Company Details	Name	Mkt Cap	Price	52-Wk Hi/Lo
	Franchise Brands (FRAN)	£262mn	135p	250p / 130p
Size/Debt	NAV per share*	Net Cash / Debt(-)	Net Debt / Ebitda	Op Cash/ Ebitda
	54p	-£87.1mn	–	63%

Valuation	Fwd PE (+12mths)	Fwd DY (+12mths)	FCF yld (+12mths)	P/Sales
	14	1.8%	6.6%	2.6
Quality/ Growth	EBIT Margin	ROCE	5yr Sales CAGR	5yr EPS CAGR
	8.8%	13.0%	30.1%	–
Forecasts/ Momentum	Fwd EPS grth NTM	Fwd EPS grth STM	3-mth Mom	3-mth Fwd EPS change%
	17%	8%	-8.2%	-1.6%

Year End 31 Dec	Sales (£mn)	Profit before tax (£mn)	EPS (p)	DPS (p)
2020	49	4.8	4.3	1.10
2021	58	6	5.4	1.50
2022	99	13	8.4	2.00
Forecast 2023	160	20	8.5	2.23
Forecast 2024	187	27	10.2	2.53
Change (%)	+17	+35	+20	+13
Source: FactSet, adjusted PTP and EPS figures
NTM = Next 12 months
STM = Second 12 months (ie, one year from now)
*Includes intangible assets of £85mn, or 44p a share