Top Franchises: Investing in Red Robin Gourmet Burgers

Source: Jwinters, Wikimedia Commons.

Since opening its first restaurant in Seattle in 1969, Red Robin Gourmet Burgers (RRGB -0.60%) has delivered an unparalleled top-line burger dining experience to millions of patrons. When Red Robin opened its first franchise location 10 years later in Yakima, Wash., it opened the door to a new business model for the company that has helped carry it forward over the ensuing decades. Now Red Robin has about 500 locations, of which more than a quarter are owned under franchise agreements by independent business owners. Although the company has had its ups and downs, Red Robin has come a long way. Let's look at Red Robin from an investment perspective, both for those who are considering buying its stock and for would-be franchisees seeking to cash in on the restaurant chain's success.

Stats on Red Robin Gourmet Burgers

Source: Red Robin Gourmet Burgers 10-K. .

How Red Robin franchises work
Red Robin's franchisees operate in 20 U.S. states and two Canadian provinces. Two of Red Robin's 18 franchisees account for almost a third of its total franchise store count, with one concentrating in the Midwest and the other on the eastern portion of Pennsylvania. Red Robin hasn't actively sought new franchisees in recent years, but the company has said it is considering expanding its franchise program in a way that could open up new regions to entrepreneurs. For instance, last year, Red Robin gave one of its existing franchisees the right to develop five new restaurants in West Texas.

The typical Red Robin franchise agreement occurs in stages. First, would-be franchisees sign an area development agreement with the company to gain the exclusive right to operate one or more restaurants in a particular area, with an initial five-year term. The franchisee pays Red Robin a $10,000 development fee per restaurant. Once those restaurants open, the franchisee must pay an additional $25,000 franchise fee, giving the restaurant the rights to Red Robin's intellectual property for an initial 20-year term and an option for a 10-year extension upon meeting certain conditions.

Source: Red Robin Gourmet Burgers.

Best of all for Red Robin, franchisees pay ongoing royalties as a percentage of revenue. Currently, the royalty fee is 4% of adjusted gross restaurant sales, although some of Red Robin's existing franchisees pay lower royalties of 3% to 3.5% depending on when they negotiated their agreements.

A potential payday for franchise owners
Typically, most franchisees enter a franchise agreement with the expectation of building a successful business that can support them for the long run. But opportunistic franchisees can also hope for a shorter-term exit strategy that can be extremely lucrative.

Specifically, Red Robin has regularly acquired some of its franchised restaurants in order to bolster its internal growth. In April, Red Robin said it would pay $40 million to acquire 32 of its franchise locations from franchisee parent 5B Investments. The benefit for Red Robin is that franchisees have already done all the work in getting the locations off the ground, allowing the company to sweep in and collect the rewards. In exchange, franchisees can get buyout payments that reflect not only what they have invested in development and franchise fees, but also the future value of the income they generate.

Source: Red Robin Gourmet Burgers.

The best way to play Red Robin right now
At least for now, though, expanding its franchise network doesn't appear to be a top priority for Red Robin. That's largely because it has sought growth through its "effective expansion" strategy of opening new company-owned restaurants. Yet in its most recent quarter, Red Robin announced disappointing results, with a more than 15% drop in year-over-year net income and revenue growth that slowed to 7.5%.

With purchases of existing franchisees, Red Robin has prioritized maximizing revenue over the longer-term income prospects of franchise agreements. That makes investing in the stock the best way to participate in Red Robin's future success. But if the company expands at an even quicker pace, would-be franchisees might have the opportunity to invest more directly in Red Robin once again.