An acquisition is sizzling at Chili's restaurant owner Brinker International (NYSE:EAT). On July 10, Brinker announced an agreement to acquire 116 Chili's restaurants from a franchise owner. This transaction will give Brinker full control over the day-to-day management of these locations.

Brinker has been a strong operator of its company-owned stores, and this deal should provide a boost to earnings.

A man and woman eating hamburgers in a restaurant.

Image Source: Getty Images.

Owning vs. franchising restaurants

To franchise or not to franchise? For Brinker, the answer has been to do both. The company has long employed a strategy of operating a sizable base of both company-owned and franchised restaurants under the brands Chili's Grill & Bar and Maggiano's Little Italy. Of the company's 1,676 total restaurants, roughly 60% are currently owned and operated by Brinker.

The deal to acquire an additional 116 units will tip that balance toward owning more stores outright. But what are the trade-offs to owning vs. franchising units?

Store Category Chili's Store Count*

Maggiano's Store Count*

Total Stores

Company-owned 945 52 997
Franchised 678 1 679

*Store count as of March 27, 2019. Note: Table reflects store counts before the announced acquisition of 116 franchised units. Data Source: Brinker International Financial Reports.

There are advantages to franchising. Namely, a restaurant brand owner (Brinker, in this case) can outsource the day-to-day management of individual locations and focus on marketing and advertising. Brand owners charge fees to franchise operators to cover marketing expenses and also get a royalty on restaurant sales. This can be a very profitable business for the brand owners who do not have to tie up money into buying inventory or paying restaurant staff.

Restaurant companies including McDonald's, Wendy's, and Dunkin' Brands franchise the vast majority of their units and boast healthy operating profit margins. Other restaurant companies including Chipotle Mexican Grill and Darden Restaurants operate their own units and have inferior profit margins.

MCD Operating Margin (TTM) Chart

MCD Operating Margin (TTM) data by YCharts.

However, franchising doesn't make sense for every restaurant concept. When you outsource day-to-day operations to a third party, you lose control over the customer experience. If a third party operating a franchise doesn't do a good job or cuts corners, it could hurt the brand. Furthermore, a streamlined concept like Dunkin' Donuts may be easier for a third party to operate than a sit-down restaurant like an Olive Garden (owned by Darden Restaurants) or a Chili's.

Also, having control over the restaurants gives the company control over all of the cash flows, not just the royalties received from a franchise. Profit margins may be lower, but the gross sum of profits is higher.

Clearly, there are pros and cons to both restaurant strategies.

The opportunity to improve performance

A likely motivation for Brinker to acquire the franchised restaurants is the opportunity to create value by improving their operating performance.

The 116 units being acquired generate $300 million in annual sales, or $2.6 million per restaurant. This compares to $2.8 million per company-owned restaurant. This represents a nearly 10% gap in gross revenue at the restaurant level that could be improved.

The direction of revenue has also been stronger at company-owned Chili's locations. The comp growth metrics show that Brinker's company-owned Chili's have grown at a faster rate than franchised stores overall. Note that franchised comp growth reflects all franchised units, not just the ones being acquired.

Store Category Q3 2018 Q4 2018 Q1 2019 Q2 2019 Q3 2019
Company-owned Chili's comp growth (0.4%) 0.6% 2% 2.9% 2.9%
Franchised Chili's comp growth (2.2%) (1.4%) (0.2%) (0.8%) (0.2%)

Data Source: Brinker International Financial Reports.

Brinker doesn't report the profitability of franchised restaurants, but restaurants that generate more revenue are probably more profitable.

If Brinker can acquire franchised restaurants at a reasonable price and then make those units more profitable, the company will be able to create value for shareholders. The company has not disclosed the purchase price of the announced transaction, so investors do not yet know what kind of deal the company is getting.

Brinker's low valuation

One of the perks of being a franchisor is that investors generally reward you with a high valuation multiple. Investors like that franchisors are capital-light businesses that typically generate healthy profit margins, and they do not mind paying up for these stocks.

Brinker International has not benefited from a premium valuation. Trading for just 10 times price to earnings (P/E), its valuation is quite low despite the fact that it franchises a third of its restaurants.

MCD PE Ratio (TTM) Chart

MCD PE Ratio (TTM) data by YCharts.

Perhaps Brinker has a low valuation multiple because investors do not care for a hybrid owned/franchise model and have focused on the fact that the company is mostly a restaurant owner-operator. Another explanation could be Brinker's recent slide in profit margins. Whatever the reason, the low valuation gives the company less of an incentive to stay franchised.

Looking forward

The acquisition of the franchised stores checks out as a smart move. Brinker is a proven restaurant operator, and there is limited operational risk involved. The company can finance the deal with relatively cheap debt and is in a good position to improve profitability at the acquired restaurants. This is a surefire way to create value for shareholders so long as the company doesn't overpay for the assets.

The deal is slated to close early in the company's fiscal year 2020 and is expected to be immediately accretive. Management will probably have more details to share in the coming months. With obvious upside and limited downside, the transaction appears to be a no-brainer.

This article represents the opinion of the writer, who may disagree with the “official” recommendation position of a Motley Fool premium advisory service. We’re motley! Questioning an investing thesis -- even one of our own -- helps us all think critically about investing and make decisions that help us become smarter, happier, and richer.