Third largest fast-food chain Wendy's (NASDAQ:WEN) wants to strip one of its biggest restaurant operators of its franchise agreement for failing to upgrade its restaurants and install a point-of-sale system. While it could result in the franchisee being forced to close or sell its restaurants, it also brings into focus the larger issue of just how much control a parent company can exert over its affiliates.
A lone holdout
DavCo Restaurants operates over 150 restaurants in Maryland, Washington, D.C., and northern Virginia, and is Wendy's fourth largest operator. According to Wendy's, the franchisee has proved through word and deed it won't remodel its restaurants or install a new POS system from NCR (NYSE:NCR).
According to the Baltimore Business Journal, DavCo had revenue of more than $220 million in 2013, but it still might be hesitating to upgrade due to its finances.
While the estimated $450,000 to $650,000 per restaurant cost of the Image Activation upgrade isn't cheap, Wendy's says restaurants that have completed the remodel enjoy an average 10% to 20% increase in sales. And to curb costs, Wendy's has offered franchisees incentives to upgrade, such as paying for the software license fees, help with financing the rollout for restaurants committed to installing the system by July 2015, and offering deductions in royalty payments for one or two years after completing construction depending upon the type of remodel.
Wendy's wanted about half of the company-owned restaurants and about 20% of the total system to have completed Image Activation upgrades by the end of last year, and it wants to have 60% of its North American restaurants upgraded by 2020 at a rate of 10% a year, which suggests DavCo would be required to upgrade 15 restaurants annually.
Wendy's believes the primary reason same-store sales at company-owned stores are higher than those of its franchisees is because it has remodeled more of its restaurants than they have. In its third quarter earnings report issued last November, comps at Wendy's-operated restaurants were up 2% from the year ago period while franchised comps were just 0.5% higher.
But because there are more franchised restaurants than company-owned stores to upgrade going forward, the burger chain could enjoy a big uptick in revenues over the next couple of years as the franchisees ramp up their conversions -- which explains why Wendy's takes issue that its fourth largest franchisee is balking at participating in the upgrade program.
A lesson in recent labor law
Control over rogue franchises and enforcing compliance was the subject of the National Labor Relations Board's ruling against McDonald's (NYSE:MCD) last month, which stated that the burger chain is a "joint employer" and could be held liable for actions its franchisees took against employees that participated in protests for higher wages last year.
The ruling essentially said because McDonald's uses its resources and technology to exert sufficient control over its franchisees' operations, beyond just protecting its brand, it has more than an arms-length relationship to them. McDonald's counters it's franchisees are the ones that set wages and working conditions, and the rulings "strike at the heart of the franchise system" and overturn decades of settled law if allowed to stand.
In this context, Wendy's forcing DavCo and other franchisees to upgrade their restaurants and install the POS system would certainly be part of protecting its brand, but others argue dictating rules for franchisees, such as renovations, shows the extent of control parent companies exert over the business.
A complete makeover
While it's unclear if Wendy's will strip DavCo of its franchise agreement, this conflict certainly highlights the complicated relationships between franchisees and their parent companies and how franchisees contribute to the overall success and long-term health of the brand.
Wendy's believes its remodeling program will help it remain competitive as it faces challenges from the fast-casual dining trend. To do so, the parent company will need to keep its franchisees in line. Stripping marketing rights from those that try to buck the system may be a necessary component of its business.
Follow Rich Duprey's coverage of all the restaurant industry's most important news and developments. He has no position in any stocks mentioned. The Motley Fool recommends McDonald's and NCR. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.