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How to Finance a Franchise

2008-03-24T22:23:00.000-07:00

Money is harder to come by these days. But you can still come up with the cash.

Put franchising on the list of credit-crunch victims.

Money for franchise start-ups and expansions is getting harder to come by. Fewer lenders are financing the businesses, and those that do so are being increasingly picky about whom they will bankroll.

That has left many borrowers turning to other sources of financing. More people are seeking out loans from the Small Business Administration, which are partially guaranteed by the government, making them less risky -- though some lenders participating in the program are tightening their lending criteria as well. And some would-be franchisees are even tapping retirement funds.

The shakeout is partly due to the mounting defaults by franchisees who got in during good times, perhaps short-changed themselves on working capital and then, when the economy faltered, couldn't cover their loans.

"Lenders just don't know what the future will bring," says Robert Snelling, president of Honor Capital Group of Plano, Texas, a financial intermediary between franchisees and financial institutions.

Who's In -- and Out

Cautious lenders are less likely to throw money at newer franchises these days. Banks are favoring those with brand names, businesses that aren't seasonal, and, therefore, don't have highly fluctuating cash flow, as well as those that have a solid core of long-term operators. Ventures with only a smattering of locations are being bypassed, in part because they lack proof that they can do well in all types of areas or fluctuating economic climates.

For would-be entrepreneurs who do get financing, unsecured loans are relatively rare. Even those with good credit may have to crack their retirement nest eggs to come up with enough cash to make a deal work.

"The first thing we want to know is, 'How much cash do you have? Any outside income coming in?' " says Rick Anderson, general manager of Franchise Finance of Little Rock, Ark., a company that originates loans and leases for the franchise industry.

Mr. Anderson says if borrowers have substantial cash, "we'd recommend they put more money into the deal -- maybe 40% to 50%, and we'd finance it conventionally." If they aren't flush, he says, they still may have to contribute at least 20% along with collateral -- perhaps just enough from a retirement account to cover the down payment to qualify for an SBA loan.

Brian Colburn, managing director of franchise finance at Butler Capital Corp., a commercial lender in Hunt Valley, Md., says that the "only bank loans I see being made to new franchisees are if a person has established other relationships with a banker, or has previous experience, or is a local figure in the marketplace. The average Joe, 99% of the time the bank will turn him over to an SBA" office.

Government Backing

Indeed, with banks becoming more tight-fisted, the SBA is becoming the place more would-be franchisees are turning to.

"It's what the SBA was created for, to provide access to capital for small businesses who can't get it through conventional means," says Christine Reilly, head of small-business lending at CIT Group Inc., a New York-based finance company. According to Ms. Reilly, CIT has recently "made some changes" to its underwriting criteria for franchising in order to reduce its risk exposure. She declines to say what those changes are.

The standard SBA loan for franchisees is known as the 7(a), which is issued by a bank or other qualified lender, and partly guaranteed against default by the government. Because of that backing, such loans are seen as relatively low-risk. SBA loans include those for short-term working capital and equipment, which often have a five- to six-year maturity; and real-estate loans, which can run for 20 years or more.

Despite the current tight-money situation, "we expect to have adequate funding to meet demand for fiscal '09," says James Hammersley, director of the agency's loan-programs division. About 10% of all SBA loans go to franchisees, with the size running between $250,000 and $500,000, although the maximum is $2 million. Most of that money is earmarked for franchise entry fees, improvements or working capital.

Even so, the program is feeling a bit of the crunch. Mr. Hammersley says about 300 of some 4,000 bank participants around the country have reduced their SBA lending activity. He also suspects that many bankers still in it are asking for more collateral.

Borrowers must be creditworthy, typically contribute some equity, and are expected to repay the SBA loan out of the franchise's cash flow. "You need to have your own blood, sweat and tears in the business," Mr. Hammersley says.

Many SBA loans carry fluctuating interest rates. While the actual rate is negotiated between the bank and the borrower, it's subject to SBA maximums, which are tied to the prime rate. While a low rate may be attractive initially, if borrowers can't generate enough business to cover their payments, "they could be in a bit of a bind," says Mr. Snelling at Honor Capital. "I get a lot of calls from individuals with SBA loans who want to refinance them," he says. "They might have gotten in at 8%, and now the rate has gone up to the high 9s or 10s."

For at least one big SBA lending participant, Wells Fargo Bank, a unit of Wells Fargo & Co., it's still business as usual. "We are not tightening up," says Thomas W. Burke, senior vice president of the bank's SBA lending unit. Nor, he adds, has the bank changed its credit criteria. Last year, Wells Fargo closed 209 SBA loans to franchisees and "year over year we're up," he says.

Wells Fargo concentrates on lending to service- and restaurant-industry franchisees -- both first-timers and established multiple-unit operators. Interest rates are market-driven and terms depend on the specific deal, Mr. Burke says.

Helping Out Veterans

Another government lending program involves the Department of Veterans Affairs. The program, called Patriot Express because of its relatively fast approval time, makes loans up to $500,000 to active-duty military preparing to transition to civilian life, as well as to spouses and survivors of veterans. The loans feature the SBA's lowest rates.

In a spinoff of that, at least one franchiser is offering financial assistance to disabled veterans who want to start a franchise. At Little Caesars Enterprises Inc., the initial $20,000 franchise fee for a store is waived for disabled veterans, and these franchisees get a 10% discount on equipment, plus about $18,000 to help open the business. "Their first food order -- dough, sauce and cheese -- we give them for free," says David Scrivano, president of the pizza franchiser. Other vendors also contribute. There's about $68,000 in total aid.

A few other franchisers offer internal financing to the general population. One is Dwyer Group, which franchises a half-dozen home-and-auto service concepts including Mr. Appliance and Glass Doctor.

The Waco, Texas, company will finance up to 70% of the typical initial $42,000 fee. The interest rate -- currently at 9% to 12% -- is based on the franchisee's credit score. Rates "may seem high," says Robert Tunmire, Dwyer's executive vice president, "but they're not putting their homes up as collateral or anything like that." Dwyer also gives a 10% discount to franchisees who pay cash.

Retirement Funds

Some would-be franchisees are foregoing loans and tapping their 401(k) retirement funds for financing. It works this way: The franchisee sets up a C corporation that will own and operate his or her business. He or she then rolls over money from a 401(k) into that corporation's profit-sharing plan. The individual then directs that those funds be invested into the franchised business.

While such maneuvers may be an attractive alternative to conventional financing, they "should be a carefully investigated decision," says Leonard Fischer, chief executive of BeneTrends Inc., North Wales, Pa., a small-business finance adviser specializing in tapping 401(k)s.

One potential downside: Should the franchise fail, the 401(k) money can be wiped out. Also, financial experts suggest checking with a professional on possible tax implications.

Expect Equifax to Perform In-Line

2008-03-24T22:21:00.000-07:00

Equifax, Inc. (NYSE: EFX - News) is finding new avenues for growth in the international, personal and commercial solution businesses, while its U.S. consumer information solution business is also showing signs of improvement. The company's growing reliance on subscription income provides a steady revenue stream, and the TALX acquisition is accretive to its earnings. Based on the company's year-to-date performance, current market trends and management's expectations -- as well as a weak U.S. economic environment -- Equifax expects consolidated annual revenue growth to be in the range of 9% to 12% for full-year 2008.

Management expects adjusted EPS in the range of $2.48 to $2.58. However, continued weakness in mortgage activity has resulted in a 7.8% decline in mortgage-related revenues in 2007. Shares of Equifax are currently trading at a P/E multiple of 13.7x our 2008 EPS estimate of $2.54. This multiple is a discount to its peer group. Though the acquisition of TALX Corporation is expected to expand margins, this will come with increased execution risk.

We believe that the stock will perform in line with the broader equity market over the near-term. Over the last six years, EFX has traded in a range of 14x to 20x forward earnings. Given the challenging market for equities, we continue to expect that the stock will trade at the low-end of this range.

Thus, we maintain a Hold recommendation on EFX shares with a six-month target price of $36.50 given its sensitivity to the credit market. Our new target price of $36.50 represents a multiple of 14.4x our 2008 EPS estimate, a discount to the industry mean and S&P 500.

Double Whammy: Bank Card Companies May Be Next

2008-03-24T22:18:00.000-07:00

Aside from Visa (V) or Mastercard (MA), it doesn’t seem as if the credit card issuers have been getting the attention they deserve. With all of the panic and concern surrounding the brokers and builders, perhaps plates are too full to take on any more. Yet, I have been thinking about how easy credit policies made available for housing created a monstrous economic problem. Even so, it does seems plausible that companies issuing collateralized debt could eventually see a recovery if the underlying property can be liquidated for some portion of its worth. But, what happens as defaults rise on credit/bank card debt, which is only backed by the full faith and credit of the borrower?

During the past few months, investors have pummeled Discover Financial (DFS) and others lenders over fear of rising defaults and delinquencies. Here is an example of the recent news and behavior of credit companies caused by the subprime problems (2/12/08 Washington Post):

The subprime mortgage meltdown has spilled into the credit card industry in other ways. Banks have reported steep write-offs related to the mortgage mess, and their stock prices have plummeted.

“Credit cards historically have been a very profitable segment for the banking industry, so what they’re doing is trying to squeeze customers as much as they can, particularly for accounts they don’t see as profitable or as high risk,” said Curtis Arnold, founder of CardRatings.com, a consumer resource on credit cards.

Bank of America (BAC), for instance, notified some customers last month that their rates would increase as a result of a periodic review of their credit risk. Chase (JPM) last fall increased the rate paid by new customers of its Freedom card. Bank of America and Chase are also among some banks that have increased ATM fees for other banks’ customers to as much as $3. Capital One (COF) has changed its cash-advance fee for new customers from 19 percent to 23 percent.

Beyond the current economic crisis, there is an even more troubling issue confronting the industry with the pending legislation known as H.R. 5244: (MSNBC Consumerman)

‘The Credit Cardholders’ Bill of Rights Act of 2008, known as H.R. 5244, would protect cardholders from arbitrary interest rate increases and unfair fees. Maloney, who chairs the House Financial Institutions and Consumer Credit Subcommittee, is quick to point out that her bill does not have any price controls. It does not cap rates or fees.

Interestingly, it looks as though some analysts are continuing to recommend a BUY rating on COF and other names within the sector and are oblivious to the mountain of problems facing bank card companies, aka: The Double Whammy: (Yahoo/AP)

Amid difficulties with mortgages in the U.S. and unloading corporate debt, banks are competing more than ever for market share in their core business — deposits. A large source of profit, banks are introducing newer, higher-yielding accounts to attract more customers’ cash.

The grease that keeps the wheels turning for these companies is capital. In times when money is easily available, bank-card companies utilize their customer accounts to lend money to the credit card customers. As credit card balances rise, new capital is needed to meet the consumer demand.

In order to bring in fresh capital, brokers such as Lehman (LEH), JP Morgan and Goldman Sachs (GS) raise money through note, bond and stock offerings. What do banks do? Of course if they are publicly traded they have the ability to do the same as the brokers and other companies, yet a quieter and quicker maneuver is to bring in new deposits through higher yielding savings accounts. This also helps to bring up the reserve requirements for loans issued through credit card issues and direct loans.

The simple point shows that as customers continue to look for safer alternatives and margins are squeezed as delinquencies and defaults rise, banks that do a big business within the consumer credit card arena could be hit by both problems of limited capital available to loan and ceilings on the fees they can charge for those loans.

The problem for COF is not restricted to our country. Over the past several years, Capital One move aggressively into England and offered attractive terms in order to expand their reach into the credit card business. The New York Times recently explored this problem in the March 22 article entitled, Debt-Gorged British Start to Worry That the Party Is Ending:

…Economists say Britain’s relationship to debt is complex, but at its core is a phenomenon more akin to recent American history than European trends. As in the United States, a decade-long housing boom and strong economic growth bolstered consumer confidence, creating a perception of wealth almost unknown in countries like Germany and Italy.

…The average British adult has 2.8 credit or debit cards, more than any other country in Europe. A growing number are borrowing to pay for vacations, furniture, even plastic surgery. As a result, Britons are spending more than they earn, racking up a household debt-to-income ratio of 1.62 compared with 1.42 in the United States and 1.09 in Germany.

CNN/Fortune has picked-up on the potential problem back in October, 2007. It is becoming ever apparent that there is a trend that is developing on both sides of the Atlantic. The looming question being asked is; How similar are the problems of British consumers to those of their Americans counterparts. If England is really an advanced indicator, the pain will be unbearable in the next few months. The $915B bomb in consumers’ wallets:

If there is an international precedent the U.S. should be watching, it’s actually that of the U.K. British consumers are just as overstretched as Americans, but since the real estate market there rose faster and fell earlier, they’re about 18 months ahead in the credit cycle. Since the last quarter of 2005, credit card delinquencies and charge-off rates in Britain have risen as much as 50%, forcing banks to take huge write-offs.

It’s a sign of the times that, according to one survey last month, 6% of British homeowners have been using their credit cards to pay their mortgages. That’s suicidal, of course, given that credit card interest rates are more than double even the heftiest mortgage. Keep your fingers crossed that it’s not a trend that crosses the Atlantic.

So, that all leads to the main point of the discussion: Capital One Financial. Take a look at the business model for the biggest issuer of credit/bank cards in the U.S.:

The National Lending segment consists of three sub-segments: the U.S. Card sub-segment, which consists of domestic consumer credit and debit card activities; the Auto Finance sub-segment, which includes automobile and other motor vehicle financing activities, and the Global Financial Services sub-segment consisting of international lending activities, small business lending, installment loans, home loans, healthcare financing and other diversified activities.

At this stage of our economic cycle, any one of the three sectors would be enough to concern for an investor . This is not the time to be tinkering in an area that has seen a historic contraction without any real plan for recovery. Reports on revolving and non-revolving credit have not been encouraging either. It is perplexing how COF’s stock price has maintained a relatively decent level of support with all of the data and projections available; yet that is exactly why we are zeroing in on this particular company.

The chart above shows the massive increase in revolving credit over the past 18 months. This will only be good for the issuers of credit cards as long as payments stay current. If we see a further increase in late payments and defaults, all bets are off as this stock could nosedive towards the $20 price not seen since 1998. The last time we saw a share price significant slide was during 2002 when the economy was slowing at a rapid pace. The fact is that right now, there are too many headwinds to own this name.

Beyond that, there is one recent piece of news out that needs to be addressed and flushed-out. Odd as it seems, on February 1, 2008, COF’s press release explained of the company’s plan to raise the quarterly dividend from $0.027 to $0.375, payable Feb. 20, 2008 to stockholders of record on Feb. 11. In addition, they put a $2BILLION stock buyback plan into motion. Why? The only thing that can be made of this is an attempt to make it look as though the company is past their problems, and management is convinced they will be profitable over the long term. The ugly little truth is that this kind of maneuver allows the company to actually pay less for the dividend, in total, and increases EPS by taking shares off the market. It appears to be nothing more than a move to buy some more time hoping to see if this whole credit crisis will blow over. I am not buying that hype, or the stock!

It is abundantly clear that we are seeing a rise in delinquency rates across all credit genres. The only reason that there has been a lag for the bank card component is that consumers have realized that this is the only remaining source of funds as the equity in their homes have dried up and new home equity loans will be difficult or impossible to find. What used to be the order of payments: Mortgage-Auto-Credit Cards has now changed to Credit Cards-Auto-Mortgage. At first this may seem to be a ray of sunshine in an otherwise cloudy forecast. yet, once again, this is actually a more concerning trend as it shows that borrowers are keen to the current need to keep credit available until they exhaust their limits. None of this is very encouraging.

Throughout the country, credit counseling professionals concur. (USA Today 2/28/08)

Credit bureau analyses of consumer payment data show that financially squeezed borrowers have begun paying their credit card and car bills before their mortgages. That’s a striking reversal from the norm, one that reflects rising desperation. It suggests that some people essentially have given up trying to stay current with their mortgages and instead are focused on using credit cards to squeak by.

If the trend persists, many economists say, it could accelerate mortgage losses and further drag down the economy.

Adding further concern is the fact that COF insiders are dumping shares. Whether planned or not, insiders reduced their positions by 10% during the past few months. Keep in mind that this company announced, back in February, a massive buyback program planning to redeem 10% of the total market cap. This points to the obvious strategy of the company’s management to help keep shares artificially high as they are selling. Institutions have also had the same idea and have sold off over 23 million shares during the past 6 months, effectively reducing their positions by 7%.

Needless to say, COF=SHORT for our portfolios. We have been recently begun building a position for clients. There just doesn’t seem to be any good reason to put money into an institution that relies on uncollaterlized consumer debt as its product/inventory. Adding the economic climate, consumer sentiment and the pending legislation does not seem to provide a recipe for success. Sure, anything is possible - but why go long into a position that appears to have so many potential traps?

Moody's Downgrades Hillenbrand On Split

2008-03-24T22:16:00.000-07:00

Hillenbrand Industries announced last week that it would be spinning off its funeral services business prompting Moody's on Monday to downgrade the company.

The Batesville, Ind.-based company saw its Moody's (nyse: MCO - news - people ) rating go from A3 to Baa after news that it would be having an initial public offering for its Batesville Holdings, the funeral services division that specializes in caskets. The outlook on the rating is negative.

The funeral services division, set to distribute shares on March 31, will be re-branded as Hillenbrand, while the other division of the company, the medical services division, is now called Hill-Rom Holdings.

Moody's said that the new rating better represents the risk-associated with the company due to higher margins and greater stability associated with the casket business. Moody's is concerned that this places the remaining medical supply business in line for an aggressive acquisition.

Shares of Hillenbrand (nyse: HB - news - people ) were up at close on Monday by1.2%, or 56 cents, to $49.02.

On Monday, Batesville Holdings announced a new board of directors in preparation for the split. The new company will trade on the New York Stock Exchange under the symbol HI.

Cash America raises profit outlook

2008-03-24T22:13:00.001-07:00

Cash America International Inc., a pawn shop operator and payday lender, said its first-quarter earnings will be higher than previously expected due to better revenue growth and lower-than-expected loan losses.

Fort Worth-based Cash America (NYSE: CSH) said earnings for the quarter ended March 31 will likely reach 80 cents to 82 cents a share, rather than its previous forecast of 70 cents to 75 cents a share. The company earned 63 cents a share in the year-ago quarter.

Analysts surveyed by Thomson Financial estimated earnings of 72 cents a share.

The company plans to release its first-quarter results on April 24.

Cash America has 942 locations in the United States and also offers short-term cash advances over the Internet in 32 states and in the United Kingdom.

CapitalSource Shares Jump on Killed Deal

2008-03-24T22:09:00.000-07:00

CapitalSource Shares Leap on Relief Over TierOne Deal Falling Through NEW YORK (AP) -- Shares in CapitalSource Inc. leaped Monday after the lender said it killed its deal to buy TierOne Corp., a bank struggling with bad credit.

CapitalSource, a lender and investment manager based in Chevy Chase, Md., in May agreed to buy TierOne Corp. for stock worth $652 million at the time. The company, which manages $20.9 billion in investments, wanted to buy the Nebraska-based bank for its deposits.

Last week, the deal fell through. Each side claimed responsibility for squashing the agreement.

Regardless of who killed the deal, Friedman Billings Ramsey analyst Scott Valentin said it is good news for CapitalSource. Any benefit the company would have enjoyed from the bank's $2.4 billion in deposits would have been more than outpaced by the deteriorating credit quality of the bank's loan portfolio, he said.

Of TierOne's $3.34 billion loan portfolio, more than $1 billion are real estate loans, mainly loans to builders and developers. These loans have suffered a devastating decay in quality because of flagging property values.

The bank squirreled away $68 million to cover bad loans last year, a fivefold increase from 2006 and 2005 combined.

CapitalSource's stock jumped $1.15, or 11.2 percent, to close at $11.38 Monday.