Order 1180197: Louis Vuitton- 1. What has made Louis Vuitton′s business model successful in the Japanese luxury market. 2. What are the opportunities and challenges for Louis Vuitton in Japan? 3. What are the specifics of the Japanese fashion luxury marke
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Franchising, Licensing and Distribution
Professor CJMambula1
ENT 5183-60909 Fall Semester 2018
Langston University
Table of Contents
San Francisco Coffee House: An American Style Franchise in Croatia...........................................5
ServiceForce: Scaling up Financing...............................................................................................15
Louis Vuitton in Japan....................................................................................................................33
Fast Eddie's....................................................................................................................................53
The Espresso Lane to Global Markets...........................................................................................77
Carpenter Tan Handicrafts Co. Ltd.: Franchisee Satifaction..........................................................93
Threshold Sports, LLC..................................................................................................................101
Note on Financial and Legal Aspects of Franchising....................................................................127
Franchising, Licensing and Distribution ENT 5183-60909 Fall Semester 2018
Professor CJMambula1 Langston University
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9B08A013 SAN FRANCISCO COFFEE HOUSE: AN AMERICAN STYLE FRANCHISE IN CROATIA
Ilan Alon, Mirela Alpeza and Aleksandar Erceg wrote this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. Copyright © 2008, Ivey Management Services Version: (A) 2010-04-20
On the return to their homeland of Croatia following a six-year visit to the United States, Denis Tensek and Jasmina Pacek decided to open an American-style coffee house reminiscent of San Francisco’s atmosphere. While Croatia had many coffee houses, few had the combination of service, quality, products and atmosphere that they remembered from their time living in the United States. Tensek and Pacek started with a single coffee house. From the beginning, they felt that it had the potential to grow into a franchise. Instead of purchasing a franchise from someone else, they considered creating one that had all the elements of the modern franchise chains that were available on the international market plus the adjustments needed to the local market. They decided to use all of their U.S. lifestyle and professional experiences as well as understanding of habits and behaviors of the local market to create this new local concept in Croatia. The initial coffee house became a success. The business steadily grew and operating profits had reached a satisfactory level. Motivated with the success of the first coffee shop in one of Croatia’s poorest regions, the couple realized that the potential for this concept was national, if not regional. But, how would they grow? Should they develop their own outlets or open more company-owned outlets? Growing organically by opening self-owned stores was costly, slow and hard to control. They had neither the means nor the staff. They knew they did not want to put more capital at risk, and did not have the time to travel to various locations around the country. Furthermore, their concept had started to garner local publicity and inquiries from would-be franchisees began to arise. But, how could they franchise in Croatia? Croatia had a small economy, changing legal system and little experience in franchising. Growing through franchising was appealing, but they only had one store, the business was young, and franchising was unfamiliar to the emerging market of Croatia. The conditions for franchising were not ideal. Aside from whether to franchise or not, how could they protect their intellectual property and business format know-how? How could they fight off imitators? What would happen if Starbucks or other major
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coffee chains entered the market? What should be the next steps? How could they become the biggest and most successful coffee house nationally or regionally? THE ENTREPRENEURS: TENSEK AND PACEK Tensek had an MBA from California State University and extensive experience working in large U.S. corporations. Pacek, on the other hand, had a master’s degree in fine arts and design from the University of California, and had worked as an art director in several U.S. companies. The couple’s successful careers and profitable real estate investments in the United States gave them the comfort, confidence and capital to return to Croatia to invest in a new venture while helping their country’s development at the same time. They wanted to create a business in Croatia that was world-class, towering above local offerings in service, quality and satisfying customer expectations. Tensek and Pacek recalled their days in the United States, and the economic success stories of all the major coffee franchise chains such as Starbucks. They even considered taking a master franchise licence for Croatia, but the process was long, complicated and extremely expensive in comparison to the expected return. The fact was that Starbucks had very low local brand recognition in Croatia. The other problem with imported brands was that they often did not allow the adjustments needed to succeed in local markets, the major one being to the pricing of their product when it was simply too high for the local purchasing power of a developing country such as Croatia. They therefore decided to open The San Francisco Coffee House (SFCH) in 2003, a coffee shop with a recognizable visual identity — an interior in which visitors could feel the San Francisco-style coffee shop atmosphere (see Exhibit 1). THE OPENING OF “SAN FRANCISCO COFFEE HOUSE” Osijek was a town with many coffee shops and bars, and visiting them was part of the lifestyle of the local population. But there was one competitive problem from which they all suffered: they all offered roughly the same limited product line without any differentiating concept. Tensek and Pacek noticed that what was missing in the market was an American-style coffee bar, in which most of the offerings would consist of different types of coffee, and that would include the novel (in Croatia) possibility of getting “coffee to go.” They decided to adapt this ubiquitous American concept to the local Croatian market. They were under the impression that the “Made in USA” brand would be positively received in their “new” market, so they named the coffee bar “The San Francisco Coffee House.” During the development of the business plan, Tensek traveled several times to the United States researching ideas, studying the technology of coffee making, and personally bringing back with him some of the supplies and crucial ingredients. Tensek had chosen the location for The San Francisco Coffee House carefully: he was looking for a location with a minimum of 80 square metres near an area with heavy foot traffic, since his and Pacek’s main target market was to be business people. He found an excellent location in the town’s center — across from the green market, near three university departments, and several lawyers’ and public notaries’ offices — for which he signed a five-year lease with provisions for extending the lease and a right to pre- emptive purchase in case the owner wanted to sell the premise. After the first few months, they found that their major client markets were students and business professionals of all ages. Since SFCH was the first American coffee house in Croatia, this unique place where one could enjoy the authentic ambience of the American city received excellent reviews and unusually large media attention in the first six months of existence. Elle Décor ranked it among six best-decorated service industry interiors in the country, complimenting the brave mixture of styles and materials Pacek used to create the urban, bright
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and sophisticated environment. This was particularly commendable given the entrepreneurs’ limited start- up capital of €40,000. The San Francisco Coffee House assortment was also unique for this market. It offered its customers coffee in 17 different latte (with milk) and mocha variants and American-style muffins in several varieties. Coffee could be taken in the relaxing but urban atmosphere of the bar or it could be taken out in “to-go” packaging. However, SFCH did not have its own coffee brand; instead, in the SFCH in Osijek, coffee cups were marked with a coffee supplier’s logo. Coffee suppliers in Croatia also customarily provided the coffee-making machines and their service free of charge (or the cost was included in the price of every kilogram of coffee). In order for Tensek and Pacek to adapt to their target market, guests were provided Croatian and international newspapers and magazines and free wireless access to the Internet (which was extremely rare in Croatia). The ambience was also enhanced by smooth jazz and billboard music from the 1970s, 1980s and 1990s. SFCH had eight employees and was managed by Tanja Ivelj. The employees were all young people, some of them without any previous working experience and most of whom had worked in SFCH from its inception. When searching for employees, Tensek looked for trustworthy, loyal and honest people. For each workstation, employees had a detailed job description and detailed checklists for each shift and for weekly and monthly routine duties. All employees underwent training for working in a coffee shop/bar. Their salaries were almost 20 per cent higher than those of comparable employees at other local coffee shops. Every six months all employees had scheduled performance reviews. If a review was satisfactory, there was a further five per cent salary increase. Human resource management was one of the areas where Tensek had brought his American corporate experience into Croatia. In Croatia, employee rights, salaries and general terms of employment were, in most cases, ambiguous. Also contrary to the common practice in Croatia, SFCH provided full paid vacation and benefits for its employees. As a result, in an industry where the turnover rate was extremely high, The San Francisco Coffee House was able to achieve less than 20 per cent turnover over the first three years of operation. As Tensek mentioned, “Satisfied and motivated employees offer a high standard of service to the end customers.” SFCH made an extra effort to maintain excellent relationships with its suppliers, making timely payments in a market that was known for its irregularities. Wise and responsible financial management was the company’s priority. The summary of the financial performance of the company’s operations is shown in Exhibit 2. THE ENVIRONMENT FOR FRANCHISING IN CROATIA The environment for franchising in Croatia was not ideal because of insufficient regulation, little market know-how about franchising, and low economic development. On the other hand, the emerging market and the new openness to European integration had created opportunities to start bringing in new businesses from the outside. The Economic Environment In 1991, after The Republic of Croatia gained its independence, the Croatian market increasingly opened to a great variety of international products and services. Due to the economic growth, which began in the late
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1990s, salaries had grown appreciably, especially in the larger cities and in certain other parts of Croatia.1 Basic statistics on the economy are shown in Exhibit 3. Salary growth resulted in increased consumer demand for higher-quality world brand names, which were not widely available in Croatia at the time. After independence, the Croatian market became flooded with imported goods of variable quality. The habits of younger Croatian consumers had changed as a result of this increased supply: international brands became the acquisition target of younger consumers, while older people tended to continue to seek out domestic brands. Inevitably, perhaps, purchasing habits also varied geographically.2 Financial institutions in Croatia were mostly owned by foreign banks — around 90 per cent according to one source3 — and many of these acquisitions had occurred in recent years. Although there was a predictable variety of capitalization options for would-be entrepreneurs, a main characteristic of the Croatian domestic market was the bankruptcy of small entrepreneurs as they struggled to collect their own debts. Although bartering was a common fixture of the domestic market (i.e. between local companies), the international ownership of local banks made such traditional arrangements problematic. Political Environment Creating a vibrant business environment in accordance with the standards of the European Union (EU) and with countries embedded in the local market economy was one of the major goals of the Croatian government’s policies. The government’s dedication to the reform of the national economy could be seen in its desire to attract foreign investment for the development of Croatia’s domestic and international markets. Foreign investments in Croatia were regulated by the Company Act and other legal norms. A foreign investor in Croatia had a number of organizational options available according to this act: a foreign investor would invest alone or as a joint-venture partner with a Croatian company or private citizen; there were no constraints as to the percentage of foreign ownership that was possible. In addition, in keeping with the government’s desire for foreign investment, investors gained access to a number of newly opened markets; entrants could take advantage of a number of incentives, tax benefits and customs privileges that were only available to foreign investors. The Institutions of Franchising In recent years, the Republic of Croatia had approved a number of laws, which resulted in Croatia’s acceptance into the World Trade Organization and CEFTA (Central European Free Trade Agreement); these legal changes also allowed Croatia to begin negotiations for acceptance into the EU. Nevertheless, there was no specific legal basis for franchising in Croatia. Franchising was mentioned in Croatian trade law (Narodne Novine, 2003), where the generalities of potential franchising agreements were stated, but mention was made in only one article and that mention was very condensed. Therefore, there was no legal
1 Državni zavod za statistiku, “Statistical information 2006,” 2006, http://www.dzs.hr/Hrv_Eng/StatInfo/pdf/StatInfo2006.pdf, accessed on October 26, 2006. 2 GfK, “Građani o markama,” Survey conducted by GfK, March 2005, http://www.gfk.hr/press/marke.htm, http://www.gfk.hr/press/marke2.htm, accessed on January 3, 2007. 3 Hrvatska narodna banka, “Standardni prezentacijski format,” 2006, http://www.hnb.hr/publikac/prezent/hbanking-
sector.pdf, accessed on October 20, 2006.
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standard for the development of franchising and no legal parameters (yet) for franchising agreements: business practices on the ground determined the appropriateness of such agreements. Since the concept of franchising was relatively new to Croatia and to its inhabitants, little knowledge existed about franchising. There were two Centers for Franchising, one in Osijek and one in Zagreb, Croatia’s most vibrant city. Each of these centers had worked with the Croatian Franchising Association to stimulate franchising development in several ways: Educating about franchising — The Franchise Center in Osijek, for example, had organized seminars,
“Franchise A to Z,” in order to educate entrepreneurs about franchising and its benefits; Franchising promotion — both centers and the association were trying to promote franchising as a
way of doing business through local media — interviews, articles in the newspapers and magazines, etc.;
Creating websites with information about franchising on the Internet — Information on the portal with current news about franchising in Croatia, information about new franchisors, newly opened franchised locations; connecting franchisors with potential franchisees — one section of the franchise portal contained offers from franchisors interested in the Croatian market; there were several inquiries each week from potential franchisees;
Helping domestic companies to become franchisors — The Franchise Center in Osijek, with the help of Poduzetna Hrvatska, organized training for potential franchise consultants who could help domestic companies if they decided to use franchising as a growth strategy; and
Establishing franchise fairs and round tables. Foreign franchises tended to choose one of two potential pathways into the Croatian market: distribution- product franchising and/or business-format franchising. Larger, better-known franchisors like McDonald’s opened their offices in Croatia and offered franchises to interested entrepreneurs in order to ensure quality control, while smaller and less well-known franchisors sold master franchises to local entrepreneurs in order to ensure the benefits of local knowledge and cost savings. Barriers to Franchising Development During September 2006, The Franchise Center of the Center for Entrepreneurship in Osijek conducted a survey of 50 people, asking what examinees (representatives of banks, entrepreneurs and lawyers) thought about the barriers facing franchising in Croatia. Their responses included: Laws — there was no legal regulation of franchising in Croatia. The word “franchising” was only
mentioned in trade law; the absence of clear legal precedent made it difficult for Croatian lawyers to help their clients, especially during the contracting phase — whether franchisor or franchisee, whether foreign or domestic investor;
Franchise professionals — there was a dearth of professionals related to franchising; there were too few educational efforts, and too few franchise consultants who could help potential franchisors in developing their own networks or advise franchisees about selecting one;
Problems with banks (not familiar with franchising) — banks did not recognize franchising as a relatively safe way of entering into a new business and did not have any specialized loans for the franchising industry; according to a survey conducted by The Franchise Center (2006), some banks’ representatives said that they would ask a guarantee for a loan from the franchisor also; banks were not willing to educate their employees in order to learn about this way of doing business; banks seemed unable to distinguish between start-up entrepreneurs creating footholds in new franchise sectors and franchisees who were entering preexisting, proven franchise systems;
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Small market — because there were only about four million inhabitants in Croatia, examinees were doubtful that the largest franchisors would come to Croatia due to logistical problems: the perception was that it was much easier to open a location in London than in Croatia; large and famous franchisors were looking for bigger areas to capture the population, and they often resisted adapting to local standards and prices; smaller franchisors that would have liked to enter Croatia were not as well known to Croatian entrepreneurs and were, therefore, seldom selected; and
Franchising was not a well-known way of doing business — people seldom recognized franchising; many thought it was connected with insurance; this was the biggest barrier according to the survey because people were not willing to enter into something with which they were unfamiliar; further seminars and round tables needed to be organized in order to educate entrepreneurs about franchising and its costs/benefits.
According to the above-mentioned survey, there were some identifiable reasons for the relatively slow development of franchising in the Republic of Croatia: entrepreneurial thinking, lack of franchising education, and a weak national franchising association. First, many entrepreneurs would rather own their own companies and have complete “business freedom” than submit to the restrictions they saw as related to becoming part of a system — from production and distribution to sales and to the “forced” cleaning of the premises. Second, Croatian entrepreneurs were not completely familiar with the benefits that would be gained by being a member of a successful franchising system. Despite such a pessimistic tone, industry experts also reported that there was an excellent chance for franchising in Croatia, that there was the possibility of high growth in this sector (up to 30 per cent), and that Croatia’s membership in the EU would provide the necessary boost to franchising development. The survey showed that although franchising was not a familiar way of doing business, experts saw a bright future for franchising in Croatia. Competition Franchises had become more well-known in Croatia starting in the early 1990s, after the first McDonald’s was opened in Zagreb. “McDonald’s expansion into the Croatian market has tended to use two franchising methods: direct franchising and business-facility lease arrangements… Such lease arrangements allow for franchisees to become entry-level franchisees using less capital at the outset.”4 Other franchisors followed McDonald’s lead. For example, one of the relatively new restaurant franchising concepts in the Croatian market was the Hungarian company Fornetti, which managed to spread quickly its mini-bakeries business throughout Croatia by using franchising. They were founded in 1997, and by 2007 had more than 3,000 locations in Central and Eastern Europe.5 Other international franchises represented in Croatia included Benetton, Subway, Dama Service and Remax. According to the Croatian Franchise Association, there were approximately 125 (25 of them domestic) franchise systems present in the Croatian market. These systems operated approximately 900 locations and employed almost 16,000 people.6 Companies in more than 20 industries had chosen franchising as a growth option, with the sales industry and fast-food sectors accounting for more than 20 per cent of the
4 L. Viducic and G. Brcic in I. Alon and D. Welsh, International Franchising in Emerging Markets: China, India and Other Asian Countries, CCH Inc., Chicago, 2001, p.217. 5 K. Mandel, “Franchise in Hungary,” address given at The Franchise Center Osijek seminar “Franšiza od A do Ž,” Osijek, November 2004. 6 L. Kukec., “Round table — Franchising in Croatia,” address given at EFF/IFA International Symposium, Brussels, October 24-25, 2006.
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market. Other segments with important shares included the tourist industry, rent-a-car companies, courier services and the fashion industry. Exhibits 4 and 5 show the most well-known foreign and domestic franchisors in Croatia by industry and number of outlets as of 2007. While a few restaurant franchisors had already entered the Croatian market, no well-known international coffee houses had done so. Competition for coffee houses was mostly local, dating back to Croatia’s early days. Local competitors offered a roughly homogeneous product — coffee — and, most did not bother to create a visual identity, a brand or a new concept. Price, location and ambiance distinguished one coffee bar from another. Competitive rivalry from abroad, however, was imminent. The question was not if international coffee houses would come, but when? Coffee consumption in Croatia was quite high; many Croatians spent time between meals, in the morning, or at night at coffee bars, which often also served beer and other alcoholic products. While regular bars and other restaurants competed with coffee shops for customers, coffee shops were relatively cheaper, providing a comfortable environment for socializing. Suppliers of coffee were many and included both international and local brands. Coffee, itself, was basically a commodity. WHAT SHOULD BE DONE NEXT? Tensek and Pacek looked at the facts: franchising was one of several possible models for business growth and was widely used in economically developed countries throughout the world. Some of the reasons why companies preferred to develop franchise networks rather than grow organically included lower financial investment, lower risk, faster growth, local market knowledge by franchisee, and the franchisee’s motivation to succeed. They wanted these benefits too. The barriers which the San Francisco Coffee House faced in franchising in the local market were challenging: There was just not enough information about franchising; as a result, entrepreneurial and institutional
awareness of franchising was quite low; There were no well-established support organizations for the development of franchise networks in
Croatia; there were only two Entrepreneurship Centers in Croatia which offered services regarding franchise network development; and
There was no significant support from financial institutions; banks failed to recognize the relatively lower risk of investment in start-up entrepreneurs/franchisees than in independent start-up entrepreneurs.
Moreover, the company was still young and unproven in other locations. The couple could simply enjoy their local success. They could open additional stores by themselves. Or they could try to sell franchises of their concept. See Exhibit 6 for the entrepreneurs’ estimates of store-level expenses and revenues. Could the couple develop franchising in a market where local conditions were less than conducive? Could they gain national prominence? The couple had never run a franchising business and did not have the necessary experience and knowledge. How could they overcome the weaknesses they possessed and the environmental threats? How could they seize the opportunities in the marketplace using their unique experiences, capabilities and strengths?
This case was supported by The Franchise Center, part of the Center for Entrepreneurship Osijek, and Poduzetna Hrvatska, a USAID project in Croatia.
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Exhibit 1
PICTURES OF THE SAN FRANCISCO COFFEE HOUSE (SFCH) INTERIOR AND EXTERIOR
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Exhibit 2
SFCH FINANCIAL PERFORMANCE
2006 (euros) 2007 (euros) INCOME DATA Net Revenues 133,332 166,666 Direct Costs 50,666 54,000 Gross Profit 82,666 112,666 Operating Expenses 36,000 39,333 EBITDA 46,666 73,333 Taxes 9,680 14,520 Depreciation 2,666 7,333
Exhibit 3
BASIC SOCIO-ECONOMIC DATA ON CROATIA
Annual data 2007 Historical averages (per cent) 2003-07 Population (m) 4.0 Population growth 0.0 GDP (US$ bn; market exchange rate)
51,452 Real GDP growth 4.9
GDP (US$ bn; purchasing power parity)
69,211 Real domestic demand growth 5.0
GDP per head (US$; market exchange rate)
12,863 Inflation 2.6
GDP per head (US$; purchasing power parity)
17,303 Current-account balance (per cent of GDP)
-7.1
Exchange rate (av) HRK:US$ 5.35(b) FDI inflows (per cent of GDP) 6.4 Source: The Economist, 2008, http://www.economist.com/countries/Croatia/profile.cfm?folder=Profile-FactSheet, accessed June 11, 2008.
Exhibit 4
FOREIGN FRANCHISORS IN CROATIA
FRANCHISOR INDUSTRY NUMBER OF OUTLETS
McDonald’s Fast food 16 restaurants Subway Fast food 6 restaurants Fornetti Bakeries Over 150 locations Dama service Refilling toner cartridges 3 locations Berlitz Foreign language school 1 location Firurella Weight loss center for women 2 locations Berghoff Kitchen equipment 3 locations
Source: “Round table — Franchising in Croatia,” address given at EFF/IFA International Symposium, Brussels, October 24- 25, 2006.
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Exhibit 5
DOMESTIC FRANCHISORS IN CROATIA
FRANCHISOR INDUSTRY NUMBER OF OUTLETS
Elektromaterijal Household appliances’ distribution Over 50 stores X-nation Fashion clothes 40 stores/corners Rubelj Grill Grill 17 restaurants Skandal Fashion clothes 15 stores Body Creator Weight loss center for women 4 centers Bio & Bio Health food 3 shops Bike Express Courier service 1 location The San Francisco Coffee House
Coffee bar 1 location
Source: “Round table — Franchising in Croatia,” address given at EFF/IFA International Symposium, Brussels, October 24- 25, 2006.
Exhibit 6
EXPECTED REVENUES AND EXPENSES
EXPENSES (based on one year) euros (€) 1. 2. 3. 4.
Salaries with Benefits Manager Waiter 1 Waiter 2 Waiter 3 Rent with utilities Marketing, Royalties Cost of Direct Material based on €666.66 per day)
€10,000 €6,000 €5,333 €5,333 €5,333
€32,000 €2,666
€72,000 Total Expenses per year €138,666 Total Income (based on average of €666.66 per day) €240,000 Net Income in the first year €101,333
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3.
9B13N019
SERVICEFORCE: SCALING UP FINANCING
Hitesh J. Shukla and Ashutosh Dash wrote this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. This publication may not be transmitted, photocopied, digitized or otherwise reproduced in any form or by any means without the permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western University, London, Ontario, Canada, N6G 0N1; (t) 519.661.3208; (e) cases@ivey.ca; www.iveycases.com. Copyright © 2013, Richard Ivey School of Business Foundation Version: 2013-10-02
Hitendra Joshi, the founder of ServiceForce, a vehicle maintenance company in India, was standing alone in the centre of the boardroom in the corporate house at Rajkot after the December 2012 monthly review meeting with his team members, Preeti Babia and Snehal Patel. He was thinking about his plan regarding the next step for business growth. He had received two proposals, one from an investor who was ready to take complete franchise rights for Rs70 million and one from a venture capitalist ready to invest on a large scale. If the former was accepted, the contract would allow the investor to sell ServiceForce franchises in the Gujarat, Maharashtra and Rajasthan states of India. To manage its growth, ServiceForce had already sold 24 franchises and 10 more were in the pipeline. Hence, Joshi was in a dilemma about whether to sell off the rights to the franchise, join hands with the venture capitalist, borrow money for capacity building or see the business grow with added franchises. His concern was accompanied by satisfaction that with an investment of Rs80 million the company was valued so high in the market after just 18 months. DELIVERING A UNIQUE CUSTOMER EXPERIENCE In case of road accidents in India, one could call 108 (a toll-free number) for urgent medical service, but what if a motorized two-wheel vehicle (two-wheeler) broke down on the road? Who would come forward to help, or who could the rider call for help? Since his tenure with Bajaj Auto Ltd. as a sales executive, Joshi had pondered this problem and developed his vision to start a company that would cater to the needs of two-wheeler users. In 2010, while working in Rajkot, one of the most rapidly developing cities in the Gujarat state of India, Joshi found that the city had more than 1,150,000 two-wheelers on the road and that bike sales were increasing by roughly 20 per cent per annum—so much so that the regional transport office had to open a new series of registration numbers for two-wheelers every two months. Heavy sales of two-wheelers demanded increasing support from the authorized service stations of automobile manufacturers. Joshi observed that in two years’ time in Rajkot around 0.12 million two- wheelers were sold; however, only eight major auto manufacturers were operating their own service stations there. In 2010, each of these branded service stations had to provide service every day for 137 two-wheelers, which was a herculean and almost impossible task for them. Since organized service
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Page 2 9B13N019 centres were unable to cater to the needs of their customers, the demand was growing on the 5,500 unorganized auto garages (places where motor vehicles are repaired and maintained) operating in the city. In such a situation, starting a service station on a large scale in a more organized manner would not be a bad idea, thought Joshi. Opening an ordinary service station would not achieve Joshi’s goal of extending help to a poor fellow standing on the road with a faulty bike. As a pioneer and innovator, he decided to start a company that would provide emergency services in addition to regular maintenance for two-wheelers with just one call. The proposed business was quite different from regular service stations as the idea was to take the two- wheeler from the customer’s home or office and return it to the same place after service, thereby adding tremendous value by saving customers’ time. To see his dream come true, Joshi left his prestigious and lucrative job and named his new venture ServiceForce. The name ServiceForce identified the company as a service-providing force in the two-wheeler industry in India—to begin with, in Rajkot. The company was launched on February 27, 2011 as a sole proprietor firm on a small scale with an investment of approximately Rs450,0001 and a hired workshop. A solution for two-wheeler owners’ problems was just a call away, as ServiceForce was designed to provide unique maintenance and repair services. Joshi believed that “people might have money but not time to maintain and repair their two-wheelers”; hence, for them, an organization such as ServiceForce would be a gift. Along with Joshi, two vibrant, young and dedicated women joined the initiative—Snehal Patel as head of administration and Preeti Babia as head of public relations. Five months after its inception, market operations were in full swing. Within 13 months, ServiceForce owned two workshops in Rajkot, employed 212 people and was serving 16,000 clients. THE ENVIRONMENT FOR TWO-WHEELERS IN INDIA India is known for manufacturing and exporting automobiles to countries around the globe. The turnover of the industry is more than Rs35 billion with a huge employment of 13 million people. Within the automotive industry, the two-wheeler segment dominates since India is the second largest manufacturer of motorcycles in the world. Among its states, Maharashtra, with a registered motor vehicle population of 17.4 million, accounts for the largest share of total registered motor vehicles, followed by Tamil Nadu. Along with these two states, Uttar Pradesh, Gujarat and Andhra Pradesh together account for about 49 per cent of the total vehicles registered up to March 31, 2011. Exhibits 1 and 2 reveal the state- and city-wide distribution of registered motor vehicles in India. Among the top five cities in terms of number of registered motor vehicles, the highest compound annual growth rate (CAGR) of 12.94 per cent was recorded by Pune during 2001—11. Hyderabad and Chennai recorded CAGRs of more than 10 per cent. Within the automotive industry, the composition of vehicle production had changed dramatically in the past 60 years. The share of two-wheelers was about 72 per cent of total registered motor vehicles in India as of March 31, 2011, having increased from 8.8 per cent as of March 31, 1951 (see Exhibit 3). In contrast, the number of registered cars, jeeps and taxis in the total number of registered vehicles stood at 13.6 per cent as of March 31, 2011, marking a steep decline from 52 per cent as of March 31, 1951. This situation is not unique to India but mirrors sales and penetration of two-wheelers in the three largest countries in Asia. 1 Approximately US$10,000 at an exchange rate of $1US = Rs45.11 in the month of February 2011.
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Page 3 9B13N019 Given the experience in Japan and China, it was expected that the penetration of the two-wheeler market would peak at 150 to 175 per 1,000 people or between 60 and 70 per cent of households. Beyond this level, the market would begin to saturate. For example, as penetration peaked at about 150 per 1,000 in 1986, the Japanese two-wheeler market saturated, with sales and penetration levels declining in subsequent years. The introduction of electric two-wheelers in 1999—2000 fueled a record growth in sales in China where two-wheeler penetration was estimated at 140 to 160 per 1,000 people in 2011. With penetration levels likely to touch 170 to 190 per 1,000 by 2016—17, the Chinese two-wheeler market was now heading toward saturation. Although that market was relatively more mature, India tracked the Chinese market in sales growth and penetration levels with respect to income levels, with a lag of five to seven years. In India, two-wheeler penetration was expected to reach about 150 per 1,000 people by 2020 (covering almost two-thirds of all households), comparable to current penetration levels in China. In the period 2011—12, two-wheeler sales volume in India was 13.4 million, which was a 14 per cent growth over the previous year. Affected by high inflation and the following demand slowdown, the other automobile segments had recorded single-digit growth, while the growth of the two-wheeler industry reached 14 per cent. Exhibits 4 and 5 depict the sales growth and penetration of two-wheelers in India. After the 2008— 09 global recession, two-wheeler sales in India recorded a 22 per cent CAGR between 2008—09 and 2011—12. In 2011—12, sales grew by 14 per cent.2 Owing to various positive structural factors such as a large youth population, growing urbanization, an underdeveloped public transport system and easy financing, the two-wheeler segment was expected to settle at a 10 to 12 per cent CAGR in the next five to seven years, similar to the annual growth rate witnessed during the last decade.3 Furthermore, another motivation to buy two-wheelers was an increase in urban traffic that made it difficult to drive and park four-wheelers in cities. In addition, a change in the preference and taste of the younger generation to consider motor bikes as a mark of pride also may have contributed to the growth of the two-wheeler industry. For example, Royal Enfield Bullet, which was earlier a non-accepted brand, was now considered a status symbol for the young generation. Following this trend, many automobile companies were trying to enter or re-enter the market with premium motor bikes; for example, Vespa re-entered the Indian market with a range of scooters with prices starting from Rs70,000. While sales growth in urban areas was expected to taper off over the next five to seven years, rural areas still offered considerable scope for growth. In urban areas, 55 to 60 per cent of households owned a two- wheeler, while in rural areas fewer than 15 per cent of households owned such a vehicle. New sales in urban areas were fast approaching maturity levels. By contrast, the rural market appeared to hold far greater potential for new sales: penetration levels were about 30 per 1,000 persons, and more than half the population had yet attained threshold income levels. Growth in rural sales would likely be stronger at more than 14 per cent CAGR, led by rising income (agricultural as well as non-agricultural) and low penetration. By 2016—17, the rural market would account for more than 55 per cent of total sales and would continue to dominate sales in subsequent years, too. A strong product line and a deep distribution network would be vital for larger two-wheeler companies to tap the rural opportunity.4 Exhibit 6 shows the increasing share of rural two-wheelers sales in India. After 2020, the demand for two-wheelers was expected to slow down as all Indian penetration levels would cross 75 per cent of the total addressable market. However, beyond 2020, replacement demand
2 CRISIL Research Report, www.crisilresearch.com, accessed February 11, 2013 3 Ibid. 4 Ibid.
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Page 4 9B13N019 would be the main driver of two-wheeler sales. Two-wheeler companies would have to enhance their focus on export markets as well. Intensified competition would force two-wheeler companies to launch more models at competitive prices and expand distribution aggressively. The Indian two-wheeler market could reach near saturation by 2020: eight out of 10 households who could afford a two-wheeler would own one by that year.5 THE SERVICE BUSINESS Currently, the young Indian population was seeking to buy newer vehicles due to increased purchasing power and access to easy finance. It was quite common that a significant number of two-wheeler riders neglected proper maintenance, affecting their vehicles’ longevity. No wonder almost all the two-wheeler companies in India provided automobile service centres across the country. These service centres played a vital role in the effective maintenance of two-wheelers during their guarantee/warranty period. But in reality, they failed to fulfill the customers’ needs and expectations due to insufficient infrastructure. Hence, the biggest strength and competitive advantage of ServiceForce was its unique style of providing comfort and convenience to its customers. Services Offered ServiceForce offered different packages, including a pick-and-drop service, home service, discounts on replacement auto parts, quick-response calls, accident support in the form of insurance, the issuance of pollution-under-control certificates (all vehicles were required to obtain an emission check certificate) and reminders for the payment of vehicle insurance premiums. ServiceForce, as a one-stop solution for all brands of two-wheelers, was widely recognized as a multibrand service station. Customers had a choice of various packages such as the privilege card (a registered customer could gift a one-time free-service card to friends) and the gold card (credit points were added to the customer’s card, which would reduce the price of renewals of ServiceForce contracts). Various services provided by ServiceForce are described in Exhibit 7. The acceptance of platinum and gold cards in the market was outstanding. At the end of December 2012, ServiceForce observed that 40 per cent of its service revenue was generated through platinum cards and 20 per cent through gold cards. Only 6 per cent of the service revenue came from the doorstep service, while the silver card contributed 13 per cent to the revenue through annual maintenance contracts (AMCs). Manish Panchal, ServiceForce’s sales executive said, “[Some] customers were a bit careless about the level of petrol in the tank of their two-wheelers; hence, many times while riding they would suffer on the road due to lack of fuel. In such a situation on request over the help line number, ServiceForce would provide petrol to the caller to see a smile on their face.” The Marketing Plan The sales channel for the Rajkot business unit included direct sales by the company’s own personnel and through agents who were paid 5 per cent commission on the sales they made. ServiceForce also appointed one distributer who had his own sales team to generate 250 to 300 AMCs per month. This distributer had deposited Rs250,000 with ServiceForce as security money on a nonrefundable basis and had guaranteed
5 Ibid.
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Page 5 9B13N019 sales of 200 AMCs per month. A commission of 7 per cent was assured to the distributor for minimum guaranteed sales, and 1 per cent more was offered for the rest, not exceeding 500 AMCs per month. As a matter of policy, the prepaid cards were only sold through distributors. The number of prepaid card users constituted only 14 per cent of total AMC revenues. Beginning in May 2012, ServiceForce celebrated the third Monday of every month as “Orange Day”: seven members of the ServiceForce team went to all major marketplaces wearing orange caps and orange tee shirts. Their visits to government offices, parking lots at railway stations and bus depots created awareness about the company’s services and sales. It was compulsory for every team member to sell one AMC on Orange Day. During the eight months ending December 2012, the employees had sold about 312 AMCs for their employer. The Modus Operandi Once the clients were registered with ServiceForce, their details were recorded with the customer care department; the details were then forwarded to the technical staff who, in consultation with the customer care department, contacted customers for services. This process normally took 48 hours. Subsequently, whenever a vehicle would break down on the road, the rider just had to call the customer care number and ServiceForce would send mechanics and a vehicle within 30 minutes to the place where the two-wheeler broke down. If it was impossible to repair the two-wheeler then and there, the client would be dropped at their destination in ServiceForce’s vehicle and the defective vehicle would be brought to the service station for repair. ServiceForce had two well-designed service stations covering nearly 5,000 square feet. On average, a service station for two-wheelers in India requires 4,000 square feet of space (see Exhibit 8). About 120 vehicles could be handled per day by each of the stations at their optimum capacity. Both were utilized to their optimum without having much scope to meet additional demand. ServiceForce operated for at least 300 days a year, at the same time providing ample opportunities for its employees to enjoy vacation time. The stations served 16,000 customers with guaranteed satisfaction. As far as the inbound logistics of ServiceForce were concerned, Joshi had tie-ups with local wholesalers for supplying spare parts and other components required for repairs. In general, an hour’s time was required for the pick-and-drop service. A well-designed workshop and experienced workers were equipped to service the two-wheelers in just three hours’ time. After repair, ServiceForce would deliver the vehicle to the location preferred by the customer. Generally, vehicles were returned to customers within four hours. The Manpower In a service-based organization, it is very important to understand the strength of every individual and utilize them to their optimum. ServiceForce was no exception to this. Its competitive advantage was its excellent human resources, which gave it an edge over its competitors. It had 212 employees, including 104 mechanics to repair and maintain two-wheelers, 24 salespersons, 54 workshop assistants in the pick- and-drop service and 30 other staff members. The mechanics had adequate expertise and experience from 10 to 35 years in various two-wheeler workshops. Pravin Parmar, with 35 years of supervisory experience, was the team leader of the first workshop on Nana Mava Main Road, Rajkot; Idrish Quadri, supervisor of the second workshop, which was situated on Gondal Road, had 22 years’ experience. ServiceForce understood the needs of its customers and provided them with the best possible service from
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Page 6 9B13N019 the best mechanics using genuine spare parts. The company also had arranged with industry training institutes (ITIs) in Rajkot to hire trainee mechanics as interns to repair two-wheelers. This industry- academia alliance helped the company get skilled and qualified resources at a low cost for its operations. A combination of experienced and inquisitive but inexperienced people in the team truly made ServiceForce capable of dealing with more complex and difficult problems. Since manpower was considered to be the firm’s main strength, Joshi focused on a powerful work relationship to drive the company forward. In order to motivate the employees with limited resources, ServiceForce provided a positive emotional atmosphere that helped everyone to work creatively and productively. Emotional attachment was the fuel that vitalized and motivated the workforce. The organizational structure was clearly laid out with proper delegation and clear definition of goals (see Exhibit 9). Potential Customers Apart from repairing at service stations and on emergency calls, in April 2012, ServiceForce launched a new concept called the “mobile workshop” to cater to the needs of industrial workers and rural people working and living in the area. The company put considerable effort into making contracts with industries to maintain and repair the two-wheelers of their workers using the mobile workshops. They had arrangements with four industrial units for this purpose. ServiceForce also identified the Metoda and Sapar industrial areas near Rajkot as a potential business hub. These two industry belts contained more than 18,000 corporate houses that provided a huge opportunity for ServiceForce to serve in the long run. Up to this point, customers covered under corporate packages constituted 7 per cent of the service revenue. Mobile service stations (motor vans) were sent to repair and provide service to two-wheelers owned by villagers residing in nearby rural areas. This service was well-received by the villagers due to the low cost and reduced time consumption. Previously, to have their vehicles repaired and maintained, villagers had to pay a visit to the city in the morning and wait till evening to get the vehicle back, thus losing their daily wages for that day. Mobile workshop visits to their villages provided them with an opportunity to save their wage loss and travel expenses. Joshi expected both markets to grow at 8 per cent till 2020. BRAND AWARENESS AND PROMOTION ServiceForce celebrated the first Sunday of every month as “Green Day.” Employees would go to public places such as Race Course (an amusement park in Rajkot) and Aji Dam (a picnic place in Rajkot) to create awareness of the ServiceForce brand. They would meet owners of two-wheelers and provide them with tips on the “do’s and don’ts” of vehicle maintenance. They would offer small gifts to the public, gather data about potential customers and subsequently contact them to sell their product. In addition to other freebies, the company provided to all customers spare-wheel covers with the name ServiceForce printed on them. With the continual efforts of its committed employees, ServiceForce became a regional brand within 18 months of its inception. To promote the brand further, the company decided to take part in the business fair ADEX, which was organized in Rajkot, and obtained the sole rights of advertisement during its September 2011 event. This created huge brand awareness followed by high demand for AMCs. Unfortunately, the sales were frozen owing to the inadequate capacity of the organization. Subsequently, ServiceForce took part in a fun fair, named Vacation 2012 and organized by ADEX Inc. in Rajkot during
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Page 7 9B13N019 May 2012, to further build a strong brand. Amazingly, ServiceForce experienced a footfall of about 600,000 during this 15-day event and added 1,200 new customers to its portfolio. With these new members, the total client base crossed the 16,000 threshold in Rajkot with continuous growth forecast for the future. The first sentence written on all ServiceForce products was “satisfaction guaranteed,” and the services rendered were truly satisfying in terms of spirit, not just words. Due to excellence in providing services and unique features such as its money-return policy if the customer was dissatisfied, ServiceForce became a name of trust to its customers. As a result, its customers felt proud to be associated with it. Happy with these value-added services, clients started paying in advance for services, sometimes even agreeing to higher rates than other leading automobile players. According to Joshi, the biggest leading automobile player would charge Rs900 per annum for four services, whereas ServiceForce charged Rs1,160 per annum for four services, indicative of the trust and satisfaction bestowed on the company by its clients. Recently, ServiceForce discontinued the sale of its AMCs to new customers due to its inadequate capacity to serve clients efficiently and on time. To meet the increasing demand, ServiceForce needed to build capacity in the near future by setting up a couple of new service stations. Approximately 65 per cent of customers had renewed their AMC at the end of the first year. Manish Panchal considered this ratio as the barometer of the company’s success and teamwork and was confident that the ratio would never fall below 60 per cent in the future owing to the excellent quality delivered by ServiceForce. MANAGING GROWTH: THE FRANCHISE BUSINESS A look at the industry analysis of two-wheelers revealed that a huge growth in this sector was yet to be seen: growth would come owing to inadequate public transport systems in semi-urban and rural areas, cheap and easy finance for buying two-wheelers, increasing urbanization that had created a need for personal transportation and steady increases in per capita income over the past five years. Service stations, ancillary to the two-wheeler industry, would certainly lead to positive growth. ServiceForce was a real-life example of this trend. Business Standard, one of India’s leading dailies, reported that within just four months of its launch, ServiceForce had gained more than 2,800 clients in Rajkot and had a target to cover more than 5,000 clients by the end of March 2012.6 In reality, as per the latest data, ServiceForce was serving 16,000 customers in Rajkot itself. Joshi’s study of the market and his projections revealed that the potential market for AMCs of Rajkot’s two-wheelers would be 150,000, but he could accept only 70,000 two-wheelers given his current team. With experience over time, Joshi observed that 10 per cent of the customers made use of about 12 services per year, 60 per cent of customers availed eight services per year and 30 per cent of customers availed only four services per year. ServiceForce was not equipped with adequate infrastructure to serve more than 16,000 customers; hence, it decided to join hands with prospective investors through franchising, which could offer growth potential in two-wheeler service and maintenance. Business Standard revealed:
ServiceForce is planning to expand its network to other cities of Gujarat like Ahmadabad, Kutch, Junagadh and Porbandar. Joshi said, “We are appointing franchisees in Saurashtra and Kutch and are looking for partners to cover other parts of Gujarat as well. Within the next two years, we are
6 “Rajkot-based Service Force Launches Automobile Emergency Services,” Business Standard, December 29, 2011, www.business-standard.com/article/companies/rajkot-based-service-force-launches-automobile-emergency-services- 111122900015_1.html, accessed September 26, 2013.
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Page 8 9B13N019
aiming to cater to the entire Gujarat region. We also have plans to appoint 300 franchisees across India thereafter.7“
In May 2012, Gaurav Makwana, a loyal employee ServiceForce, expressed his interest in leaving his job and starting a similar kind of business in his hometown Bhavanagar, another city in Gujarat. Joshi, who was in search of expansion for his company, exploited the opportunity and decided to lend the name of ServiceForce on an experimental basis to Gaurav, who paid Rs500,000 for the deal, while Joshi agreed to guide him in setting up the workshop. In June 2012, ServiceForce started its operation as a franchise in Bhavanagar and was running exceptionally well within a month’s time. Subsequently, the company partnered with 24 different franchisees covering Gujarat and Maharashtra. For deciding the right franchisee, ServiceForce’s team would find prospective partners, conduct a feasibility study and prepare a presentation for the investors, focusing on the growth of the two-wheeler industry in India. As a sweetener, they would present a prepared spreadsheet that would calculate the payback period8 for the franchisee’s investment. As per Joshi’s calculations based on the initiation stage in Rajkot, one could get one’s investment back in one-and-a-half to two years’ time. The requirement list for franchising ServiceForce included a passion for the automobile business, the ability to keep the customers happy, a suitable workshop space and immediate ability to invest Rs1,500,000 and liquid cash of Rs200,000. ServiceForce charged a one-time franchise fee of Rs700,000 and took a 10 per cent share in AMCs sold by franchises as a royalty fee. ServiceForce provided a tool kit for new workshop materials of Rs200,000 to the franchisee. The net one-time fee from one franchisee was reduced to Rs500,000. Once the venture had been agreed on, ServiceForce would guide the franchisee in almost all preliminary activities, including selection of location, setting up the service station, training mechanics at the home workshop, training sales team members and orienting the entire team, including the franchising owner, to the company culture. ServiceForce had a training centre in Rajkot where all mechanics were trained to repair two-wheelers of all brands, using ServiceForce blueprints and three-dimensional pictures of various components of two-wheelers. During training, the mechanics worked under senior supervisors and subsequently were sent to their actual work destinations. The per-head average incidental expense (including training and administrative expenses) came to around Rs50,000. Joshi was expecting a substantial growth in the franchise business in the forthcoming years; however, the next two years were going to be quite crucial for ServiceForce with its pan-India expansion plans. ServiceForce had identified 226 centres for starting service stations in Gujarat by way of the franchise model. It had 10 pending offers for franchises under consideration. Exhibit 10 outlines the franchise locations in Gujarat and Maharastra. The target was to take on a minimum of five franchisees per month. THE FINANCE SIDE For starting ServiceForce, Joshi did not depend on any borrowed funds. He invested his own savings and emolument received from his previous employers. His friend Nilesh Parmar and his elder brother Hasmukh Joshi also helped finance the start-up. The contribution of his wife Manisha Joshi, an executive with the Indian government, was quite considerable in terms of financial and moral support. ServiceForce owned several assets: the building acquired for use as its corporate house was valued at Rs40 million; two workshops represented an investment of Rs25 million; equipment was worth Rs9
7 Ibid. 8 “Payback period” refers to the time frame in which one could make one’s initial investment back.
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Page 9 9B13N019 million9; and a couple of other assets were worth Rs6 million. The company also had working capital investment in spare parts, oil and fuel. Concerning working capital management, the inventory requirement for the whole year was Rs3.6 million, but ServiceForce maintained only one month’s inventory in stock. It had a negative operating cycle at all times as money came from customers in advance. ServiceForce did an incredible job in an 18-month period to earn Rs70 million in revenue. The initial deposits of franchisees and the distributor were not considered as revenue, but rather were added to the capital fund to sustain ServiceForce. The top line consisted of income from AMC sales; income from sales of oil, spares and scrap; and royalties from franchises. The major part of the revenue, i.e., 45.375 per cent, came from the sale of AMCs, while the lowest chunk of 12.375 per cent came from franchise royalties. Various AMCs were priced differently to attract different customers. Packages with pick-and- drop service were sold at a price of Rs1,160 for four services per year. Yet another package was sold for Rs960 for four services per year excluding pick-and-drop. While the former was covered under the platinum card, the latter was named the gold plan. The AMC for doorstep service, and the silver scheme, were offered at Rs1,300 and Rs890, respectively. Both these schemes were not accepted well by the market. ServiceForce received the highest margin from sales of oils and spares. While oil generated a 60 per cent margin, spare parts could be sold at 40 per cent profit, though the overall margin could be considered as 50 per cent. But this revenue depended totally on the number of vehicles serviced. A look at the cost structure of ServiceForce revealed a fixed expense of Rs600,000 per month paid toward salaries of employees and Rs200,000 toward rent of the two workshops in Rajkot. Other than these, various costs included oil, grease, etc., and spare parts for two-wheelers, costs which were directly recovered from customers. On average, the cost to ServiceForce amounted to Rs50 per pick-and-drop service and Rs100 per servicing of a vehicle. Though the cost per service remained the same under the platinum, gold and silver schemes, the cost per service for the doorstep service was estimated to be around Rs173. The expenses of ServiceForce primarily consisted of workshop expenses (operating), general and administrative costs and promotional expenses. The ratio of general and administrative costs (including salary) and promotional expenses to sales were estimated to be 15 per cent and 8 per cent, respectively. WHAT’S NEXT? ServiceForce was facing competition from both organized and unorganized workshops. Customers who believed in national brands preferred the company’s authorized workshops, while those who were cost conscious focused on the unorganized sector. ServiceForce was considered to be a premium service station by two-wheeler owners since it charged higher prices compared to authorized service stations. To take advantage of the situation, a few trained employees from ServiceForce left their jobs and started individual service stations in the same region. Similarly, students from the ITIs, whom ServiceForce considered as trainees, considered ServiceForce as a platform for on-the-job training. Hence, they posed a threat of becoming prospective owners of unorganized service stations. In order to attract more and more customers, Joshi was planning to launch a new product as a “floater.” The product, named “Total Care,” offered membership to families for services for all the two-wheelers they owned. This product was expected to reduce bother for customers as one plan would cover all their vehicles. Joshi was also excited to start a short message service for two-wheeler owners through which they could receive information about their vehicles and make their feedback available on the company’s 9 Depreciable over a 10-year period.
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Page 10 9B13N019 website. The feedback on the website would be of tremendous help in promoting the brand and franchise businesses. ServiceForce was still in its infancy, and Joshi understood very well that this was just the beginning. All of India presented an opportunity for ServiceForce growth, but up to December 2012, the company had sold only 24 franchises, with 10 more in the pipeline. For the coming years, Joshi had a bigger plan to open 120 new workshops in different states apart from his expansion plan in Gujarat; to begin, he wanted to experiment with Maharashtra and Rajasthan, the two neighbouring states. Implementing such a huge expansion was almost impossible without massive investment in infrastructure and information technology (IT). Even for additional franchise businesses, at least Rs15 million in outlay was expected in IT and infrastructure for better management. Joshi was at a crossroads: should he borrow money to ramp up the growth of the business through new capacity building or see ServiceForce grow through more and more franchises? He had received two offers from the market, one from a venture capitalist who was ready to make a significant investment of about Rs700 million and another to sell all the franchise rights to Gujarat, Rajasthan, and Maharashtra for Rs70 million. The venture capitalist wanted a return of 25 per cent annually or 40 per cent share in the firm with adequate control on the board. The fate of the 10 franchises in the pipeline would also depend on the decision taken by ServiceForce to manage its growth. Joshi evaluated each of the options and considered the justification of the 40 per cent share demanded by the venture capitalist. He gathered some supportive market and industry information (provided in Exhibits 11 and 12) to facilitate his evaluation process. He also took a look at the challenges and opportunities ahead before making up his mind about accepting any of the offers put forward by the various investors.
Hitesh J. Shukla is from Saurastra University and Ashutosh Dash is from Management Development Institute in Gurgaon, India.
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Page 11 9B13N019
EXHIBIT 1: REGISTERED MOTOR VEHICLES ACROSS STATES ON MARCH 31, 2011
States Two-Wheelers Transport Vehicles Non-Transport Vehicles
Andhra Pradesh 7,488,771 1,515,955 9,001,726
Assam 958,935 348,671 1,307,606
Bihar 1,899,017 542,004 2,441,021
Chhatisgarh 2,232,929 370,613 2,603,542
Goa 541,934 157,390 699,324
Gujarat 9,507,556 2,158,607 11,666,163
Haryana 3,370,426 1,466,637 4,837,063
Himachal Pradesh 331,418 158,220 489,638
Jammu & Kashmir 446,791 338,379 785,170
Jharkhand 1,947,572 302,277 2,249,849
Karnataka 7,033,045 1,924,328 8,597,373
Kerala 3,294,953 1,270,025 4,564,978
Madhya Pradesh 5,783,120 1,153,371 6,936,491
Maharashtra 12,429,011 3,132,243 15,561,254
Manipur 145,286 35,134 180,420
Meghalaya 56,790 65,201 121,991
Mizoram 47,978 25,153 73,131
Nagaland 61,085 81,869 142,954
Odisha 2,614,980 375,336 2,990,316
Punjab 3,956,279 1,047,560 5,003,839
Rajasthan 5,859,719 1,463,125 7,322,844
Sikkim 6,843 18,973 25,816
Tamil Nadu 12,393,788 1,829,877 14,223,665
Tripura 117,486 27,848 145,334
Uttarakhand 708,595 206,615 915,210
Uttar Pradesh 10,563,850 2,190,687 12,754,537
West Bengal 2,260,657 578,362 2,839,019
Total States 96,058,814 22,784,460 118,480,274
Note: Figures for the state of Arunachal Pradesh are not available, and thus are excluded from the exhibit. Source: Created by the authors from the transport year book 2009—10 and 2010—11 of the Ministry of Road Transport, Government of India, http://morth.nic.in/showfile.asp?lid=838, accessed February 2, 2013.
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EXHIBIT 2: DISTRIBUTION OF VEHICLE POPULATION (IN 00’S) IN CITIES WITH MILLION PLUS INHABITANTS
States Million+ Cities 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011
Andhra Pradesh
Hyderabad 1,241 1,319 1,356 1,433 1,522 2,181 2,444 2,682 2,728 3,033
Visakhapatnam 364 393 412 435 462 472 515 559 586 617
Bihar Patna 313 336 — 378 405 437 471 516 581 658
Delhi Delhi 3,699 3,971 4,237 4,186 4,487 5,492 5,899 6,302 6,747 7,228
Gujarat
Ahmedabad 899 978 1,075 1,632 1,780 1,451 1,586 1,691 — —
Surat 575 633 692 — — 912 982 1,036 — —
Vadodara 506 546 586 — — 861 934 1,009 — —
Karnatak Bengaluru 1,680 1,771 1,891 2,232 2,617 2,179 2,640 3,016 3,491 3,791
Kerala Kochi 152 166 — — — 257 247 303 322 409
Madhya Pradesh
Bhopal 333 361 392 428 476 524 571 617 674 755
Indore 550 592 645 705 771 844 929 1,007 1,098 1,213
Maharastra
Greater Mumbai
1,069 1,124 1,199 1,295 1,394 1,503 1,605 1,674 1,768 1,870
Nagpur 459 503 543 770 824 884 946 1,009 1,079 1,157
Pune 658 697 755 827 874 930 1,141 1,153 1,908 2,094
Rajasthan Jaipur 693 753 824 923 1,051 1,177 1,289 1,387 1,549 1,694
Tamil Nadu
Chennai 1,356 1,895 2,015 2,167 2,338 2,518 2,701 2,919 3,149 3,456
Coimbatore 448 578 630 682 750 827 910 1,002 1,110 1,241
Madurai 240 281 304 330 364 402 440 478 530 603
Uttar Pradesh
Kanpur 385 425 — — — 553 598 642 940 1,002
Lucknow 556 615 — — — 801 962 1,025 1,107 1,211
Varanasi 339 366 — — — 456 482 522 497 538
West Bengal
Kolkata 801 842 875 911 948 987 573 581 411 445
Note: All figures are reported on March 31 every year. Source: Created by the authors from the transport year book 2009—10 and 2010—11 of the Ministry of Road Transport, Government of India, http://morth.nic.in/showfile.asp?lid=838, accessed February 2, 2013.
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EXHIBIT 3: COMPOSITION OF VEHICLE POPULATION (IN PERCENTAGE)
Year Two-Wheelers Cars/Jeeps/Taxies Buses Goods Vehicle Others Total Percentage of total Vehicle Population Million
1951 8.8 52 11.1 26.8 1.3 0.3 1961 13.2 46.6 8.6 25.3 6.3 0.7 1971 30.9 36.6 5 18.4 9.1 1.9 1981 48.6 21.5 3 10.3 16.6 5.4 1991 66.4 13.8 1.5 6.3 11.9 21.4 2001 70.1 12.8 1.2 5.4 10.5 55.0 2002 70.6 12.9 1.1 5 10.4 58.9 2003 70.9 12.8 1.1 5.2 10 67 2004 71.4 13 1.1 5.2 9.4 72.7 2005 72.1 12.7 1.1 4.9 9.1 81.5 2006 72.2 12.9 1.1 4.9 8.8 89.6 2007 71.5 13.1 1.4 5.3 8.7 96.7 2008 71.5 13.2 1.4 5.3 8.6 105.3 2009 71.7 13.3 1.3 5.3 8.4 115.0 2010 71.7 13.5 1.2 5 8.6 127.7 2011 71.8 13.6 1.1 5 8.5 141.8
Source: Ministry of Road Transport, Government of India, http://morth.nic.in/showfile.asp?lid=838, accessed February 2, 2013.
EXHIBIT 4: TREND IN SALES VOLUMES OF THE INDIAN TWO-WHEELER INDUSTRY
2010—11 2011—12 2012—13 April 856 1,043 1,157 May 937 1,071 1,193 June 933 1,071 1,170 July 939 1,054 1,058 August 957 1,133 1,108 September 992 1,228 1,285 October 1,128 1,145 1,175 November 930 1,161 — December 1,007 1,092 — January 981 1,114 — February 1,022 1,145 — March 1,093 1,183 — * Latest Data from October 2012 to March 2013 are not available
Source: Created by the authors using data from “Two Wheelers Penetration Fast Approaching Peak Levels,” www.crisilresearch.com/industryasync.jspx?serviceId=5&State=null#, accessed February 10, 2013.
EXHIBIT 5: HISTORICAL AND PROJECTED TWO-WHEELER PENETRATION LEVEL
Year Total Household TW Addressable Household Penetration
2006—07 222,000,000 87,000,000 48 per cent
2011—12 248,000,000 152,000,000 45 per cent
2016—17
(Projected)
268,000,000 210,000,000 55—60 per cent
2019—20
(Projected)
281,000,000 235,000,000 75—80 per cent
Source: Created by the authors using data provided by CRISIL Research, “Two Wheelers Penetration Fast Approaching Peak Levels,” www.crisilresearch.com/industryasync.jspx?serviceId=5&State=null#, accessed February 10, 2013.
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EXHIBIT 6: SHARE OF RURAL POPULATION IN TWO-WHEELER SALES (BY PERCENTAGE)
Year Urban Share Rural Share
2001—02 66 34
2006—07 60 40
2011—12 (Projected) 58 42
2016—17 (Projected) 55—60 40—45
Source: Created by the authors using data provided by CRISIL Research, “Two Wheelers Penetration Fast Approaching Peak Levels,” www.crisilresearch.com/industryasync.jspx?serviceId=5&State=null#, accessed February 10, 2013.
EXHIBIT 7: SERVICE PACKAGES OFFERED BY SERVICEFORCE Service at your door: The customer receives service of their two-wheeler at home. Mechanics go to the customer’s location and provide customized service. Platinum: The customer receives four services per annum along with pick-up and drop-off of their two-wheelers at their preferred location. If required, mobile service can be provided for maintenance of their two-wheelers. The price of this service is Rs1,160. Gold: Four services are provided to customers per annum, although the pick-up and drop-off service is not included. If required, mobile service can be provided to the customers for maintenance of their two-wheelers. The price of this service is Rs960. Silver: Customers register their needs with customer care to gain this special service. Most customers come to make changes to their motor bikes, i.e., conversion of a normal bike to a sport bike. The price of this service is Rs890. Corporate Packages: A mobile service station provides cheap and convenient services to corporate employees at the corporate location. This service is available for Rs700 for a minimum 100 members. Prepaid Cards: A unique prepaid card is available to customers from any provision store or panwalas shop (a place where people go to buy tobacco and other products). A customer who buys this card can make a call to customer care and get registered with ServiceForce for three months during which time the customer can make use of all the benefits that Platinum customers receive. This product is sold for Rs300. Source: Reports of ServiceForce.
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EXHIBIT 8: INFRASTRUCTURAL REQUIREMENT OF A SERVICE STATION
Measure Total workshop area requirement 4,000.00 sq. ft. Bay requirement
a) Quick repair bays 1 b) Mechanical repair bays 4 c) Accident repair bays 1 d) Washing bays 1 Total No. of bays 7
Workshop covered area 2,240 sq. ft. Parking bays 5 Parking area 300 sq. ft. Workshop facilities
a) Front office 100 sq. ft. b) Customer lounge 100 sq. ft. c) Workshop office ( Workshop Manager Cabin and back
office)
Workshop Utilities a)Tool room 70 sq. ft. b) Electrical room c) Warranty room d) Lubricant store 20 sq. ft. e) Generator &compressor room 10 sq. ft. f) Worker’s change room 05 sq. ft.
Spare parts area 100 sq. ft.
Source: Company files.
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EXHIBIT 9: ORGANIZATION STRUCTURE OF SERVICEFORCE
Source: Company files.
Business Head
Admin HR
Accounts
Customer Care
Head Rajkot Market
Franchises Operation
Technical
Rajkot Business
Franchisee Business
Direct Sales
Distributor Agent
Direct Sales
Distributor Agent
Development
Business Development
Brand Awareness
Training
Sales
Technical Training
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EXHIBIT 10: FRANCHISE LOCATIONS IN VARIOUS STATES
State City Numbers City Numbers Gujarat Rajkot 1 Porbandar 1
Jamnagar 1 Bayad 1 Bhavnagar 1 Bhiloda 1 Himmatnagar 2 Surat 2 Khambhaliya 1 Valsad 1 Vadali 1 Vyara 1 Khadbrahama 1 Upleta 1 Idear 1 Dhoraji 1 Junagadh 1 Palanpur 1 Disa 1 Total 21
Maharashtra Bhivandi 1 Vashi 1 Thana 1 Total 3
Source: Company files.
EXHIBIT 11: BOND AND EQUITY MARKET INFORMATION
Interest Rate on Central Government Dated Securities Range Weighted Average
2009—10 6.07—8.43 7.23 2010—11 5.98—8.67 7.92 2011—12 7.80—10.01 8.52
Source: Created by the authors using data of the Reserve Bank of India, http://dbie.rbi.org.in/DBIE/dbie.rbi?site=home, accessed April 15, 2013.
Market Risk Premium in Indian Market Year 2008—09 2009—10 2010—11 2011—12 2012—13 Percentage 9.0 8.6 8.6 9.0 8.8
Source: Compiled by the authors using data available at http://people.stern.nyu.edu/adamodar/, accessed February 11, 2013.
EXHIBIT 12: TWO-WHEELER INDUSTRY INFORMATION
Covariance Correlation Coefficient D/E βe10 Hero Motors Corp. 0.004 0.561 0.017 0.64 Bajaj Auto Ltd. 0.007 0.690 0.078 1.13 TVS Motor Co. Ltd. 0.008 0.651 0.728 1.23 Mahindra & Mahindra Ltd. 0.007 0.781 0.142 1.08 BSE Variance—0.006540 * Tax Rate 33.99 per cent
Source: Created by the authors from www.bseindia.com, accessed April 8, 2013.
10 Beta of equity (βe) is a measure of systematic risk and is used to calculate the cost of equity. It shows the movement of a particular security price with market swing, hence is calculated by dividing the covariance of return of a particular stock and market by variance of market return.
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4.
9B10M067 LOUIS VUITTON IN JAPAN1
Justin Paul and Charlotte Feroul wrote this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. This publication may not be transmitted, photocopied, digitized or otherwise reproduced in any form or by any means without the permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western University, London, Ontario, Canada, N6G 0N1; (t) 519.661.3208; (e) cases@ivey.ca; www.iveycases.com. Copyright © 2010, Richard Ivey School of Business Foundation Version: 2017-02-21
In Japan, whether you are in Tokyo, Osaka or Nagoya, just turn your head and Louis Vuitton is everywhere. The celebration of the 30th anniversary of the presence of the illustrious, glittering French multinational in Japan took place in Aoyama, one of Tokyo’s fashionable districts. A unique vision of luxury took shape when Louis Vuitton opened yet another new store inside Comme des Garçons on September 4, 2008, in the heart of Japan’s capital. The pop-up store situated on the prestigious Omotesando Street was an illustration of Louis Vuitton’s attachment to the Japanese luxury market. Yves Carcelle, chairman and CEO of Louis Vuitton, said, “This project not only brings a new meaning to luxury, but also speaks volumes about how the know-how and heritage of Louis Vuitton have always been perceived in Japan, including by its foremost designers. We are very proud to have been able to help Rei Kawakubo2 relive her memories in such an original and creative way.”3 The Omotesando guerrilla marketing event reflected Louis Vuitton’s success in Japan. Louis Vuitton had been following an aggressive marketing strategy in the country, opening extravagant stores such as those in Ginza or Roppongi. Take a walk on Ginza’s main street, Chuo Dori, the centre of a paradise for shoppers, with long- established department stores, such as Mitsukoshi, Takashimaya and Matsuzakaya. Continue through the high-end fashion street Namiki-dori. Stop. There it is. You have reached the massive flagship Louis Vuitton store. When Louis Vuitton, the world’s biggest luxury-goods firm, inaugurated its huge shop in 2002 in the district of Omotesando, Tokyo, hundreds of people were queued outside. During the first few days, sales exceeded the initial estimations by ¥1 million.4 In the last decade, Japan had been Louis Vuitton’s most profitable market, representing almost half of its profits, but it seemed that with the 2008-2009 economic crisis, there might be the start of a decline in sales.
1 This case has been written on the basis of published sources only. Consequently, the interpretation and perspectives presented in this case are not necessarily those of Louis Vuitton or any of its employees. 2 Rei Kawakubowas a famous Japanese fashion designer. She founded the fashion house Comme des Garçons Co. Ltd in 1973. The designer, known for her anti-fashion, austere and conceptual universe, was the guest designer of Louis Vuitton for one of its collections in 2008. 3 Lesley Scott, “Louis Vuitton at Comme des Garcons in Tokyo,” http://fashiontribes.typepad.com.Accessed July 11, 2008. 4 “Japan’s luxury-goods market — Losing its shine,” The Economist, September 18, 2008, www.economist.com. US$1 was equivalent to approximately ¥150 (yen) in 2002.
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Facing a weak economy and a shift in consumer preferences, Louis Vuitton started adapting its strategy in the Japanese market. The days of charging a high price for products with a proprietary logo seemed to be gone in Japan. The company had to launch relatively low-priced collections to boost sales. The firm had also been taking steps to open stores in other mid-size cities where the LV brand was not well-known. Louis Vuitton might be French, but Japan had become the land of Louis Vuitton lovers. Over the years, Japanese consumers had demonstrated fascination and passion for the iconic brand. What would be the key to Louis Vuitton’s continuing success in the Japanese market? LOUIS VUITTON —THE HISTORY The Foundation Louis Vuitton Malletier, often referred to as Louis Vuitton, was an international, well-established brand mostly famous for its craftwork leather bags and trunks. The firm was established in France in 1854 by Louis Vuitton and became known as one of the oldest French luxury fashion houses. Louis Vuitton, the company’s founder, was born in 1821 in Anchay, Jura, France. He became a Layetier in Paris and earned a reputation while working for the Empress Eugénie de Montijo, wife of Napoleon III. Learning from his work for the French aristocracy, he acquired personal “savoir-faire”5about leather luggage. In 1854, he founded the firm,” Louis Vuitton: Malletier à Paris.”6 The flat-bottom trunks of Louis Vuitton with trianon canvases represented a real revolution for travelling in those days as they combined lightness and storage capacity. In 1885, the firm opened its first overseas store in London, England, on Oxford Street. In 1888, Louis Vuitton developed the Canvas Damier Pattern in order to make the Louis Vuitton experience unique and recognizable by anybody. The logo “marque Louis Vuitton deposée,” meaning “mark Louis Vuitton deposited,” was also created. Following the death of Louis Vuitton in 1892, his son, Georges Vuitton, took over the leadership of the firm. He was ambitious about taking Louis Vuitton to the next step — building a global brand and setting up a multinational corporation.7 He participated in the Chicago World Fair in 1893, presenting the company’s product, and travelled all around the United States to promote the brand. In 1896, Georges Vuitton created the Monogram Canvas and attained worldwide trademarks on it to limit counterfeiting. The LV monogram was inspired by the Japanese and Oriental designs of the Victorian age. By 1914, the company opened the Louis Vuitton Building of the Champs-Elysées, now a symbol of the success and prestige of the company. Though World War I had begun, the firm initiated its global expansion strategy by opening stores in New York, Bombay, Washington, London, Alexandria and Buenos Aires. In 1936, Gaston-Louis Vuitton took over the direction of the company when his father, Georges Vuitton, passed away. The Modern Age of Louis Vuitton Gaston-Louis Vuitton guided the brand into its modern age. The company expanded its product line by applying the craftwork and design of its leather to small leather goods, such as purses and wallets, and to its whole luggage line. As a consequence, the Monogram Canvas was redesigned in 1959 to fit the new
5 “Know-how.” 6 “Louis Vuitton: Luggage maker in Paris.” 7 Official Louis Vuitton MySpace, www.myspace.com/louisvuittonmyspace, accessed June 25, 2010.
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range of products. The brand started its first advertising strategy by handing bags to Hollywood celebrity actresses. Audrey Hepburn carried a Louis Vuitton bag in 1963 in the film Charade, directed by Stanley Donan. In the mid 1970s, Louis Vuitton had become the world’s biggest luxury brand in terms of market share. The Vuitton-Racamier family,8 owner of the brand, had focused mainly on building a Japanese clientele. By 1977, the company owned two stores in Japan with annual profits of US$10 million. It further tapped into the Asian market in 1983, in Taipei, Taiwan and, in 1984, in Seoul, South Korea. The creation of Louis Vuitton Moët-Hennessy (LVMH) in 1987 established the largest luxury-goods conglomerate in the world. Moët et Chandon and Hennessy were the leading manufacturers of champagne and brandy. The merger resulted in an increase in profits for Louis Vuitton of 49 per cent in 1988 compared to 1987. By 1989, Louis Vuitton had entered into 130 countries across the world.9 In 1990, Yves Carcelles was nominated for president of Louis Vuitton. He carried on with an international expansion strategy, inaugurating the first Chinese store in the Palace Hotel in Beijing. The Monogram Canvas centennial was celebrated in 1996. Seven cities across the world held extravagant parties at stores and Louis Vuitton asked seven prestigious designers to imagine new products featuring the LV monogram. Azzedine Alaia, Manolo Blahnik, Romeo Gigli, Helmut Lang, Isaac Mizrahi, Syvilla and Vivienne Westwood created seven original and functional objects in a limited edition series.10 Louis Vuitton in the 21st Century In 1998, the American designer Marc Jacobs was appointed as Louis Vuitton’s art director. Jacobs was already a highly successful international designer, who became distinguished as the youngest fashion designer ever to be awarded the industry’s highest tribute, the Council of Fashion Designers of America (CFDA) award for New Fashion Talent. The challenge was huge, as Jacobs had to guide Vuitton’s first shoes and ready-to-wear collections. With this nomination, Louis Vuitton aimed at establishing the brand as a consistent trendsetter in high fashion. Since the late 1990s, creating limited-edition collections had become Louis Vuitton’s marketing strategy to capture consumers’ attention and reinvigorate the brand’s identity while boosting the bottom line. In 2001, Stephen Sprouse and Jacobs collaborated to design a limited edition series of Louis Vuitton bags. Sprouse was already a highly popular artist, as he had collaborated with the extravagant Andy Warhol and with contemporary artists and musicians, such as Debbie Harry and Duran Duran. In line with what The New York Times called Sprouse’s mix of “uptown sophistication in clothing with a downtown punk and pop sensibility,” the collaboration with Jacobs resulted in a limited edition that featured green and white graffiti written over the monogram pattern. All bags were made for Louis Vuitton’s VIP list and were meant to be collector’s items. In 2001, following the success of the Louis Vuitton limited edition, Jacobs designed Louis Vuitton’s first jewelry piece. In 2002, the Tambour watch collection was introduced. Pursuing its globalization strategy in the 21st century, Louis Vuitton opened one of its most famous stores on Fifth Avenue in New York City, then opened more stores in Sao Paulo, Brazil, Johannesburg, South Africa, and Shanghai, China. The brand reopened its store on the Champs-Elysées, which became the largest Louis Vuitton store in the world. Louis Vuitton celebrated world wide its 150th anniversary in
8 Henri Racamier married a descendant of Louis Vuitton. He was asked at the age of 65 by the family of his wife, Odile Vuitton, the great-granddaughter of Louis Vuitton, to run the family’s leather goods business. 9 Official Louis Vuitton MySpace, www.myspace.com/louisvuittonmyspace, accessed June 25, 2010. 10 Diana Prince, “Louis Vuitton: The history behind the purse,”www.associatedcontent.com, accessed July 26, 2008.
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2004. It had taken more than a century, starting with a family house, to build a timeless image of class, luxury and elegance. The industry-leading luxury conglomerate, LVMH, had been a major player in Louis Vuitton’s success; it had been setting the tone and practices of the brand. The LVMH group had divided itself into five business divisions: fashion and leather goods, selective retailing, wines and spirits, perfumes and cosmetics, and watches and jewelry. There were 50-plus luxury brands belonging to the group, which captured business in many countries. Louis Vuitton had been returning the favour to its parent company, as it represented the group’s best-performing brand due to continuous double-digit growth during the past years. Although LVMH did not disclose sales for Louis Vuitton alone, analysts reckoned that in 2003, sales had grown at least 16 per cent worldwide and had repeated that growth in 2004. Thanks to Louis Vuitton’s rapid growth, LVMH’s Paris-traded shares had almost doubled in price in 2004 to more than $75. Exhibits 1 to 4 show LVMH’s financial results for 2008, LVMH’s Fashion & Leather Goods Division’s 2008 financial statements and the division’s key figures.11 The LVMH group’s upward trend was said to be poised to continue as chairman Bernard Arnault’s expectations for the future were very optimistic. At that time, Louis Vuitton had already quintupled sales and increased margins six-fold since Bernard Arnault had bought the company in 1989, and the brand was said to have the greatest potential for growth of all luxury brands (see Exhibit 5). The Vuitton Machine: Inside the World’s Biggest Luxury Brand Thinking of Louis Vuitton, what would come to mind? It would certainly be top model celebrity ads in trendy fashion magazines, or fashionistas in new Louis Vuitton retail temples from the Champs Elysées to Tokyo’s high-end Omotesando shopping district. Behind the glamorous image of Louis Vuitton, one could see what made it unique, and what made it the most profitable luxury brand worldwide (see Exhibit 6). As Louis Vuitton had been progressing smoothly for the past years, Yves Carcelle, the charismatic textile executive who had been widely credited with masterminding Louis Vuitton’s ever-rising growth, had commented about the brand’s growth that “the sky’s the limit.” With $3.8 billion in annual sales, Louis Vuitton represented in 2004 about twice the size of its two main competitors, Prada and Gucci Group’s Gucci division. This fact was even more striking when LVMH announced a 30 per cent increase in Louis Vuitton’s earnings in 2003 due to a record operating margin at 45 per cent. The standard average margin in the luxury accessories business was 25 per cent.12 Efficient management practices Through the years, Louis Vuitton had established a strictly controlled distribution network thanks to an efficient structuring of the company that relied on continuously increasing productivity in design and manufacturing. Louis Vuitton owed much to its executives. Emmanuel Mathieu, who had headed Louis Vuitton’s industrial operations since 2000, had contributed to the boost in manufacturing productivity by five per cent a year, with more productivity, efficiency and teamwork. In 1999, the firm took 12 months to launch a new product; in 2004, the time was reduced to about six months. This continuous improvement had been the theme of Louis Vuitton’s industrial operations and was facilitated by manufacturing methods from auto makers and other industries that had been adopted to boost productivity.
11 The Louis Vuitton Company was part of the Fashion & Leathers Goods Division of LVMH. 12 Carol Matlack, “The Vuitton Money Machine,” Business Week, www.businessweek.com, accessed March 22, 2004.
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Managers such as Emmanuel Mathieu had helped transform the brand from a family business to a 21st century business.13 The manufacturing of Louis Vuitton products was still a labour-intensive process. Each team of 24 workers was responsible for producing about 120 handbags a day. Over a period of time, the brand seemed to have achieved perfect equilibrium between machines and labour. Quality products Louis Vuitton focused on constant improvement of quality and offered lifetime repair guarantees for its customers. The brand had been striving to increase both fidelity and endless desire in its consumers. Louis Vuitton based its strategy on the loyalty of its consumers and strove to attract more consumers to buy bags ranging from classic tan-and-brown monogrammed bags to newer lines, such as the Murakami line, which was priced at $1,000, and Suhali, a line of goatskin bags priced at more than $2,000. As they bought Louis Vuitton items, loyal shoppers stepped into the dream of the brand. The more the prices were raised, the more they would come back. When Jacobs joined Louis Vuitton, the New York designer had a challenge — attracting young buyers. However, Jacobs happened to be the perfect match, as the two product lines that he had launched (ready- to-wear and shoe lines) tapped into a market of younger consumers, even if those lines accounted for less than 15 per cent of the brand’s sales. The younger buyers were attracted by brand image and older clients by quality and lifetime free repairs. Production and quality control The efficiency of the manufacturing facilities and employees helped Louis Vuitton compensate for its decision to keep most manufacturing plants in France, one of the most expensive labour markets in the world. Eleven out of 13 factories that made Louis Vuitton bags were in France. The brand had never planned to manufacture its products in a location where labour was less expensive as the quality control standards in France were very high and customers expected “un savoir-faire à la Française,” meaning the famous refined French know-how. Quality control was conducted in the brand’s test laboratories. The leather raw material came from the hides of Northern European cattle. They were known for relatively few blemishes from insect bites. Despite high-quality leather, the quality of the bags was tested with mechanical arm hoists. The bags, loaded with weights, were lifted and dropped, again and again, as part of quality checking. Then, ultraviolet rays were projected on the handbags in order to determine their resistance to fading. Eventually, zippers were opened and shut 5,000 times. For other pieces, such as jewelry and bracelets, mechanized mannequin hands were strongly shaken to make sure none of the charms would fall off. In all Louis Vuitton factories, employees worked in teams of 20 to 30. Each team was responsible for one product at a time and were encouraged to suggest improvements in manufacturing. They were also briefed about the products, such as their price and how they were selling. The aim was to have autonomous and multi-skilled employees.
13 Ibid.
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The Boulogne Multicolor shoulder bag provided an example of how the whole production process worked. With the success of the Murakami line in 2003,14 the marketing executives thought that this line could be a source of further revenue. They questioned store managers and found out that customers wanted a Murakami shoulder bag. A prototype of this new Boulogne Multicolor bag went directly from the marketing department to top executives. Straight away, they approved it. The prototype went to the factory in Ducey on the Normandy coast of France. The teamwork efficiency of Louis Vuitton’s factory paid off. When some workers were asked to test it, they discovered that decorative studs were causing the zipper to bunch up. Following this discovery, managers were informed right away and technicians managed to place the studs a few millimetres away from the zipper in less than one or two days. The problem was solved.15 Advertising As Louis Vuitton had been going global, it had been able to develop a successful advertising strategy in line with its global expansion strategy. The advertising strategy of the company remained based on the idea that productivity would not sustain growth. Rather than cutting its ad budget like most luxury groups, the company increased ad spending by 20 per cent in 2003. This figure might have seemed very high, but in fact, it only represented five per cent of revenues, half the industry average.16 The company meticulously cultivated a celebrity culture and employed famous models and actresses, such as Jennifer Lopez and, more recently, Madonna, in its advertisement campaigns. However, in 2007, the firm implemented a change in its strategy and announced that former Soviet leader Mikhail Gorbachev would be featured in an advertisement campaign with sports stars Steffi Graf, Andre Agassi and Catherine Deneuve.17 The firm wanted a shift from hiring traditional top models. Louis Vuitton frequently used print ads in magazines and billboards in large cosmopolitan cities. The campaigns often involved famous stars like Gisele Bündchen, Eva Herzigova, Sean Connery, and Francis and Sofia Ford Coppola. Lots of customers were attracted to the mind-boggling 90-second commercial advertisement on television with the catchy question, “Where will life take you?” Translated into 13 different languages, it helped LV to build its brand. The media (communication) department was strategic in choosing the newspapers and magazines to reach out to the higher income group. Future challenges The most serious issue that would remain for years to come was the question of whether Louis Vuitton had reached its growth potential or not. One of its challenges would consist of reducing its risky dependence on the Japanese market. In 2004, 55 per cent of revenues came from Japanese consumers. To reduce dependence on this market, the brand aspired to continue building its sales in the United States, as well as tapping new emerging markets, mainly China and India. The second challenge would be to fight against worldwide counterfeiting. This was important because Louis Vuitton had been itself synonymous with status, convincing customers that they belonged to a privileged club.
14 In 2003, Takashi Murakami, in collaboration with Marc Jacobs, created the Monogram Multicolor canvas range of handbags and accessories. First designed for the Japanese market, the line was a worldwide success. 15 Carol Matlack, “The Vuitton Money Machine,” Business Week, www.businessweek.com, accessed March 22, 2004. 16 Carol Matlack, “The Vuitton Money Machine,” Business Week, www.businessweek.com, accessed March 22, 2004. 17 Official Louis Vuitton MySpace, www.myspace.com/louisvuittonmyspace, accessed June 25, 2010.
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In the future, Louis Vuitton would have to face a shift that all fashion houses feared, the possible departure of Jacobs. Yet, Jacobs had signed a contract as Louis Vuitton’s artistic director until 2018 and Marc Jacobs’s label18was one of the rising stars in LVMH’s portfolio. However, the biggest challenge was in keeping control of the multinational business. As brands went global, the temptation for many was to immediately find new outlets and new channels of distribution and to decide on the price in different countries. However, Louis Vuitton was highly disciplined and focused on quality. JAPAN —A KEY MARKET Overview of the Japanese Luxury Market Over the past few years, Japan had become the capital of luxury and a mass-market paradise for luxury brands. According to an estimate by HSBC in February 2009, it was the final destination of 45 per cent of luxury goods sold worldwide.19 According to some luxury analysts, the statistics were exaggerated. Indeed, Japan was considered the world’s largest market for luxury brands, but statistics said that Japan represented between 12 and 40 per cent of worldwide sales. The rate would vary according to the definition of the market. Claudia D’Arpizio upheld that, “Japan is the world’s largest market, and has the highest per capita spending for luxury goods.” She added, “Much of that volume is from Japanese purchases while on trips to Hawaii, the U.S. or Asia.”20 Competition Japan was the world’s most concentrated source of revenue for luxury brands. It represented the mass market and, consequently, the first source of profit for many international luxury brands. Exhibit 7 shows the percentages of several companies’ overall revenues generated in Japan. The CEO of Bulgari, Francesco Trapani, revealed, “Accounting for 26 per cent of total revenues, Japan is for Bulgari the first and most important market.” In 2006, Japan represented the biggest market for other luxury brands, such as Baccarat, Burberry, the Gucci Group, Louis Vuitton and Salvatore Ferragamo. In addition, Japan was the second biggest market for Coach and Tiffany & Co.21 Comparing Japan’s geography to the U.S. geography, the former was equivalent in size to the region of Montana. Within its tiny territory, Japan was sprinkled with 34 Bulgari stores, 37 Chanel stores, 115 Coach stores, 49 Gucci stores, 64 Salvatore Ferragamo boutiques, 50 Tiffany & Co. boutiques and 252 stores of the LVMH group, including leading brands such as Louis Vuitton, Donna Karan, Marc Jacobs, Berluti, Moet & Chandon, TAG Heuer and De Beers LV.22 18 Marc Jacob created his own label, Marc Jacobs Co. Ltd, in 1994. The company was part of LVMH. 19 Glenn Smith, “Luxury sector loses its recession-proof status,” Media, February 12, 2009,p. 19. 20 Ibid. 21 “Japan is the world’s most concentrated source of revenue for luxury brands,” Japan External Trade Organization, www.jetro.org, accessed May 8, 2006. 22 Louis Vuitton had settled an agreement for a joint venture with the diamond company De Beers for the Japanese market. “Japan is the world’s most concentrated source of revenue for luxury brands,” Japan External Trade Organization, www.jetro.org, accessed May 2006.
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Quality had always been a key factor for successful brands in the Japanese market, especially for smaller brands or niche brands that did not enjoy the same success as larger brands, such as Louis Vuitton. But new, foreign brands were trying to shake up the market share of existing luxury companies in Japan by offering high quality at competitive prices. The popular worldwide Swedish brand H&M tapped into the Japanese market in 2008 with its fast fashion concept. The entry of H&M into the market completely revolutionized it. As a consequence, the effectiveness of the business models of brands like Zara, H&M or Uniqlo enabled them to compete with quality brands amazingly quickly. Affordability was a new concept that was radically changing the mindset of Japanese customers, who were always eager to resemble top fashion models from famous catwalk shows. Consumer Behaviour in Japan Japan had been known for a group-oriented culture in which there was a real pressure to possess luxury status-driven brands. Successful brands, such as Prada, Hermès or Louis Vuitton, had made the Japanese luxury market the mass market. The Japanese way of consumption was different from the Western one. In Japan, young women were more beauty-conscious. The proportion of the urban population in Japan that possessed a famous, expensive luxury brand item was immense, reflecting a tendency not as deeply ingrained in other developed cities, such as New York, Sydney or even Paris, the high-end capital of luxury fashion. The Japanese way of consuming cosmetics and luxury brands seemed more like a compulsory form of social expression. According to Davide Sesia, the president of Prada Japan, Japanese women, to a much greater extent than Europeans, had a “psychological need to own something considered to be beautiful.”23 In Western societies, luxury shopaholics were not very well-perceived among society. However, the cultural and social homogeneity among Japanese society helped explain its attachment to luxury items. The existence of a large middle class and a high population density affected Japanese habits. Japanese people were used to spending more time out of their homes than people in any other culture. Japanese society could be described as an “impersonal” society in which looks were very important, and people were supposed to dress in a way that corresponded to their social position. Yet, times had changed and Japanese consumers were becoming less inclined to tolerate high prices that had formerly created desirability. Although young Japanese women would still be eager to save money for the “it” brands, they had become more aware of the value of money. The lower-priced accessories and small leather items, such as wallets, travellers or clutches, had reported a huge increase in sales in the recent past. Since 2000, luxury goods had held a different position in the consumer mindset. As the market had evolved towards more sophistication, luxury brands were no longer purchased as badges of membership in the new urban class. The norms of mature brand behaviour and consumer habits seen in the Western world were about to be reflected in the Japanese luxury market. Davide Sesia had advocated that, “The increased attitude of Japanese women in their 20s and 30s understanding themselves much better than in the past was a key phenomenon.”24 As a consequence, in the luxury market, the ready-to-wear segment had most incontestably been affected by the new trends in Japanese women’s choices.
23 “The State of Luxury in Japan,” Carter Associates, http://carterassociates.net/aboutJapan/view_04_Luxury.html, accessed February 12, 2008. 24 “The State of Luxury in Japan,” Carter Associates, http://carterassociates.net/aboutJapan/view_04_Luxury.html, accessed February 12, 2008.
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New Perspectives In response to the sluggish economy and appreciation of the Japanese yen, foreign luxury brands were lowering their prices. Louis Vuitton and Christian Dior had lowered their prices the week before Christmas in 2008. Louis Vuitton had made a seven per cent price reduction on leather goods, accessories, ready-to- wear, shoes, watches and jewelry. The decrease in prices was justified by “a policy of offering its products at appropriate prices.”25 This policy relied on the exchange rate fluctuation, manufacturing costs and quality considerations as the yen had strengthened against the euro in 2008.26 Although sales of luxury products had notably decreased due to the global financial crisis, which originated in the United States and spread all over the world during 2008-2009, a new, curious phenomenon had taken over — the rental of bags. Nonetheless, many luxury brands were aiming for the return of better days, like the luxury Belgian chocolatier Godiva, which was carrying on with plans to open two new cafés in Tokyo, or the luxury mobile phone company Vertu, which planned to open a shop in Ginza. Characteristics of the evolution of the ageing Japanese population, such as wealthier families and older women with increased purchasing power, represented new perspectives for the future of the Japanese luxury market. Though there was sustained slowdown in the demand for luxury goods in 2008 and 2009 due to the adverse consequences of the global recession, the Japanese luxury market would remain a healthy and growing industry. There had never been an annual sales decline and the growth for the next few years was still expected to be around six per cent.27 The Japanese market was defined as cyclical in the sense that there were periods of huge spending often followed by periods of slow growth and moderation. In order to compete, brands would have to rethink their decisions and strategies in a more complex way than in past years. Milton Pedraza, the chief executive officer of the Luxury Institute of New York, upheld that, “Luxury has to reinvent itself every few years, and I believe it will return to the traditional meaning of something unique and exclusive.”28 In the near future, prices of goods and lines of products would oscillate, but the average price would be considered the crucial issue in the luxury market. LOUIS VUITTON IN THE JAPANESE MARKET The year 1977 saw the opening of the first stores of Louis Vuitton in Japan in Tokyo and Osaka. In the 1980s, with the economic boom in Japan, there was “Vuittonmania” in Japan. Around 20 million Japanese women (out of a population of 127 million people in Japan) owned a bag of the brand and each year, Louis Vuitton sold more than five million units of “Keepal” and “Speedy,” the classic leather monogram bags.29 The famous Malletier made more than a third of its profit in Japan. What had been the key to its successful strategy?
25 Miles Socha, “Vuitton, Dior to Lower Prices in Japan,” Women’s Wear Daily, February 12, 2008. 26 Miles Socha, “Vuitton, Dior to Lower Prices in Japan,” Women’s Wear Daily, February 12, 2008. 27 “The State of Luxury in Japan,” Carter Associates, http://carterassociates.net/aboutJapan/view_04_Luxury.html, accessed Feb 26 , 2008 28 Glenn Smith, “Luxury sector loses its recession-proof status,” Media, February 12, 2009, p. 19. 29 Phillipe Adam, “La passion japonaisede Louis Vuitton,” International Commerce, www.actu-cci.com, accessed July 9, 2007.
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The Entry into the Japanese Market Louis Vuitton was the first multinational luxury house to open its own shop-in-shops in Japan, without the help of a Japanese distributor. This strategy had become an efficient economic and commercial business model in the luxury market. In the 1970s and 1980s, foreign firms had manufactured and distributed their products by licensing. When Louis Vuitton decided to opt for a controversial strategy and to establish its own subsidiary, the company turned out to be a pioneer. It decided to export products from France to Japan. Kyojiro Hata had been the CEO of Louis Vuitton Japan for 28 years. Louis Vuitton’s headquarters’ management style meant strict control of the selective retail store network across the globe. Each subsidiary was, to a certain extent, extremely autonomous. The French headquarters had been relying on the Japanese business savoir-faire, believing Japanese managers to be more likely to make efficient market-driven decisions as they understood the local people. Louis Vuitton entered into the Japanese market at first through department stores with a single brand of its portfolio. The company offered its Japanese partners, like Seibu or Mitsukoshi, an interior design comparable to that found in its flagship stores in Paris. The purpose remained making a French luxury purchasing experience and controlling entirely the shop-in-shops (prices, products, sales teams, etc.). A few years later, in 1981, Louis Vuitton opened its first retail store in Namiki Dori, Ginza, in Tokyo. The company followed its expansion strategy and, by 2007, controlled 54 stores through a directly owned shop network in Japan.30 LVMH as a group had more than 250 stores in Japan. Some of them were stores opened as franchises during the last decade. New generations of shops opened in Nagoya, Osaka, Sapporo, Tokyo and elsewhere, revolutionizing the whole purchasing experience of luxury goods. The architecture of the stores had become part of the brand’s identity. A perfect illustration of this was the architecture of the Louis Vuitton building in Omotesando, Tokyo, built by Jun Aoki, which looked as if several trunks were piled up. Louis Vuitton had shifted towards a new approach in which the experience in a store would accord with the emotion brought out by the products. Louis Vuitton took advantage of the Japanese demand for high fashion. Japan had been, and remained, a source of creative ideas and trends. In a sense, Japan represented a fantastic laboratory to test new selling methods and to inaugurate innovative Louis Vuitton stores. Contrary to Europe, there were few rules and standards to follow in terms of urbanization and architecture. This enabled Louis Vuitton to design audacious and amazing stores like the ones in Ginza, Ometesando and Roppongi in Tokyo, or even one of the latest stores inaugurated in February 2007 in Nagoya’s Midland Square, just below the Toyota headquarters. The Japanese clientele were receptive to Louis Vuitton, as they were truly avid for new products and very demanding of the quality of products they bought. Strategic Approach Louis Vuitton had always been a trend-setting brand strategist in Japan, a country that revolved around tradition and culture. Since the designation of Jacobs as the artistic director of the brand, Louis Vuitton had successfully entered the Japanese ready-to-wear market. Jacobs had strived to combine his own artistic universe with the tradition and heritage of the brand. The designer had created a new energy and enthusiasm for each ready-to-wear runway collection, mixing tradition and innovation.
30 Phillipe Adam, “La passion japonaisede Louis Vuitton,” International Commerce, www.actu-cci.com, accessed July 9, 2007.
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Since 1995, the worldwide luxury market had been growing by 10 per cent each year.31 In 2002, the global economy faced a slowdown due to the recession caused by the September 11, 2001 terrorist attacks in the United States. The direct consequence was a decrease in sales, such as luxury shopping in duty free zones in international airports and prestigious luxury destinations like Tokyo’s Ginza Namiki Dori, the Place Vendôme in Paris and Madison Avenue in New York. The September 11th attacks had caused a major decline in tourist flows and in the luxury market. In Europe, foreign tourists accounted for 60 per cent of customers of luxury items.32 Louis Vuitton in Japan had to redefine its strategy because the sluggishness in the United States had an adverse impact on the purchasing power of the Japanese consumers as Japan was relying on export income from the United States. At that time, Louis Vuitton realized that it had to focus on local consumers rather than tourists. Luxury started to go local.33 Louis Vuitton reacted early to proceed with this major shift in strategy. The brand realized that for the past years it had been setting the trend as a brand leader, but that the guarantee of future growth would depend on adapting to and understanding local customers. To do so, the company tried to adjust its approach and products to reach local customers. A revelation came from the Japanese market. Limited editions: A new marketing strategy After Jacobs had seen an exhibition at the Fondation Cartier pour l’art contemporain in Paris by Takashi Murakami, Louis Vuitton decided to collaborate with the Japanese artist for its 2003 spring/summer collection. Takashi Murakami, who was known as the “Japanese Andy Warhol,” re-created a colourful pop version of Louis Vuitton’s monogram in 33 colours on a black and white background. In stores, Louis Vuitton’s handbags with smiling blossom designs became huge sellers in Japan. The strategy appeared to be a huge success for the leading luxury conglomerate LVMH, as the Murakami line increased Louis Vuitton’s profits by 10 per cent.34 The success was not only in the Japanese market but also in the European and American markets, which showed true admiration for Japanese culture. Following the massive success of the line, in 2003 and 2005 collaborations between Murakami and Jacobs resulted in the Monogram Cherry Blossom line, featuring a trendy motif inspired by the fruit of the cherry blossom — Japanese art wedded to Louis Vuitton’s perfection — and the Monogram Cerise line, with a new pattern that gave freshness and cheerfulness to the monogram. While announcing the exclusive Louis Vuitton store at the Murakami Exhibition in the Brooklyn Museum in April 2008, Jacobs had commented on their collaboration. “Our collaboration has produced a lot of work, and has been a huge influence and inspiration to many. It has been, and continues to be, a monumental marriage of art and commerce. The ultimate cross-over, one for both the fashion and art history books.”35 He had it spot on — it was indeed “commerce” and strategy, as Takashi Murakami had been the starting point of Louis Vuitton’s success in Japan.
31Claudia D’Arpizio, “Luxury goes local,” The Wall Street Journal Europe, www.bain.com/bainweb/home.asp, accessed May 1, 2004. 32 Ibid. 33 Ibid. 34 Ibid. 35 Sally Williams and Mona Sharf, “The Brooklyn Museum announces the inclusion of an exclusive Louis Vuitton store within the retrospective of Japanese artist Takashi Murakami,” www.brooklynmuseum.org, accessed March 21, 2008.
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The limits of limited editions For the past years, Louis Vuitton had boosted its sales with continuous limited editions in the Japanese market. Once again, in June 2008, Louis Vuitton had launched a major new accessory line called Monogram Ouflage, which combined the iconic brand’s monogram canvas with a new camouflage print designed by Takashi Murakami and Jacobs. It was unveiled at the pop-up Louis Vuitton shop opened at the Brooklyn Museum of Art. However, limited editions were under threat. The company had used them to market several lines of bags. In the end, the flood of mass-market interest would end up robbing the brand of some of its cachet and overdoing the profitable “limited edition” strategy would confuse consumers as they would no longer be able to differentiate between a real limited edition and a marketing ploy. Democratized luxury for all was good, but with precautions. Market dilution: A luxury brand is dead, a fashion brand is born How did the brand that had been synonymous with luxury and exclusivity grow while retaining its cachet? Though Louis Vuitton had been an enduring status symbol in Japan, it had to face a major challenge: brand dilution as it moved into offering new product lines. As a leader of the sector, the challenge was to continue growing in the Japanese market and still preserve the exclusivity and great quality the brand had always offered. There were two stages in luxury culture — the “show off” stage and the “fit in” stage — and Japan had already passed the two stages. The “fit in” stage was represented by Louis Vuitton. As an example, more than three-quarters of women in Tokyo of about twenty years of age possessed an item of the brand. This phenomenon was considered normal, as luxury goods symbolized membership of the “acceptable” group of society. Accordingly, mass expansion and mass distribution had become a real issue. In 2007, in the sulphurous book “Deluxe: How Luxury Lost Its Luster,” journalist Dana Thomas reported that 40 per cent of all Japanese owned a Louis Vuitton-monogrammed item. She compared Louis Vuitton’s expansive growth over the past decade to that of McDonald’s, suggesting that the “LV” logo had become almost as ubiquitous as the Golden Arches.36 These declarations damaged Louis Vuitton’s image. In addition, constant questioning over the origins of Louis Vuitton’s products and the repetition of limited editions over the past years had marked a new era for Louis Vuitton — an era characterized by disposable “it” bags with shelf lives of two fashion seasons at most. This climate seemed to be contrary to what was the essence of Louis Vuitton: tradition and longevity. Counterfeiting The LV-branded bags were priced high in Japan (see Exhibit 8) as in other countries. Therefore, the firm had to face challenges from fake bags. Louis Vuitton had been trying to battle against issues such as the falsification of the logo and market dilution. Since the end of the 1990s and the Asian Financial Crisis, there had been a flood of fake Louis Vuitton products coming from Seoul, Hong Kong, Tokyo and Los Angeles. Though China was the largest producer of Louis Vuitton counterfeited bags, South Korea was the largest producer in terms of high-quality bags. Most South Korean Louis Vuitton counterfeits were exported to Japan.
36 Dana Thomas, Deluxe: How Luxury Lost Its Luster, The Penguin Press, 2007.
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Louis Vuitton had been fighting this issue and remained optimistic. In 2001, at an International Herald Tribune conference in Paris, Christophe Girard, director of fashion strategy at LVMH, declared that when the economy is bad, consumers still wish to turn to luxury products, as their value is reliable and long- lasting. He added that “the quest for pleasure” did not fade away and “it even happens in war. People want to enjoy themselves.”37 This statement appeared to be accurate in Japan, which had been suffering from the Asian Financial Crisis and facing 10 years of economic slowdown, but in which women still had a “cult” for luxury brands. In 2000, Louis Vuitton sales in Japan had increased by 16 per cent, reaching ¥100 billion for the first time in the company’s history.38 However, Japanese consumers had been eager to buy Louis Vuitton bags at inexpensive prices. According to Hidehiko Sekizawa, the executive director of the Hakuhodo Institute of Life and Living in Tokyo, “Japanese shoppers have always been very fussy about quality. Now that the counterfeits are hard to distinguish from authentic products, they no longer mind buying fakes, even though they probably own a couple of authentic bags. They save the genuine articles for formal events like weddings and parties, and dinners and dates, and use counterfeits on rainy days, or to go to the supermarket for milk.”39 The Japanese laws regarding intellectual property had been modified in 1985 and had become similar to Western laws. These rules did not really diminish counterfeiting, which remained a gigantic issue in the following years. In 2008, a scandal went public. It was alleged that more than 90 per cent of the Louis Vuitton-branded products sold on the Japanese “Super Girls Auction” website (Girl-Oku) were counterfeit.40 The website, which targeted mobile phone users, was an auction site of Media Matrix Inc., a member company of the XAVEL group. Louis Vuitton reacted through the Union des Fabricants Tokyo (UDFT). A federal inspection was led in order to prove that the auction site had indeed broken the law. Following the investigation, there was a noticeable decline in sales due to Girl-Oku’s countermeasures, but the issue remained unsolved. Louis Vuitton’s Further Growth in Japan — Change in Management Even though there were doubts about future opportunities for Louis Vuitton in Japan, Kiyotaka Fujii, the new chief executive officer (CEO) of Louis Vuitton Japan, announced that this was not the case in December 2006. The designation of Fujii as the new CEO appeared to be the first change in the Japanese management team of the firm.41 Fujii, a 49-year-old businessman, had previous work experience in consulting and information technology. He had served as the director and an executive committee member of Quintiles Transnational Japan K.K., a leading pharmaceutical services organization providing professional services and information and partnering solutions to the pharmaceutical, biotechnology and healthcare industries. He had also worked at McKinsey & Co. at the New York headquarters. He had graduated from Tokyo University and had obtained an MBA from the Harvard Business School. His vision was to steer the Japanese subsidiary of Louis Vuitton to the next level, relying on the company’s long-term vision and high-quality business. When Yves Carcelles had revealed the appointment of the new CEO, he had pointed out that the person who was chosen as CEO had had to necessarily be Japanese with 37 Velisarios Kattoulas, “Counterfeiting bags of trouble,” Far Eastern Economic Review, March 21, 2002. 38 Ibid. 39 Ibid. 40 Kenji Toda, “Mobile-phone auction sites flooded with fake brand products,” Nikkei Business, August 20, 2008. 41 Koji Hirano, “Vuitton Sees Further Growth in Japan,” Women’s Wear Daily, December 6, 2006.
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a clear vision of Japanese culture. Fujii’s term of office was an absolute success. Among his remarkable acts, the creative collaboration with the Japanese architect Jun Aoki and the artist Takashi Murakami had resulted in smash hits, boosting Louis Vuitton’s sales in the market. He had also introduced Kabuki, or Japanese dance-drama, in Paris. Through the years, one of the strengths of the firm’s global strategy had been to take the best practices from certain cultures and implement them in selected markets. To continue to do so, Fujii would have to face the challenge of exporting the originality of Japanese artists and best practices internationally. Next steps for further growth After his designation as CEO of Louis Vuitton in Japan, Fujii announced that the priorities for the brand would be establishing an Internet business and expanding the range of Louis Vuitton’s products for children. Sales of smaller leather goods and other products, such as jewelry and eyewear had outstripped initial sales objectives. Fujii said that, “Ready-to-wear is another category to grow, and this communicates the message from Louis Vuitton to consumers and increases the brand value of Louis Vuitton. Business on the web is another possible approach to consumers.”42 The marketing strategy had been one of the key points of Louis Vuitton’s success in Japan. The brand was now expanding its strategy towards mid-size and smaller cities. By 2006, Louis Vuitton already had 52 stores and 40 shops-in-shops and was reconsidering its strategy in terms of adapting to Japanese demographic changes and rethinking the range of products offered. Despite changes in Japanese society, Louis Vuitton was still confident about its future. In 2006, an analyst from Mitsubishi UFJ Securities’ research division assessed that, “The Japanese market is not considered saturated yet; the strength of Louis Vuitton is its high recognition among people of wide generations, so opening more shops in middle-size cities makes sense. That’s the integrated power of the brand that includes product development and image management.”43 Louis Vuitton’s power was not about to fade away. CONCLUSION The after-shocks of the global recession were a threat to Louis Vuitton’s luxury business in Japan since its products were priced very high. There were signs that young Japanese women did not have the same vision as the previous generation. They were no longer eager to buy Louis Vuitton products. This represented a real change in the Japanese mindset and Louis Vuitton was already suffering the consequences. Japan had always been the luxury mass market symbol of Louis Vuitton’s golden age. Over the years, Louis Vuitton had been building its global strategy thanks to the experiences and lessons learned from Japan. In a gloomy economic context, the market was tending towards saturation, sales were declining, and competition was fiercer than ever. How could Louis Vuitton reinvent itself and regain what used to be its well-attested fame in Japan?
42 Koji Hirano, “Vuitton Sees Further Growth in Japan,” Women’s Wear Daily, December 6, 2006. 43 Ibid.
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Exhibit 1
LOUIS VUITTON MOËT-HENNESSY FINANCIAL HIGHLIGHTS (FINANCIAL YEAR 2008)
Key consolidated data
(EUR millions and percentage) 2008 2007 2006 Revenue 17,193 16,481 15,306 Profit from recurring operations 3,628 3,555 3,172 Net profit 2,318 2,331 2,160 Group share of net profit 2,026 2,025 1,879 Cash from operations before changes in working capital (1)
4,096 4,039 3,504
Operating investments 1,039 990 771 Total equity 13,887 12,528 11,594 Net financial debt (2) / Total equity ratio 28% 25% 29%
(1) Before income taxes and interest paid. (2) Net financial debt does not take into consideration the purchase commitments for minority interests included in other non-current liabilities.
Data per share
2008 2007 2006 Earnings per share (EUR) Basic group share of net profit 4.28
4.27 3.98
Diluted group share of net profit 4.26
4.22 3.94
Dividend per share Gross amount paid during the period (3) 1.60 1.60 1.40
(3) Excludes the impact of tax regulations applicable to the beneficiary. Source: Official Financial Report 2008, Louis Vuitton Moët-Hennessy website, published December 31, 2008, www.lvmh.com, accessed July 8, 2010.
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Exhibit 2
LOUIS VUITTON MOËT-HENNESSY, REVENUE BY BUSINESS GROUP (FINANCIAL YEAR 2008) (EUR MILLIONS)
Product Category 2008 2007 2006 Wines and spirits 3,126 3,226 2,994 Fashion and leather goods 6,010 5,628 5,222 Perfumes and cosmetics 2,868 2,731 2,519 Watches and jewellery 879 833 737 Selective retailing 4,376 4,164 3,877 Other activities and eliminations (66) (101) (43) Total 17,193 16,481 15,306
Source: Official Financial Report 2008, Louis Vuitton Moët-Hennessy website, www.lvmh.com,accessed July 8, 2009.
Exhibit 3
LOUIS VUITTON MOËT-HENNESSY, FASHION & LEATHER GOODS DIVISION 2008 FINANCIAL STATEMENTS
2008 2007 2006 Revenue (EUR millions) 6,010 5,628 5,222 Revenue by geographic region of delivery (%)
France 8 9 9 Europe (excluding France) 21 20 19 United States 19 20 21 Japan 20 22 26 Asia (excluding Japan) 25 23 20 Other markets 7 6 5 Total 100 100 100
Type of revenue as a percentage of total revenue (excluding Louis Vuitton)
Retail 47 49 50 Wholesale 44 38 36 Licenses 8 8 7 Other 1 5 7 Total 100 100 100
Profit from recurring operations (EUR millions)
1,927 1,829 1,633
Operating margin (%) 32.1 32.5 31.3
Number of stores Louis Vuitton 425 390 368 Fendi 180 160 135 Other brands 485 439 451 Operating investments (EUR millions)
311 246 319
Source: Official Financial Report 2008, Louis Vuitton Moët-Hennessy website, published December 31, 2008, www.lvmh.com, accessed July 8, 2009.
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Exhibit 4 LOUIS VUITTON MOËT-HENNESSY, FASHION & LEATHER GOODS DIVISION 2008 KEY FIGURES
Revenue and Profits from Recurring Operations
Millions of Euros
2006 2007 2008
Revenue 5,222 5,628 6,010 Profit from recurring
operations
1,633 1,829 1,927
Revenue by Geographical Region of Delivery in 2008
Investments in Millions of Euros
Fashion & Leather GoodsNumber of Stores
Source: Compiled using statistics from Louis Vuitton Moët-Hennessy website, www.lvmh.com, accessed December 31, 2008.
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Exhibit 5
LOUIS VUITTON SA — FINANCIAL DATA
Financial data are given in euros (millions)
12/2007 12/2006 % 12/2005 % 12/2004 % Number of months 12 12 12 12 Summarized Results 12/2007 12/2006 % 12/2005 % 12/2004 % Turnover 1,848 1,697 9 1,566 8 1,444 8 Export turnover 1,650 1,513 9 1,385 9 1,307 6
Wages and expenses 5 6 -17 5 20 5 0 Value added 688 676 2 618 9 578 7 Gross operating surplus 667 655 2 598 10 559 7 Operating income 637 659 -3 588 12 560 5 Financial result 491 456 8 462 -1 378 22 Exceptional result -5 -55 91 -8 -588 -50 84
Net income 866 819 6 815 0 650 25 Cash flow 919 892 3 841 6 706 19 Balance Sheet 12/2007 12/2006 % 12/2005 % 12/2004 % Net fixed assets 1,242 1,242 0 1,229 1 1,062 16 Net assets 1,297 1,315 -1 1,545 -15 1,495 3 Equity 2,187 2,197 -0 2,154 2 1,952 10
Long-term debt 1 3 -67 3 0 Current liabilities 286 291 -2 555 -48 513 8 Yearly investments 40 61 -34 46 Cash 12/2007 12/2006 % 12/2005 % 12/2004 % Net working capital 945 956 -1 927 3 889 4
Working capital requirements 946 957 -1 926 3 890 4 BFR overall turnover days 184 203 -9 213 -5 222 -4 Cash -1 -1 0 -1 Main Indicators (%) 12/2007 12/2006 % 12/2005 % 12/2004 % Profitability 46.89 48.25 -3 52.03 -7 45.03 16 Rate of value added 37.26 39.84 -6 39.43 1 40.01 -1 Solvency 286 291 -2 555 -48 513 8 Financial independence 86.14 85.96 0 77.66 11 76.32 2 Debt ratio 0.01 0.03 -67 0.15 -80 0.13 15
Source: Kompass International Neuenschwander SA website,www.kompass.fr/recherche.php?action=signin, accessed December 31, 2007. The original French version was translated into English.
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Exhibit 6
THE LEADING LUXURY BRANDS IN THE WORLD IN 2008
Rank Brand 2008 Brand Value in USD
(m.)
2008 Brand Value in Euros (m.)
Country of Origin
1 Louis Vuitton 21,602 16,718 France
2 Gucci 8,254 6,388 Italy
3 Chanel 6,355 4,918 France
4 Rolex 4,956 3,836 Switzerland
5 Hermès 4,575 3,541 France
6 Cartier 4,236 3,278 France
7 Tiffany & Co. 4,208 3,257 United States
8 Prada 3,585 2,775 Italy
9 Ferrari 3,527 2,730 Italy
10 Bulgari 3,330 2,577 Italy
11 Burberry 3,285 2,542 United Kingdom
12 Dior 2,038 1,578 France
13 Patek Philippe 1,105 855 Switzerland
14 Zegna 818 633 Italy
15 Ferragamo 722 559 Italy
Source: “2008 Leading Luxury Brands,” Interbrand, 2008, www.interbrand.com,accessed July 5, 2008.
Exhibit 7
TOP MULTINATIONAL LUXURY FASHION BRANDS — PERCENTAGE OF OVERALL REVENUE
FROM JAPAN IN TOTAL WORLD WIDE SALES (2005)
Baccarat 35%
Bulgari 26% Burberry 36% Coach 22% Hermes 25% Gucci Group 27% LVMH Group 15% Louis Vuitton(Fashion & Leather Goods) 30% Salvatore Ferragamo 27% Tiffany & Co. 20% Van Cleef and Arpels 33%
Source: “Japan is the world’s most concentrated source of revenue for luxury brands,” Japan External Trade Organization, May 2006,www.jetro.org/content/361 15, accessed February 18, 2008.
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Exhibit 8
LOUIS VUITTON BESTSELLING HANDBAGS IN JAPAN
Keepall 55 Speedy 35 The Alma Normande
The world’s most famous travel bag that dates back to the 1930s.
Price: $1,270.00
The LV Speedy is one of the most classic and easily recognizable LV bags.
Price: $725.00
Inspired by a shape invented by Gaston Vuitton in the 1930s, Alma is now a classic.
Price: $1,290.00 Keepall 55 Roses Multicolore Speedy Multicolore Tote Artist: Stephen Sprouse Year of Release: 2001 Price: $2,000.00
Artist: Takashi Murakami Year of Release: 2003 Price: $2,240.00
Artist: Takashi Murakami Year of Release: 2008 Price $1,200.00
Source: Nagoya franchisee of Louis Vuitton. Price has been converted at an exchange rate of ¥100 = US$1.
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9A94B008 FAST EDDIE’S Maria Gudelis and Dirk Schrader prepared this case under the supervision of Professor Jim Hatch solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. Copyright © 1994, Ivey Management Services Version: (A) 2010-02-19 It was January of 1994 and Mike Gorski, the owner of Fast Eddie’s, was sitting in his Brantford, Ontario office contemplating the future. With some satisfaction he noted that in the past six years he had established five Fast Eddie’s double-drive-thru take-out restaurants. Now, as he planned the new year, he knew that there was a tremendous untapped potential for his concept, but he was unsure how to proceed. Should he expand by opening additional company-operated stores, or should he establish a franchise system? If he established a franchise, what should be the financial arrangements with the franchisees? THE CONCEPT Fast Eddie’s operated as a double-drive-thru fast food restaurant with no internal seating for customers. The double-drive-thru allowed two service windows to operate simultaneously; one on either side of the restaurant. There were also two windows at the front for walk-up customers. Mike had become aware of the concept of a double-drive-thru hamburger restaurant while travelling in the United States in 1986. He had also noticed that these restaurants offered limited menus and value pricing of the core products of the hamburger industry. Gorski recognized that this was an idea that could be successful in Canada and opened his first Fast Eddie’s restaurant in Brantford in 1987. The second location was started in 1988 in Simcoe. Cambridge was the site of the third restaurant, opened in 1990. Two more restaurants were opened in the city of London; one in 1992 (Highbury site) and one in 1993 (Wharncliffe site). THE PRODUCT The Fast Eddie’s menu was limited and inexpensive. It offered hamburgers, French fries, milkshakes, and soft drinks from Pepsi Co. The food prices were positioned below other fast food hamburger restaurants (see Exhibit 1). Lower prices were possible because of the lower costs associated with limited menu, no in-store service and greater through-put per square foot of space.
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At Fast Eddie’s, speed of service was a significant product characteristic. It was believed that customers would choose other fast food hamburger restaurants if the drive-thru queue was too long. The two lines and windows at Fast Eddie’s allowed two orders to be taken simultaneously, resulting in shorter waiting times than at single-line competitors. Fast Eddie’s targeted a two-minute turnaround between the time the order was placed and handed to the customer. MARKETING Promotion expenditures averaged two per cent of sales, and were directed mainly at promotions to existing clients to encourage repeat business. Some examples were: cents-off coupons included with the customer’s take-out order, T-shirts or hats, advertised 29 cent hamburgers on Sundays, and promotions such as roll up the cup lip to win free products. Fast Eddie’s advertised externally through local radio (FM96 in London) and local newspapers (such as the London Pennysaver). The newspaper advertising typically stressed low prices and included coupons. Mike believed that once a customer ate at the restaurant, the recognized quality of the product in relation to price would result in repeat business. Fast Eddie’s outlets were located on high traffic roads near shopping centres and other fast food restaurants. The “fast-food strip” provided a steady stream of hungry people who might switch to Fast Eddie’s from other restaurants based on convenience, price, or value. OPERATIONS Fast Eddie’s were double drive-thru restaurants with no seating room. The buildings were specially designed to meet the needs of this concept. They ranged from 600 to 900 square feet (19 feet wide by 46 feet long) which provided room for a manager, a shift leader and four to six additional employees (two on cash/order taking, the remainder preparing the food). The small restaurant size required efficient operations and the limited menu permitted fewer people to prepare the food than traditional fast-food restaurants. Only six to eight people were required to operate the restaurant at peak times. The property dimensions of a Fast Eddie’s restaurant were wide enough to provide room for the restaurant, three traffic lanes, and a parking area for stopping to eat a meal. The resulting road frontage ranged from 80 to 120 feet. The complete layout is seen in Exhibit 2. Hours of operation were 10:30 a.m. to 11:30 p.m. each day of the week, but the majority of sales took place within certain peak periods (e.g., lunch and dinner hour, and Fridays and Saturdays). Highly variable peak demands meant that staff scheduling and an ability to work at a high level of efficiency were critical to success. HUMAN RESOURCES Fast Eddie’s had a head office management team of four people: the president, the vice president-finance, the supervisor of operations, and the office manager. There was a restaurant manager at each of the five restaurants, plus 15 to 25 part-time and full-time employees. The organization chart for the company is seen in Exhibit 3.
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The 32-year-old president, Mike Gorski, founded the firm in 1987. Mike had earned a bachelor of commerce degree at McMaster University in 1985. Before starting Fast Eddie’s, Mike sold cars full time. However, he had many years of fast food restaurant experience that began at the age of nine while working part-time in his father’s restaurant, a McDonald’s franchise. Mike’s main role was to ensure a successful marketing strategy for his restaurants, negotiate deals with the food suppliers, and achieve high performance from his managers. The Vice-President Finance was Mike’s sister Monika Lindsay. Monika graduated from McMaster University with an honors bachelor of commerce degree and had spent two years with Second Cup as a corporate accounting assistant. Her restaurant experience included six years of part-time work at McDonald’s. Monika divided her time between financial management of the business and restaurant supervision. The supervisor of operations had been employed in the restaurant industry for a total of nine years, four of which had been with Fast Eddie’s. She had responsibility for supervising all of the locations. This involved inspecting, preparing reports, giving advice to managers and responding to any critical situation at any location (e.g., filling in for the manager if illness occurred). The office manager had joined the company two years ago and was responsible for the bookkeeping. The five restaurant managers were responsible for daily operations of their site (e.g., managing the staff, ensuring a high quality customer service, hiring and training of employees, and ordering supplies), which required at least 60 hours per week. All five managers had previous restaurant work experience and were paid a salary of $32,000 per year. Mike Gorski was convinced that the manager played a key role in the success of a Fast Eddie’s outlet. According to Mike, training an unskilled new hire for a store manager position required approximately three years. Management training and selection were critical. There was a 20-week on-the-job training program for new managers that utilized video-based training and on-site restaurant experience. Regular staff required modest skills such as manual dexterity and the ability to manage cash. They were paid the minimum wage, while the shift leader was paid somewhat more. New hires received on-the-job training by teaming up with experienced workers. The ideal employee was a clean-cut, honest, dependable and reliable person. FINANCIAL HISTORY Mike Gorski financed the first Fast Eddie’s with $87,000 of his own money and further investments of $480,000 from family members. Additional outlets were financed through further family investments of $1.55 million. The consolidated income statement and balance sheet for the firm as of December 31, 1993 are seen in Exhibits 4 and 5. Since the fifth outlet was opened in late 1993, the revenues seen in the income statement largely reflect the results from four units.
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Competitive Environment1 Fast Eddie’s was the only double drive-thru hamburger restaurant (without seating) in Canada. Other drive-thru fast food hamburger restaurants (with seating) included McDonald’s, Wendy’s, Burger King, Harvey’s, local chains like Big Mack’s, and independent burger restaurants. Consumers’ preferences for the 1990s were speed, convenience, and value. The newest players in the hamburger segment in the United States were the double-drive-thrus serving hamburgers and French fries at cut-rate prices, and these were among the fastest-growing restaurants in that market. Rally’s Hamburgers Inc. was the largest double drive-thru chain in the U.S. According to Rally’s 1993 annual report, average 1992 restaurant sales per company-owned store were $573,000 U.S. dollars.2 The fast food industry was proving resilient in the tough economic times of the early 1990s. In the January 1994 issue of Entrepreneur magazine, four fast food restaurants (Subway, McDonald’s, Little Caesars Pizza and Burger King) were ranked in the top 10 fastest-growing franchises in North America. Exhibit 6 provides key information about various North American franchises in the fast food hamburger business. The Opportunity3 The business had grown rapidly over the past seven years, financed by family members and operating profits, but the family did not have additional resources to devote to this initiative. Mike wondered if he could continue and even accelerate the rate of growth? Mike reviewed the data he had available on the five restaurants, which had been opened to date. He noted that, as seen in Exhibit 7, the start-up costs for a new restaurant could be between $575,000 and $825,000. Building costs seemed high, given the small size of the premises, but they included a substantial amount spent on site preparation (e.g., demolition, grading, paving, site services such as plumbing and hydro) and signage. Gorski noted that the average outlet operated at a loss in the first year of operations. Only two restaurants had been in operation as long as three years, but he believed that it would take up to three years for an individual unit to reach its peak volume. Based on these data, he constructed Exhibit 8(a), which outlined a representative income statement for a single Fast Eddie’s restaurant over a three-year period. It assumes that sales gradually grow to a peak in Year Three and are maintained at that level thereafter. Based on the observed growth of his established Fast Eddie’s outlets, Mike was confident that sales of $900,000 were easily achievable. The exhibit makes the implicit assumption that there is no debt since no interest is deducted. Exhibit 8(b) provides a balance sheet for a single outlet. The investment required to start up a new location is taken from Exhibit 7 and year-to-year retained earnings are based on the income statements seen in Exhibit 8(a). Since the method of financing has been left blank, the cash balance is shown as a negative value. Exhibit 8(c) provides the internal rate of return for a single outlet assuming that there is no debt and sales are $900,000 when the unit is at steady state.
1 Unless otherwise stated, information in this paragraph was obtained from the January, 1993 issue of a U.S. magazine, Restaurant Business. 2Based on restaurant sales of $113 million divided by 197 company-owned stores. Since 81 of the 197 restaurants were opened in 1992, this average figure underestimates the potential sales of a mature operation. Rally’s also had 253 franchised stores. 3Please refer to Appendix A for the assumptions used in Exhibits 8(a) – 8(c), 9(a), 9(b), 10(a)-10(d), 11(a) and 11(b).
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The large capital investment required to open a restaurant and the demands of being a dedicated and motivated restaurant manager had stretched Mike Gorski’s resources to the limit. However, Mike wanted to achieve long-term growth and greater corporate exposure by increasing the number of Fast Eddie’s restaurants as rapidly as possible without sacrificing quality. Two alternatives which presented themselves were to grow from internally generated funds or to grow through franchises. Mike constructed the projected income statement and balance sheet for his firm (seen in Exhibits 9(a) and 9(b) under the assumption that all new outlets would be owned by the company. One new unit is created each year beginning in 1994. All of the revenues and costs seen in the income statement are based on the individual unit revenues and costs seen in Exhibit 8(a). The labor expense of $192,000 for management in 1994 for six outlets assumes a $32,000/year salary for each of the six managers. Each additional outlet added is assumed to require the hiring of an additional manager at $32,000/year. The head office salary expense of $190,000 is assumed to be constant, regardless of the number of units added. In the 1993 consolidated income statement (Exhibit 4), there was a lower head office management salary figure of $105,000. The increase to $190,000 in 1994 is explained by the fact that head office management included family members who accepted a lower salary in the start-up phase of the Fast Eddie’s corporation. The tax rate is assumed to be 25 per cent on the first $200,000 of income and 50 per cent thereafter. After completing the projected statements assuming company ownership of all outlets, Mike created projections based on the assumption that all growth would come from new franchisees. To get his analysis started, he decided to assume that all land and building would be purchased by the franchisor and the equipment would be purchased by the franchisee. In return for the land and building, the franchisee would be charged a rent which he initially set at eight per cent of sales. While the franchisee would be expected to engage in some of its own advertising, it was expected that the franchisor would provide broad advertising coverage for all outlets. This would cost the franchisee two per cent of sales. Finally, in order to cover set-up costs and ongoing assistance the franchisee would be charged a royalty of four per cent of sales. All of these assumptions are built in to Exhibits 10(a) and 10(b), which contain the projected income statements and balance sheets for a single franchisee. Exhibit 10(c) provides the internal rate of return for a franchisee with one restaurant, and Exhibit 10(d) provides Fast Eddie’s internal rate of return as franchisor of one restaurant. Assuming the revenues derived from the franchisees outlined in Exhibits 10(a) and 10(b), Mike created projected consolidated income statements and balance sheets seen in Exhibits 11(a) and 11(b). These statements showed the impact on Fast Eddie’s of scenarios consisting of five company-owned units plus a number of franchised units. THE DECISION Should Mike expand his business? If so, should he expand through retaining earnings from current operations or through franchising? If franchising was the preferred method, what type of franchise agreement should he negotiate with the prospective franchisees? Mike knew that timing was critical because competitors could easily enter the market if he did not.
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Exhibit 1
COMPETITIVE PRICING OF FAST FOOD RESTAURANTS1
Note: For basis of comparison to Fast Eddie’s menu, only similar items on McDonald’s and Wendy’s menus were used. Both McDonald’s and Wendy’s offer more products on their menus. 1 McDonald’s and Wendy’s quarter-pounder w/cheese were used for comparison to Fast Eddie’s double cheeseburger. 2 McDonald’s Big Mac was used for comparison. 3 McDonald’s and Wendy’s large soft drinks do not come with a free cup.
Fast Eddie's McDonald's Wendy's
Hamburgers: Basic 0.69 0.99 0.99 Cheeseburger 0.89 1.09 1.09 Double Cheeseburger1 1.99 2.59 2.79 Double Burger Works2 1.99 2.59 n/a Chickenworks 1.99 2.59 Add Bacon 0.29 Fish Filet 0.99 2.09 Shoestring Fries: Small 0.79 0.99 0.95 King Fry (large) 1.29 1.49 1.45 Crazy Fry (served w/chili) 1.69 Soft Drinks - Small (16 oz) 0.79 1.09 - Med (20 oz) 0.99 1.19 1.15 - Gigantic (32 oz, comes with free supercup)3 1.49 1.39 Milkshakes - Small 0.99 1.39 1.25 Milkshakes - Large 1.49 1.69 Coffee 0.45 0.85 0.65 Hot Chocolate (seasonal) 0.39 0.75
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Exhibit 2
LAYOUT FOR FAST EDDIE’S
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Exhibit 3
ORGANIZATION CHART
Office Manager
Brantford Manager
Simcoe Manager
Cambridge Manager
Highbury (London) Manager
Wharncliffe (London) Manager
Supervisor of Operations
Monika Lindsay Vice President
Finance
Mike Gorski President
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Exhibit 4
CONSOLIDATED INCOME STATEMENT FOR THE YEAR ENDED DECEMBER 31,1993
($000s)
Note: This statement has been disguised
Sales 2,768$ Cost of Food/Paper Sold: Food 1,102 Paper 132 Total Cost of Goods Sold: 1,234
Gross Profit 1,534
Labor: Crew 633 Management 143 Head Office 105 Total Labor 881
Operating Expenses: Advertising 47 Utilities 62 Uniforms 8 Auto 5 Business Taxes 37 Garbage Removal 19 Maintenance 32 Cleaning Supplies 8 Administrative Expense 19 Depreciation 110 Total Operating Expenses 347
Operating Profit 306
Interest on Long-Term Debt - Income Before Taxes 306 Income Taxes 103 Net Income After Tax 203$
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Exhibit 5
CONSOLIDATED BALANCE SHEET AS OF DECEMBER 31, 1993
($000s)
Assets Current Assets Cash 303$ Inventory - Food, Paper 20 Total Current 323
Land 900 Building 1,150 Acc Dep - Building (75) Equipment 700 Acc Dep - Equipment (164) Net Fixed Assets 2,511
Total Assets 2,834
Liabilities & Shareholder Equity Accounts Payable 132 Payroll Payable 32 Total Current 164 Total Long-Term Debt - Total Liabilities 164
Common Shares 2,117
Beginning Retained Earnings 350 Net Income 203 Ending Retained Earnings 553
Total Liabilities & Equity 2,834$
*This statement has been disguised.
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n g a
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n iv
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ity t a u g h t b y
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62
Page 11 9A94B008
Exhibit 6
COMPARISON OF FAST FOOD FRANCHISE SYSTEMS IN THE WORLD (US$)
Name of Franchise
Number of
Franchises 1993
Company Owned 1993
Start-Up
Costs ($000s)
Franchise Fee
($000s)
Royalty
Advertising Royalty
Financing Provided
McDonald’s Burger King Hardee’s Sonic Drive In A&W Restaurants Checkers Drive-In Back Yard Burgers Juicy Lucy’s Drive Thru Arctic Circle Restaurant Flamers Charburgers Burger Park U.S.A. Krystal Restaurants WallyBurger Express Drive-Thru Wendy’s Int’l. Inc.
9,770 5,903 2,571 1,129
700 144
38 7
67 39 2
33 0
2,880
3,665 912 820 145
9 160
8 5
39 12 2
240 1
1,202
Varies 73 to 511
502.2 to 1.8M 395 to 600
92.5 to 668 450
279 to 382 75 to 225
185 to 236 140 to 185
225.6 293 to 668
17.3 to 267.5 250
22.5 40 15 15 15 30 25 25 20 25 15
32.5 7.5 25
3.5% 3.5%
3.5-4% 104% 4.0% 4.0% 4.0% 5.0% 3.0% 5.0% 3.0% 4.5% 4.0% 4.0%
4.0% 4.0% 5.0% 3.0% 4.0% 2.0% 1/0%
.5% 4.0% 1.0% 4.0% 4.0% 2.0% 4.0%
None None None None None
3rd Party None None None
3rd Party None None
3rd Party None
Source: Obtained from the January, 1994 issue of Entrepreneur Magazine (15th Annual Franchise 500), pgs. 150 to 153.
F o r
u se
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in t h e c
o u rs
e F
ra n ch
is in
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t L a n g st
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ity t a u g h t b y
P ro
fe ss
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1 f ro
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1 3 , 2 0
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ct o b e r
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a c
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63
Page 12 9A94B008
Exhibit 7
START-UP COSTS OF FAST EDDIE’S RESTAURANT
Low Medium High
Land 200,000 250,000 300,000 Building 200,000 250,000 300,000 Equipment Cost 150,000 175,000 200,000 Training/Inventory/Etc. 25,000 25,000 25,000 Total 575,000 700,000 825,000
F o r
u se
o n ly
in t h e c
o u rs
e F
ra n ch
is in
g , L ic
e n si
n g a
n d D
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t L a n g st
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ity t a u g h t b y
P ro
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1 3 , 2 0 1 8 t o O
ct o b e r
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tio n .
64
Page 13 9A94B008
Exhibit 8(a)
ONE COMPANY-OWNED OUTLET PRO-FORMA INCOME STATEMENTS
3 Year Projections ($000s)
1ROI is calculated using the year 1 cash need as the investment.
Amount % Amount % Amount % Sales % (Yr 3=100%) 70.0% 85.0% 100.0% Sales 630 100.0% 765 100.0% 900 100.0%
Cost of Food/Paper Sold: Food 260 41.3% 301 39.4% 330 36.7% Paper 28 4.5% 34 4.5% 41 4.5% Total Cost of Goods Sold 288 45.8% 335 43.9% 371 41.2%
Gross Profit 341 54.2% 429 56.1% 529 58.8%
Labor: Crew 158 25.0% 168 22.0% 173 19.2% Management 32 5.1% 32 4.2% 32 3.6% Head Office - 0.0% - 0.0% - 0.0% Total Labor 190 30.1% 200 26.2% 205 22.8%
Operating Expenses: Advertising 25 4.0% 31 4.0% 36 4.0% Utilities 18 2.8% 18 2.3% 18 2.0% Uniforms 2 0.4% 2 0.3% 2 0.3% Auto 2 0.2% 2 0.2% 2 0.2% Business Taxes 9 1.4% 11 1.4% 13 1.4% Garbage Removal 5 0.8% 5 0.7% 5 0.6% Cleaning 12 1.8% 12 1.5% 12 1.3% Equip and Building Maintenanc 48 7.5% 48 6.2% 48 5.3% Initial Training 25 4.0% - 0.0% - 0.0% Administrative Exp. 5 0.8% 5 0.7% 5 0.6% Depreciation 48 7.5% 48 6.2% 48 5.3% Total Operating Expenses 198 31.4% 181 23.5% 188 20.8%
Operating Profit (47) -7.2% 49 6.4% 137 15.3%
Interest on L-T Debt - 0.0% - 0.0% - 0.0%
Income Before Taxes (47) -7.2% 49 6.4% 137 15.3% Income Tax (25% / 50%) (12) -1.9% 12 1.6% 34 3.8% Net Income AT (35) -5.3% 37 4.8% 103 11.5% Return on Investment (ROI) (1) -5.3% 5.6% 15.8%
Year 1 Year 2 Year 3
F o r
u se
o n ly
in t h e c
o u rs
e F
ra n ch
is in
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e n si
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P ro
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65
Page 14 9A94B008
Exhibit 8(b)
ONE COMPANY-OWNED OUTLET PRO-FORMA BALANCE SHEETS ENDING DEC 31
3 Year Projections ($000s)
Year 1 Year 2 Year 3 Current Assets Cash (647) (563) (413) Inventory (Food, Paper) 13 17 20 Total Current (634) (546) (393)
Land 250 250 250 Building 250 250 250 Acc Dep - Building (13) (25) (38) Equipment 175 175 175 Acc Dep - Equipment (35) (70) (105)
Total Assets (7) 34 139
Liabilities & Shareholder Equity Accounts Payable 24 28 31 Payroll Payable 4 4 4
Total Current 28 32 35
New Debt - - - Total L-T Debt - - -
Total Liabilities 28 32 35
Common Shares - - -
Beginning R/E - (35) 2 Net Income (35) 37 103 Ending R/E (35) 2 105
Total Liabilities & Equity (7) 34 139
F o r
u se
o n ly
in t h e c
o u rs
e F
ra n ch
is in
g , L ic
e n si
n g a
n d D
is tr
ib u tio
n a
t L a n g st
o n U
n iv
e rs
ity t a u g h t b y
P ro
fe ss
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C JM
a m
b u la
1 f ro
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u g u st
1 3 , 2 0 1 8 t o O
ct o b e r
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id e t h e se
p a ra
m e te
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a c
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tio n .
66
Page 15 9A94B008
Exhibit 8(c)
ONE COMPANY-OWNED OUTLET INTERNAL RATE OF RETURN
Assumptions: • Land is sold for purchase price at the end of Year 10. • Equipment and building have no salvage value. • There are no annual principal payments on debt. Debt is paid out at the end of Year 10. • New Debt is received on the last day of the previous year.
Net Income Equity Working Net Plus Deprec. Investment Capital Cash
Time Zero (675) (675) Year 1 13 0 15 28 Year 2 84 0 1 85 Year 3 150 (1) 149 Year 4 150 150 Year 5 150 150 Year 6 150 150 Year 7 150 150 Year 8 150 150 Year 9 150 150 Year 10 150 250 (15) 385
Internal Rate of Return 0
F o r
u se
o n ly
in t h e c
o u rs
e F
ra n ch
is in
g , L ic
e n si
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t L a n g st
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n iv
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ity t a u g h t b y
P ro
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C JM
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b u la
1 f ro
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1 3 , 2 0 1 8 t o O
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67
Page 16 9A94B008
Exhibit 9(a)
NON-FRANCHISE SCENARIO (ALL COMPANY-OWNED UNITS) CONSOLIDATED INCOME STATEMENTS
For the Years Ending Dec 31 ($000s)
1994 1995 1996 1997 1998 New Outlets Opened 1 1 1 1 1 Total Outlets 6 7 8 9 10
Sales 5,130 5,895 6,795 7,695 8,595 Cost of Food/Paper Sold: Food 1,910 2,211 2,541 2,871 3,201 Paper 233 267 308 349 390 Total Cost of Goods Sold 2,143 2,478 2,849 3,220 3,591
Gross Profit 2,987 3,417 3,946 4,475 5,004
Labor: Crew 1,023 1,191 1,364 1,537 1,710 Management 192 224 256 288 320 Head Office 190 190 190 190 190 Total Labor 1,405 1,605 1,810 2,015 2,220
Operating Expenses: Advertising 205 236 272 308 344 Utilities 106 123 141 158 176 Uniforms 14 16 18 21 23 Auto 9 11 12 14 15 Business Taxes 74 85 98 111 124 Garbage Removal 32 37 42 48 53 Cleaning 69 81 92 104 115 Equip and Building Maintenance 285 333 380 428 475 Initial Training 25 25 25 25 25 Administrative Exp. 32 37 42 48 53 Depreciation 285 333 380 428 475 Total Operating Expenses 1,135 1,316 1,503 1,691 1,878
Operating Profit 447 497 633 770 906
Interest on L-T Debt - - - - -
Income Before Taxes 447 497 633 770 906 Income Tax (25% / 50%) 174 198 267 335 403 Net Income AT 274 298 367 435 503 Return on Equity 10.2% 10.1% 11.3% 12.0% 12.4% Return on Assets 9.7% 9.5% 10.5% 11.2% 11.6%
F o r
u se
o n ly
in t h e c
o u rs
e F
ra n ch
is in
g , L ic
e n si
n g a
n d D
is tr
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t L a n g st
o n U
n iv
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ity t a u g h t b y
P ro
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C JM
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1 3 , 2 0 1 8 t o O
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68
Page 17 9A94B008
Exhibit 9(b)
FAST EDDIE’S GROWTH PROJECTIONS NON-FRANCHISE SCENARIO (ALL COMPANY-OWNED UNITS)
CONSOLIDATED BALANCE SHEETS For the Years Ending Dec 31
($000s)
1994 1995 1996 1997 1998 Current Assets Cash 131 70 127 276 425 Inventory (Food, Paper) 82 95 110 124 138 Total Current 213 166 237 400 563
Land 1,150 1,400 1,650 1,900 2,150 Building 1,400 1,650 1,900 2,150 2,400 Acc Dep - Building (150) (238) (338) (450) (575) Equipment 875 1,050 1,225 1,400 1,575 Acc Dep - Equipment (339) (549) (794) (1,050) (1,225)
Total Assets 3,149 3,479 3,880 4,350 4,888
Liabilities & Shareholder Equity
Accounts Payable 179 207 237 268 299 Payroll Payable 27 31 35 39 43
Total Current 206 237 272 307 342
New Long Term Debt - - - - - Total L-T Debt - - - - -
Total Liabilities 206 237 272 307 342
Common Shares 2,117 2,117 2,117 2,117 2,117
Beginning R/E 553 827 1,125 1,491 1,926 Net Income 274 298 367 435 503 Ending R/E 827 1,125 1,491 1,926 2,429
Total Liabilities & Equity 3,149 3,479 3,880 4,350 4,888
F o r
u se
o n ly
in t h e c
o u rs
e F
ra n ch
is in
g , L ic
e n si
n g a
n d D
is tr
ib u tio
n a
t L a n g st
o n U
n iv
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ity t a u g h t b y
P ro
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C JM
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1 3 , 2 0 1 8 t o O
ct o b e r
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p a ra
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a c
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69
Page 18 9A94B008
Exhibit 10(a)
FRANCHISEE (ONE RESTAURANT) PRO-FORMA INCOME STATEMENTS
3 Year Projections ($000s)
1 ROI is calculated using the year 1 cash need as the investment.
Amount % Amount % Amount %
Sales % (Yr 3=100%) 70.0% 85.0% 100.0% Sales 630 100.0% 765 100.0% 900 100.0%
Cost of Food/Paper Sold: Food 260 41.3% 301 39.4% 330 36.7% Paper 28 4.5% 34 4.5% 41 4.5% Total Cost of Goods Sold 288 45.8% 335 43.9% 371 41.2%
Gross Profit 342 54.2% 430 56.1% 529 58.8%
Labor: Crew 158 25.0% 168 22.0% 173 19.2% Management 32 5.1% 32 4.2% 32 3.6% Total Labor 190 30.1% 200 26.2% 205 22.8%
Operating Expenses: Advertising 13 2.0% 15 2.0% 18 2.0% Utilities 18 2.8% 18 2.3% 18 2.0% Uniforms & Auto 4 0.6% 4 0.5% 4 0.4% Franchise Fee 10 1.6% - 0.0% - 0.0% Business Taxes 9 1.4% 11 1.4% 13 1.4% Garbage Removal 5 0.8% 5 0.7% 5 0.6% Cleaning 12 1.8% 12 1.5% 12 1.3% Equipment Maintenance 35 5.6% 35 4.6% 35 3.9% Initial Training 25 4.0% - 0.0% - 0.0% Administrative Expense 5 0.8% 5 0.7% 5 0.6% Rent of Land & Bldg 50 8.0% 61 8.0% 72 8.0% Depreciation 35 5.6% 35 4.6% 35 3.9% Total Operating Expenses 221 35.0% 201 26.2% 217 24.0%
Operating Profit (69) -10.9% 30 3.7% 108 12.0%
Advertising Royalty 13 2.0% 15 2.0% 18 2.0% Franchise Royalty 25 4.0% 31 4.0% 36 4.0% Interest on L-T Debt - 0.0% - 0.0% - 0.0%
Income Before Taxes (107) -16.9% (17) -2.3% 54 6.0% Income Taxes (25%) (27) -4.3% (4) -0.5% 13 1.4% Net Income AT (80) -12.6% (13) -1.8% 41 4.6% Return on Investment (ROI)1 -38.8% -6.1% 19.8%
Year 1 Year 2 Year 3
F o r
u se
o n ly
in t h e c
o u rs
e F
ra n ch
is in
g , L ic
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t L a n g st
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n iv
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P ro
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a c
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70
Page 19 9A94B008
Exhibit 10(b)
FRANCHISEE (ONE RESTAURANT) PRO-FORMA BALANCE SHEET ENDING DEC 31
3 Year Projections ($000s)
Year 1 Year 2 Year 3 Current Assets Cash (205) (182) (107) Inventory (Food, Paper) 13 17 20 Total Current (192) (165) (87)
Land - - - Building - - - Acc Dep - Building - - - Equipment 175 175 175 Acc Dep - Equipment (35) (70) (105)
Total Assets (52) (60) (17)
Liabilities & Shareholder Equity
Accounts Payable 24 28 31 Payroll Payable 4 4 4
Total Current 28 32 35
New Debt - - - Total L-T Debt - - -
Total Liabilities 28 32 35
Common Shares - - -
Beginning R/E - (80) (92) Net Income (80) (13) 41 Ending R/E (80) (92) (52)
Total Liabilities & Equity (52) (60) (17)
F o r
u se
o n ly
in t h e c
o u rs
e F
ra n ch
is in
g , L ic
e n si
n g a
n d D
is tr
ib u tio
n a
t L a n g st
o n U
n iv
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ity t a u g h t b y
P ro
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C JM
a m
b u la
1 f ro
m A
u g u st
1 3 , 2 0 1 8 t o O
ct o b e r
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id e t h e se
p a ra
m e te
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a c
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71
Page 20 9A94B008
Exhibit 10(c)
FRANCHISEE (ONE RESTAURANT) Internal Rate of Return
Assumptions: • Equipment has no salvage value. • There are no principal payments on debt. Debt is paid out at the end of Year 10. • The initial investment equals the cost of equipment plus the franchise fee.
Net Income Equity Working Net Plus Deprec. Investment Capital Cash
Time Zero (185) (185) Year 1 (35) 0 15 (20) Year 2 23 0 1 23 Year 3 76 (1) 75 Year 4 76 76 Year 5 76 76 Year 6 76 76 Year 7 76 76 Year 8 76 76 Year 9 76 76 Year 10 76 0 (15) 61
Internal Rate of Return 21.45%
F o r
u se
o n ly
in t h e c
o u rs
e F
ra n ch
is in
g , L ic
e n si
n g a
n d D
is tr
ib u tio
n a
t L a n g st
o n U
n iv
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ity t a u g h t b y
P ro
fe ss
o r
C JM
a m
b u la
1 f ro
m A
u g u st
1 3 , 2 0 1 8 t o O
ct o b e r
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id e t h e se
p a ra
m e te
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a c
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tio n .
72
Page 21 9A94B008
Exhibit 10(d)
FRANCHISOR (ONE RESTAURANT) Internal Rate of Return
Assumptions: • Investment required equals land plus building less franchise fee. • Land is sold at the end of Year 10 for the purchase price. • There are no principal payments on debt. Debt is paid out at the end of Year 10. • Advertising Royalty Received equals advertising expenditures. • No additional working capital is needed.
Investment Required 490 Equity Investment 490 Debt Financing 0
EBIT Interest Taxes Net Income Investment Cash Plus Depr. Flow
Time Zero (490) (490) Year 1 50 0 13 50 50 Year 2 67 0 17 63 63 Year 3 83 0 21 75 75 Year 4 83 0 21 75 75 Year 5 83 0 21 75 75 Year 6 83 0 21 75 75 Year 7 83 0 21 75 75 Year 8 83 0 21 75 75 Year 9 83 0 21 75 75 Year 10 83 0 21 75 250 325
Internal Rate of Return 11.18%
F o r
u se
o n ly
in t h e c
o u rs
e F
ra n ch
is in
g , L ic
e n si
n g a
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is tr
ib u tio
n a
t L a n g st
o n U
n iv
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ity t a u g h t b y
P ro
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a m
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1 f ro
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1 3 , 2 0 1 8 t o O
ct o b e r
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p a ra
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a c
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73
Page 22 9A94B008
Exhibit 11(a)
FAST EDDIE’S GROWTH PROJECTIONS FRANCHISE SCENARIO (ALL NEW UNITS ARE FRANCHISES)
CONSOLIDATED INCOME STATEMENTS For the Years Ending Dec 31
Number of Company Outlets 5 ($000s)
1. Assumes new outlets opened are franchises. 2. Assumes the first five outlets are corporately owned.
1994 1995 1996 1997 1998 New Outlets Opened (1) - 1 1 1 1 Total Outlets (2) 5 6 7 8 9
Revenues: Sales 4,500 4,500 4,500 4,500 4,500 Rental Income - 50 111 183 255 Franchise Royalty & Fee - 35 66 102 138 Total Revenues 4,500 4,585 4,677 4,785 4,893
Cost of Food/Paper Sold: Food 1,650 1,650 1,650 1,650 1,650 Paper 205 205 205 205 205 Total Cost of Goods Sold 1,855 1,855 1,855 1,855 1,855
Gross Profit 2,645 2,730 2,822 2,930 3,038
Labor: Crew 865 865 865 865 865 Management 160 160 160 160 160 Head Office 190 190 190 190 190 Total Labor 1,215 1,215 1,215 1,215 1,215
Operating Expenses: Advertising 90 90 90 90 90 Utilities 88 88 88 88 88 Uniforms & Auto 19 19 19 19 19 Franchise Setup Expenses - 10 10 10 10 Business Taxes 65 65 65 65 65 Garbage Removal 27 27 27 27 27 Maintenance & Cleaning 58 58 58 58 58 Initial Training - - - - - Aministrative Expense 27 27 27 27 27 Depreciation 285 285 285 285 285 Total Operating Expenses 658 668 668 668 668
Operating Profit 773 848 940 1,048 1,156
Interest on L-T Debt - - - - -
Income Before Taxes 773 848 940 1,048 1,156 Income Taxes 336 374 420 474 528 Net Income AT 436 474 520 574 628 Return on Equity 16.30% 15.30% 14.50% 14.00% 13.40%
F o r
u se
o n ly
in t h e c
o u rs
e F
ra n ch
is in
g , L ic
e n si
n g a
n d D
is tr
ib u tio
n a
t L a n g st
o n U
n iv
e rs
ity t a u g h t b y
P ro
fe ss
o r
C JM
a m
b u la
1 f ro
m A
u g u st
1 3 , 2 0 1 8 t o O
ct o b e r
0 5 , 2 0 1 8 .
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id e t h e se
p a ra
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a c
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74
Page 23 9A94B008
Exhibit 11(b)
FAST EDDIE’S GROWTH PROJECTIONS FRANCHISE SCENARIO (ALL NEW UNITS ARE FRANCHISES)
CONSOLIDATED BALANCE SHEETS For the Years Ending Dec 31 Number of Company Outlets
($000s)
1994 1995 1996 1997 1998 Current Assets Cash 904 1,093 1,340 1,630 1,870 Inventory (Food, Paper) 71 71 71 71 71 Total Current 976 1,164 1,412 1,701 1,942
Land 900 1,150 1,400 1,650 1,900 Building 1,150 1,400 1,650 1,900 2,150 Acc Dep - Building (138) (213) (300) (400) (513) Equipment 700 700 700 700 700 Acc Dep - Equipment (304) (444) (584) (700) (700)
Total Assets 3,284 3,758 4,278 4,851 5,479
Liabilities & Shareholder Equity
Accounts Payable 155 155 155 155 155 Payroll Payable 23 23 23 23 23
Total Current 178 178 178 178 178
New Long-Term Debt - - - - - Total L-T Debt - - - - -
Total Liabilities 178 178 178 178 178
Common Shares 2,117 2,117 2,117 2,117 2,117
Beginning R/E 553 989 1,463 1,983 2,557 Net Income 436 474 520 574 628 Ending R/E 989 1,463 1,983 2,557 3,184
Total Liabilities & Equity 3,284 3,758 4,278 4,851 5,479
F o r
u se
o n ly
in t h e c
o u rs
e F
ra n ch
is in
g , L ic
e n si
n g a
n d D
is tr
ib u tio
n a
t L a n g st
o n U
n iv
e rs
ity t a u g h t b y
P ro
fe ss
o r
C JM
a m
b u la
1 f ro
m A
u g u st
1 3 , 2 0 1 8 t o O
ct o b e r
0 5 , 2 0 1 8 .
U se
o u ts
id e t h e se
p a ra
m e te
rs is
a c
o p yr
ig h t vi
o la
tio n .
75
Page 24 9A94B008
Appendix A
SELECTED ASSUMPTIONS USED IN THE SPREADSHEETS
Changeable
L-T Debt interest rate 10.00% Building Depreciation 20 Years Franchise Royalty 4.00% Equipment Depreciation 5 Years Rental of Land & Bldg 8.00% Land Cost 250 Accounts Payable 30 Days Building Cost 250 Payroll Payable 1 Weeks Equipment Cost 175 Food/Paper Inventory 2 Weeks Advertising Royalty 2.00% Franchise Fee 10 Depreciation equals Maintenance Expenses
Fixed
F o r
u se
o n ly
in t h e c
o u rs
e F
ra n ch
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6.
9B12M058 THE ESPRESSO LANE TO GLOBAL MARKETS
Ilan Alon and Meredith Lohwasser wrote this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. Richard Ivey School of Business Foundation prohibits any form of reproduction, storage or transmission without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Richard Ivey School of Business Foundation, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. Copyright © 2012, Richard Ivey School of Business Foundation Version: 2017-05-10
“Espressamente is all about a perfect shot of dark elixir . . . Espresso is a miracle of chemistry in a cup.”
Andrea Illy, CEO of Illycaffé S.p.A. The global coffee industry was booming. From October 2010 to September 2011, world coffee exports increased by 9.4 per cent to 103.1 million 60-kilogram bags.1 The International Coffee Organization stated, “Demand prospects for coffee continue to be promising, particularly given the growth of niche markets in traditional consuming countries and the arrival of new consumers in emerging markets and exporting countries.”2 Christophe Reale, managing director of Espressamente at Illy, contemplated Espressamente’s place within the global market and the company’s future growth opportunities. He knew that a global route to market meant prioritizing markets, but where did the greatest potential for success lie? And what kind of strategy should he pursue to take Espressamente to market? ILLY Founded in Trieste, Italy, and inventor of the precursor to the espresso machine, Illy marketed a unique blend of coffee drinks in over 140 countries and in more than 50,000 high-end restaurants and coffeehouses. Over six million cups of Illy espresso were consumed every day. In Italy, Illy coffee is widely recognized as the best coffee and is a “must have” in Italian restaurants. Over time, Illy became known as a company based on quality and espresso culture. The company focused on premium travel, business-to-business operations, fashion and culture.3 Illy was well-known for producing the world’s finest tasting coffee, which it accomplished through quality obsession and knack for innovative design. After beans were purchased, Illy-branded 60-kilogram bags of coffee beans were shipped to Italy; bags were placed in shipping containers to maximize air circulation, which reduced the risk of mould, condensation and unwanted odours. In Italy, the bags were handled by an
1 International Coffee Association, “Monthly Coffee Market Report,” www.ico.org/documents/cmr-0911-e.pdf, accessed on February 13, 2012. 2 Ibid. 3 Espressamente Illy Company Report, 2011.
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Page 2 9B12M058 automated system and sophisticated machinery. “The last selection is conducted by six bi-chromatic systems that electronically photograph each bean, detecting and eliminating any that do not meet strict color standards — an indication that the bean is not fully ripe, or is a ‘stinker,’ a fermented bean that can ruin a whole batch.” If a bean was defective, it was removed, as were the beans that surrounded it. Illy’s approach was one of zero defects.4 Illy built its brand upon its decadent coffee but expanded its product lines over time to include espresso machines, cups and mugs. ESPRESSAMENTE Born in Illy’s unique Italian heritage, Espressamente was the company’s own franchised coffee bar with 200 locations in over 30 countries. It served transit retail markets and began to expand to premium retail markets. Espressamente, meaning “clearly” or “expressly” in Italian, was meant to “purvey the original Italian cult of espresso.” CEO Andrea Illy wanted to create “an exclusive destination with an emphasis on quality and aesthetics. The Espressamente experience will be oh-so-Italiano, focused on coffee served short and dark with the perfect crema, or foam, in a designed demitasse.”5 (See Exhibit 1.) In its 2010–12 strategic plan, Espressamente stated that its goals were to be “recognized as the only authentic Italian bar chain delivering superior customer satisfaction to premium transit coffee lovers,” to be profitable and to become a strong stand-alone brand. To achieve these goals, the company first focused on premium transit, retail and service partners instead of private dealers, as well as consistency development. In addition to premium transit locations, the company added luxury retail stores. THE GLOBAL COFFEE INDUSTRY Coffee, after oil, was the most heavily traded commodity in the world.6 As of 2005, coffee sales each year amounted to over US$70 billion. The International Coffee Organization emphasized that “the importance of coffee to the world economy cannot be overstated.” Recently, demand had grown in both developed and emerging markets. Specialty coffee was projected to increase worldwide; in the United States alone, specialty coffee sales were forecasted to increase by 20 per cent each year.7 Coffee sales across the globe were greatly affected by disposable income and the general economic environment: “Coffee manufacturers depend on a healthy economy and strong consumer spending to drive sales, as consumer spending drives demand for higher priced specialty products.”8 As the middle class grew in emerging markets, so did prospects for a successful coffee market where the expectation for a premium product was particularly strong. Additionally, the coffee market was characterized by high saturation and aggressive competition. In developed nations, there were thousands of coffee shops, both chains and independents, that competed for space. As a result, many of the larger retail chains looked to international expansion for growth. Emerging markets with growing middle classes, such as in China and India, were experiencing high competition among coffee retailers as Western companies expanded. Although there was 4 www2.illy.com/wps/wcm/connect/us/illy/, accessed February 17, 2012. 5 “Basta with the Venti Frappuccinos,” Bloomberg Businessweek, 2006, www.businessweek.com/magazine/content/06_32/b3996057.htm, accessed February 13, 2012. 6 Global Exchange, “Coffee FAQ,” www.globalexchange.org/fairtrade/coffee/faq, accessed February 14, 2012. 7 NACS Online, “Fact Sheets: Coffee Sales,” www.nacsonline.com/NACS/News/FactSheets/MerchandiseandServices/Pages/Coffee.aspx, accessed February 14, 2012. 8 First Research, “Industry Profile: Coffee Shops,” http://search.proquest.com.ezpprod1.hul.harvard.edu/abicomplete.docview/192463238/fulltextPDF/1321075EF8488208B4/1 1?accountid=11311, accessed February 14, 2012.
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Page 3 9B12M058 still room for growth in these markets, competition was aggressive. High levels of competition in the premium coffee industry forced players such as Starbucks, the Coffee Bean & Tea Leaf, Costa Coffee and independent coffee shops to continually innovate and adapt their products and offerings to compete in these concentrated and saturated markets. A variety of environmental and legal issues surrounded the coffee industry as well. Sustainable coffee production and human rights issues that affected the supply side of coffee became essential to the future of the industry. The world coffee market was characterized by a coffee paradox: there was a “coffee crisis in producing countries with trends towards lower prices and declining producer incomes,” while there was a coffee boom in consuming countries characterized by rising sales and profits for retailers. Suppliers had very limited power; in 2005, when coffee sales amounted to over $70 billion, producers only received about $5 billion.9 Some legal issues arose as a result of increased coffee sales in emerging marketplaces. For example, developing nations had fewer laws related to copyright and other regulatory measures. COMPETITORS The coffee industry was highly competitive. Espressamente’s main competitors worldwide included Starbucks, McDonald’s McCafé, Costa Coffee, Lavazza, Tchibo, Segafredo and the Coffee Bean and Tea Leaf. Each had different competitive advantages, and all continued to expand internationally (see Exhibit 2). Reale considered international expansion and, based on an analysis of Illy sales (see Exhibit 3), internal analysis of documents, executive knowledge of external markets and sales potential, decided to focus on the markets with the highest potential: Brazil, China, Germany, India, Japan, the United Kingdom and the United States. BRAZIL Brazil, the largest grower of coffee in the world, was the second-largest consumer coffee market behind the United States. Coffee consumption in Brazil rose rapidly “in line with increased interest in premium varieties and the opening of new, American-style coffee shops,” which presented opportunities for coffee retail companies. Brazil was one of the fastest growing markets by sales in the specialty coffee shops industry, with growth rates always exceeding 30 per cent.10 Additionally, the coffee market in Brazil was one of the most dynamic in the world and increasingly attracted foreign direct investment.11 Starbucks was highly successful in Brazil, highlighted by the growing demand for higher value gourmet coffee varieties. It was projected that the continuation of this trend meant that value sales would increase at a faster rate than volume sales over the next five years.12 Although consumption was rising due to a larger and wealthier middle class, consumption per capita was still quite low compared to mature markets. Despite this, it was possible that Brazil would overtake the United States in terms of overall coffee consumption sometime in the next few years as increased wealth in Brazil drove a rise in locals’ thirst for espressos and cappuccinos.13 As the eighth-largest economy in the 9 Geoff Riley, “Market for Coffee,” http://tutor2u.net/ economics/revision-notes/as-markets-coffee.html, accessed February 17, 2012. 10 Business Monitor International, “Brazil: Food & Drink Report Q4,” http://search.proquest.com.ezproxy.rollins.edu:2048/abicomplete/docview/904728262/fulltextPDF/1338989D72E3BF732FE/ 11 Ibid. 12 Ibid. 13 Ibid.
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Page 4 9B12M058 world, Brazil weathered the global economic crisis well and positioned itself as a regional and global power; it is expected to grow to become the fifth-largest economy in the next five years. Growth in exports and social programs lifted tens of millions of Brazilians out of poverty, and a majority of the population became a part of the middle class. As a result, purchasing power parity increased dramatically, and domestic consumption became a driver of Brazilian growth. Brazil’s franchise sector was growing on a large scale: in 2010, 1,855 franchises operated 86,365 units and employed 777,285 people.14 Only 11 per cent of franchises were foreign-based franchisors and there was “natural fierce sector competition.”15 Entering the Brazilian market meant localizing products and services to better compete in a market in which the strength of local brands was a major challenge. Foreign-based franchisors developed relationships with non-competing businesses because of the challenge of finding suitable master franchisees in Brazil; additionally, joint-venture partnership tended to appeal to Brazilian partners because it meant risk was divided between the two partners.16 “Breaking into this market requires thorough research on the viability and uniqueness of the services and products.”17 Brazil’s capital, Brasilia, was approximately 9,054 kilometers away from Rome, Italy. The flight time from Brasilia to Rome was approximately 12 hours. CHINA China’s beverage industry was one of the country’s fastest growing sectors. Tea and coffee were established product categories there and were expected to experience modest growth between 2011 and 2015; coffee consumption was projected to increase at a compound annual average growth rate of 10.7 per cent. “The relatively modest growth forecasts can be attributed to the saturated and mature nature of the market.”18 Despite saturation and maturation, large coffee industry players such as Starbucks, China Resources Enterprise and Gourmet Master had plans for aggressive expansion “to capitalize on the growing café culture in China.”19 Coffee drinkers in China often enjoyed food while they drank coffee, which resulted in minimal to-go sales. However, on-the-go consumption of coffee was increasing. Historically a tea drinking culture, coffee had become an established product category as well. China boasted a huge population, 43 per cent of which lived in urban areas. After the economic downturn, “consumption’s role in the economy declined even though real wages increased in China 12.5% a year for a decade . . . “20 As a result, the country experienced decreasing rates of consumption. Despite the threat of decreased consumption, “rising consumer income and increasing standards of living, as well as the awareness of better-off lifestyles, especially among the growing number of middle-class consumers, have boosted the demand for high-quality products.”21
14 Brazilian Franchise Association, “Economic Impact in Brazil Reaches New Heights in 2010,” www.franchise.org/uploadedFiles/Economic%20Impact%20in%20Brazil%20Reaches%20New%20Heights%20in%202010.p df, accessed February 17, 2012. 15 Paulo Rodrigues, “Brazil: Franchising,” http://franchise.org/ IndustrySecondary.aspx?id=45562, accessed February 17, 2012. 16 Ibid. 17 Bachir Mihoubi, “Dealing with the Complexities of International Expansion,” www.franchise.org/Franchise-Industry-News- Detail.aspx?id=53325, accessed February 17, 2012. 18 Business Monitor International, “China: Food & Drink Report Q1,” http://search.proquest.com.ezproxy.rollins.edu:2048/abicomplete/docview/887119018/13245EC23682C2987CC/20? accountid=13584, accessed February 14, 2012. 19 Ibid. 20 Ibid. 21 International Trade Centre, “The Coffee Sector in China,” www.intracen.org/WorkArea/DownloadAsset.aspx?id=37584, accessed February 17, 2012.
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Page 5 9B12M058 The complex nature of conducting business in China resulted in the establishment of foreign companies through partnerships or master franchising. In 2007, the Chinese Ministry of Commerce changed and clarified many laws that made doing business difficult for foreign companies. Importantly, the “two-plus- one-requirement stipulating that prospective franchisors own at least two directly operated outlets in China for at least a year” was amended.22 Although China was slowly changing, franchising there was still complicated: “The concept is still new to China with many Chinese unfamiliar with it. Moreover, collecting royalty payments from your mainland franchisee and ensuring that the franchisee maintains the integrity of your brand is also a challenge.”23 Additionally, foreign franchisors were not allowed to directly purchase real estate property located in China unless it was for personal use. In 2008, China had 3,500 franchised businesses and more than 300,000 franchisees.24 As a result of the complexities of running a business in China, importance was placed on establishing different regional partners to successfully and respectfully navigate the Chinese coffee market. Partnerships also allowed companies to gain insights into Chinese tastes and preferences. Additionally, cafés were frequented by young, affluent, fashion-conscious, urban Chinese, as well as expatriates and foreign travelers. Chinese patrons of premium coffee shops preferred lattes, cappuccinos and mochas to espressos, which they considered bitter. Finally, Chinese frequented coffee shops for music and ambience, branded wares and the variety of fresh pastries and cookies offered and were usually business people in meetings, friends meeting or couples on dates.25 China’s capital, Beijing, was approximately 8,147 kilometers away from Rome, Italy. The flight time from Beijing to Rome was approximately 11 hours. GERMANY Coffee was an established product in Germany, which ranked second in the world in pounds per coffee consumed per person. Per capita consumption of coffee in Germany had been in decline over the past 15 years, in part due to the “unfashionable and unhealthy” product reputation it held. This trend had recently begun to change due to the rise in popularity of specialty coffee and an increase in U.S.-style coffee chains. “The German Coffee Association reported a shift in consumer behavior, with a clear trend toward the fresh preparation of specialty coffee.” In 2010, average German coffee consumption was 150 litres per person. Business Monitor International predicted that the coffee industry in Germany would grow by 10.5 per cent between 2011 and 2015. It was possible that this growth will be inhibited by continued world economic difficulties; however, it was not affected in 2009 when espresso drinks and single portion coffee drinks demonstrated strong growth.26 The German coffee industry was characterized by fierce competition and high concentration. Germany had about 1,000 franchise systems that operated 64,000 units with the help of 470,000 employees.27 The German Franchise Association had a great deal of power; although it was only partly 22 U.S. Commercial Service, “Country Commercial Guide, China,” www.buyusainfo.net/docs/x_8054544.pdf accessed May 13, 2012. 23 Ibid. 24 Beijing Tian Yuan Law Firm, “Franchise 2011: China,” www.franchise.org/uploadedFiles/Franchise_Industry/F2011Chinachapter.pdf, accessed February 17, 2012. 25 International Trade Centre, “The Coffee Sector in China,” www.intracen.org/WorkArea/DownloadAsset.aspx?id=37584, accessed February 17, 2012. 26 Business Monitor International, “Germany: Food & Drink Report Q4,” http://search.proquest.com.ezproxy.rollins.edu:2048/abicomplete/docview/888214090/13516D7A0CB767B9CA9/4?accounti d=13584, accessed February 14, 2012. 27 Heiko Stumpf, “Franchising in Germany,” www.franchise.org/uploadedFiles/Franchise_Industry/International_Development/Country_Profiles/GTAI_FranchisinginGerm any2011.pdf, accessed February 24, 2012.
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Page 6 9B12M058 recognized by the courts, membership in the association was regarded as an indication of quality for a reputable franchise business.28 Germany’s capital, Berlin, was approximately 736 kilometers away from Rome, Italy. The flight time from Berlin to Rome was approximately two hours. INDIA Although historically known for its tea culture, India was the sixth-largest producer of coffee in the world. Interest in coffee in India, particularly the transition to sophisticated coffee bars, began in the 1990s. Specialty and gourmet coffee shops increased in prominence for a few important reasons: first, Indians had increased exposure to international lifestyles and global trends; second, income rose and a middle class emerged; third, there was an increase in disposable incomes as well as in the number of working women; and fourth, the number of young people grew significantly.29 “Historically, Indians showed little interest in coffee, but changing lifestyles and the rise of high-end coffee shops increased consumption. Companies such as Café Coffee Day, one of the best known coffee shop brands in India, extended upward to target upper income consumers. Coffee consumption was likely to expand at a rapid rate . . .”30 In 2002, there were 200 cafes in India holding sales of $10 million compared to 1,500 shops in 2011. Coffee consumption in India had increased by 6 per cent in five years.31 The Indian coffee market was much more attractive than the tea market due to lower levels of saturation and “continued industry dynamism.”32 Coffee retailing was one of the fastest growing organized retail segments in India and had room for an additional 5,000 cafés. Illy CEO Andrea Illy saw potential in the Indian market: “I think specialty coffees in India are at the beginning. There is a good opportunity for growth, particularly through espresso, which is totally consistent with the Indian taste because it is a high body, strong flavor taste, and mixes with local food and tradition.”33 While the rest of the world dealt with an economic slowdown, India experienced unprecedented growth and was the second fastest growing economy in the world. As a result, the country boasted 300 to 350 million middle-income earners who had relatively high disposable incomes. India’s franchise sector expanded as the economy did. Franchising grew at a rate of 30 per cent and was India’s second fastest growing industry. As of 2009, over 70 international franchise operations operated in the country, while it became the “business model of choice” for the food and beverage industry.34 Although India represented a lucrative market in terms of the rising middle class and interest in Western culture and way of life, the franchising sector was still young. The country’s banking system and bureaucracy had the potential to
28 Noerr LLP, “Franchise 2011: Germany,” www.nacsonline.com/NACS/News/FactSheets/MerchandiseandServices/Pages/Coffee.aspx, accessed February 17, 2012. 29 Y. Aparna, “Coffee Parlours in India – Hotting Up,” 2003, IMCR Center for Management Research. Hyderabad, 2003. 30 Shalini Hasan, “Costa Coffee in India,” IBS Case Development Center, Hyderabad, 2006. 31 Boby Kurian and Reeba Zachariah, “Starbucks Coffee Company Set for Café Joint Venture with Tatas,” Economic Times, October 11, 2011, www.search.proquest.com.ezproxy.rollins.edu:2048/abicomplete/docview/896965090/1325AC9D3E66B29BB4/1?accountid =13584, accessed February 14, 2012. 32 Business Monitor International, “India: Food & Drink Report Q4,” 2011, http://search.proquest.com.ezproxy.rollins.edu:2048/abicomplete/docview/893679875/1327917278F1BD5F09 3/8?accountid=13584, accessed February 14, 2012. 33 Eduardo Silva, “Can Starbucks Brew Instant Success in the Indian Market?” www.coffeeclubnetwork.com/redes/form/post?pub_id =2774, accessed February 17, 2012. 34 Manjushree Phookan, “India: Legal and Regulatory Aspects of Doing Business in the Franchising Industry,” http://franchise.org/uploadedFiles/Franchise_Industry/International_ /Country_Profiles/India_Franchise%20Sector_July%202009.pdf, accessed February 17, 2012.
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Page 7 9B12M058 hinder business and successful partnerships. Dividing India into individual markets for expansion was strongly recommended.35 India’s capital, New Delhi, was approximately 5,929 kilometers away from Rome, Italy. The flight time from New Delhi to Rome was approximately eight hours. JAPAN Japan was the world’s third-largest coffee importer, over countries such as Italy and France.36 Although the hot drinks sector in Japan was expected to have lower demand in 2011 and after, coffee sales were expected to grow at a compound annual average growth rate of 5.4 per cent to 2015, which outpaced the country’s traditional drink, tea. “The outlook for the country’s hot drinks sector is considerably brighter than that of the alcoholic drinks sector . . . this is due to a continued emphasis on product innovation by major producers and continued strong consumer interest, particularly from older consumers.”37 Innovation, in terms of products and packaging, and convenience were key to growth. “Modern coffee shops will continue to influence customers’ preferences, although ready-to-drink-coffee is also fast gaining popularity in Japan.”38 While the popularity of coffee shops grew in Japan, the value consumers placed on convenience made “off- trade sales” a stronger potential growth channel. Starbucks expanded its number of store locations in Japan and worked with Suntory “to develop new products for retail distribution, such as its new take-home coffee brand, Via.” Additionally, there were opportunities in healthier and weight-conscious beverage alternatives. Another trend was taste innovation: “Manufacturers are striving to provide novelty in terms of health, mellow taste, and added-values, through the addition of traditional ingredients such as black bean and ginger.”39 The franchising sector in Japan had flattened out, in part because of poor economic conditions. As a result, it was important for companies to adjust their concepts to local tastes and expectations in order to ensure success. Another important aspect of franchising in Japan was the identification of the right business partners. Japan’s capital, Tokyo, was approximately 6,138 kilometers away from Rome, Italy. The flight time from Tokyo to Rome was approximately 13 hours. UNITED KINGDOM The coffee industry in the United Kingdom grew stronger. In 2010, U.K. coffee drinkers increased their visits to coffee shops. In fact, coffee shops were a ₤5 billion industry.40 Growth of branded coffee outlets remained stable at 6.1 per cent in 2010. Managing director Jeffrey Young of Allegra Strategies was 35 Bachir Mihoubi, “Dealing with the Complexities of International Expansion,” www.franchise.org/Franchise-Industry-News- Detail.aspx?id=53325, accessed February 17, 2012. 36 Oliver Strand, “Coffee,” The New York Times, November 30, 2009, http://topics.nytimes.com/top/reference/timestopics/subjects/c/coffee/index.html?scp=4&sq=starbucks&st=cse, accessed February 12, 2012. 37 Business Monitor International, “Japan: Food & Drink Report Q3 2011,” http://search.proquest.com.ezproxy.rollins.edu:2048/abicomplete/docview/876624562/13516DD8B0B3F5C00F2/11?account id=13584, accessed February 17, 2012. 38 Ibid. 39 Ibid, 40 Caterer and Hotelkeeper, “Coffee Drinkers Defy the Downturn,” http://search.proquest.com.ezproxy.rollins.edu:2048/abicomplete/docview/873820700/fulltextPDF/1322CDAEB4B599015C7/ 12?accountid=13584, accessed February 24, 2012.
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Page 8 9B12M058 optimistic about market growth as well: “I have never seen such exciting developments in the UK coffee shop market. This year the market grew by more than 12% compared with 2.5% for the UK retail sector, adding more than 800 outlets in 2010 in challenging economic times. The market is poised for significant further growth over the next 3–5 years.”41 Even the credit crunch of 2008–09 did not stymie coffee shop growth in the United Kingdom; from October 2008 to October 2009, 164 new coffee shops opened, which represented an increase of 60 per cent. This was attributed to the ability of companies to secure premium locations at lower prices.42 “Nearly every street has been impacted and the coffee sector defies all the recessionary gloom that has been seen elsewhere. Caffeine really has been the most significant stimulus to the UK high street in this recession.” Independent coffee shops represented another important part of the U.K.’s coffee industry, accounting for 71 per cent of outlets.43 Historically a tea-drinking nation, coffee has taken up permanent residence in the United Kingdom. A study by Glasgow University found that “the young and old, homeless and upper class, taste conscious and tasteless have all taken coffee shops to their hearts and created a new kind of socializing.”44 There were 842 franchise systems in the United Kingdom, represented by 34,800 franchise units. There were few restrictions to franchising, which made it one of the easiest places in Europe in which to set up and run a business. The UK Trade and Investment Agency helped foreign businesses invest and locate in the United Kingdom, and there were no restrictions on foreign, as compared to domestic, franchisors.45 The United Kingdom’s capital, London, was approximately 893 kilometers away from Rome, Italy. The flight time from London to Rome was approximately two hours. UNITED STATES Statistically, the United States was the global leader for coffee; it consumed about 25 per cent of the world’s market.46 Over 50 per cent of Americans 18 and over consumed coffee every day. A 2009 study of the coffee shop industry in the United States revealed that although there were 20,000 stores with annual revenues of about $11 billion, the top 50 companies held over 70 per cent of industry sales.47 The U.S. coffee market was characterized by high consumption, high saturation and concentration, a diverse demography and premium coffee as an affordable luxury good. Young adults drank more coffee, while the specialty coffee market was growing. Between 2000 and 2005, the specialty coffee market grew over 40 per cent, while improved roasting methods, better brewing equipment and higher grade coffee beans improved quality and raised customer expectations.48 Coffee was a cultural obsession in the United States; almost 20 per cent of adults drank gourmet coffee daily. The “third place” atmosphere of coffee shops had
41 Ibid. 42 Patrick Clift, “Caffeine Stimulates High Street as More Cafes Open,” http://search.proquest.com.ezproxy.rollins.edu:2048/abicomplete/docview/223771840/fulltextPDF/1322CDAEB4B599015C7/ 20?accountid=13584, accessed February 24, 2012. 43 Ibid. 44 Miki Moore and Ken Moore, “Coffee Culture in the UK,” http://cafecrem.wordpress.com/2008/11/09/coffee-culture-in-the- uk/, accessed February 17, 2012. 45 Hamilton Pratt, “Franchise 2011: United Kingdom,” www.franchise.org/uploadedFiles/Franchise_Industry/International_Development/United%20Kingdom.pdf, accessed February 17, 2012. 46 Strand, “Coffee.” 47 Nina Samaldi, “IBISWorld Industry Report 72221b: Coffee & Snack Shops in the US,” http://clients.ibisworld.com.ezproxy.rollins.edu:2048/industryus/default.aspx?indid=1973 accessed May 14, 2012. 48 First Research, “Industry Profile: Coffee Shops,” http://search.proquest.com. ezpprod1.hul.harvard.edu/abicomplete.docview/192463238/fulltextPDF/1321075EF8488208B4/11?accountid=1131, accessed February 17, 2012.
F o r
u se
o n ly
in t h e c
o u rs
e F
ra n ch
is in
g , L ic
e n si
n g a
n d D
is tr
ib u tio
n a
t L a n g st
o n U
n iv
e rs
ity t a u g h t b y
P ro
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o r
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a m
b u la
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1 3 , 2 0 1 8 t o O
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84
Page 9 9B12M058 become a place for students, businesspeople and friends. The Starbucks phenomenon created high demand for specialty coffee. Coffee was enjoyed in coffee shops as well as on-the-go, and there were thousands of chain and independent coffee shops around the country. “The typical customer for a coffee shop is 25–45, affluent and educated. Specialty coffee appeals to a diverse adult demographic, including college students and young adults.”49 The U.S. coffee industry was strengthened by the growing perception of the health benefits of coffee drinking, as well as increased popularity and demand for specialty coffee. Despite the relatively concentrated and saturated nature of the U.S. coffee franchising market, there were still opportunities for development. For example, although there were many coffee shops, the number of coffee shops per person in the United States was far lower than that of Italy. Customers in the United States looked for a number of different attributes in their coffee experience, including a unique retail experience, access to wi-fi, product innovation and health trends. The capital of the United States, Washington, DC, was approximately 4,497 kilometers away from Rome, Italy. The flight time from Washington, DC to Rome was approximately nine hours. INTERNATIONALIZATION: WHAT SHOULD ESPRESSAMENTE DO NEXT? As part of the market selection process, Reale looked for key success factors in each market that would determine the best market selection (see Exhibits 4 and 5). The criteria included: Coffee consumption Coffee shop concentration Income per capita of the top 10 per cent of the population Urbanization rate GDP per capita Ease of Doing Business rank Most attractive segments Coffee sales. While market selection was critical, mode of market entry was important as well (see Exhibit 6). Reale could pursue a number of different expansion strategies, including direct franchising, area franchising, master franchising, multi-unit franchising, sequential franchising, joint venture and wholly owned subsidiary. Direct franchising: A franchisor provides materials, training and other forms of support to a franchisee,
who pays a fee to license the company’s trademarks, products, and/or services. A well-functioning franchise provides a win-win arrangement for both parties: the franchisor gets to expand into new markets with little or no risk and investment, while the franchisee gets a proven brand, marketing exposure, an established client base and management expertise to help it succeed.
Area franchising: Area franchising allows a franchisee, or area developer, to enter into an agreement to develop a minimum number of outlets within a specified territory.50
49 Ibid. 50 Ibid.
F o r
u se
o n ly
in t h e c
o u rs
e F
ra n ch
is in
g , L ic
e n si
n g a
n d D
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t L a n g st
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85
Page 10 9B12M058
Master franchising: Master franchising allows franchisees to extend sub-franchise rights within a specific territory.51
Multi-unit franchising: Multi-unit franchising allows the franchisee to operate more than one unit, which are usually acquired at a reduced rate per unit. The franchisee would be involved in the day-to- day operations.52
Sequential franchising: Sequential franchising occurs when a franchisee must prove capable of operating one franchise before being granted a second and capable of operating two franchises before being granted a third, etc.53
Joint venture: A joint venture is created when two or more companies share ownership of a third commercial entity and collaborate in the production of its goods or services.54
Wholly owned subsidiary: Establishing a wholly owned subsidiary involves buying an existing business or building new facilities in a target country. It is the most capital intensive mode of entry, and is typically viable for only large, internationally experienced corporations.55
The mode of entry also weighed heavily on which market Espressamente chose to enter first. In markets that were incredibly different from Italy’s, it would be beneficial to pursue joint ventures or partnerships to help the company navigate local culture, trends and norms. This may not be as important in markets more similar to Italy’s. Reale also recognized the importance of timing. As companies looked to international markets for expansion, pace, rhythm and scope had to be considered in order to plan, strategize and organize the company for success; determining the appropriate levels of pace, rhythm and scope were necessary for Espressamente’s expansion. Pace: “The rate of opening new stores abroad.” Rhythm: “The regularity by which stores were opened abroad.” Scope: “The number of new countries entered.”56 “How do I prioritize these markets and determine the best mode of entry for each?” Reale thought to himself. There was so much information to consider. He looked out the window of his Trieste office, took a sip of perfect coffee and then turned his head back to his computer to contemplate the future expansion of Espressamente.
51 Don Daszkowski, “Different Types of Franchise Ownership,” http://franchises.about.com/od/buyingafranchise/tp/different- types-of-franchise-o.htm, accessed February 27, 2012. 52 Ibid. 53 Callum Floyd, “Different Types of Franchising,” www.franchise-chat.com/resources/franchise_forms.htm, accessed February 27, 2012. 54 Ilan Alon, “Global Marketing: Contemporary Theory, Practice and Cases,” McGraw Hill, New York, 2013, p. 212-218. 55 Ilan Alon, “Global Marketing: Contemporary Theory, Practive and Cases,” p. 220. 56 Rob Alkema, Mario Koster and Christopher Williams, “Resuming Internationalization at Starbucks,” Ivey Publishing, product #9B10M073, 2010.
F o r
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86
Page 11 9B12M058
Exhibit 1
ESPRESSAMENTE THROUGH PICTURES
Source: Company files.
F o r
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o n ly
in t h e c
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87
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88
Page 13 9B12M058
Exhibit 3
ILLY COMPANY DATA
Source: Company files. F
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Page 15 9B12M058
Exhibit 5
HOFSTEDE’S DIMENSIONS
Italy Brazil China Germany India Japan United Kingdom
United States
Power distance 50 69 80 35 77 54 35 40
Individualism 76 38 20 67 48 46 89 91
Masculinity 70 49 66 66 56 95 66 62
Uncertainty avoidance 75 76 40 65 40 92 35 46
Long-term orientation 34 65 118 31 61 80 25 29 Source: http://geert-hofstede.com/countries.html, accessed May 14, 2012.
Exhibit 6
RISK AND CONTROL CONSIDERATIONS IN SELECTING AN ENTRY MODE
Source: Ilan Alon, “Global Marketing: Contemporary Theory, Practice and Case,” McGraw Hill, New York, 2013, p. 206.
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91
7.
9B18M095
CARPENTER TAN HANDICRAFTS CO., LTD.: FRANCHISEE SATISFACTION
Yibo Lyu, Shaojie Han, Wei Liu, Jingqin Su, and Qi Zhang wrote this case solely to provide material for class discussion. The authors do not intend to illustrate either effective or ineffective handling of a managerial situation. The authors may have disguised certain names and other identifying information to protect confidentiality. This publication may not be transmitted, photocopied, digitized, or otherwise reproduced in any form or by any means without the permission of the copyright holder. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Business School, Western University, London, Ontario, Canada, N6G 0N1; (t) 519.661.3208; (e) cases@ivey.ca; www.iveycases.com. Copyright © 2018, Ivey Business School Foundation Version: 2018-06-29
Qi Zhang owned two franchised stores of Carpenter Tan Handicrafts Co., Ltd. (Carpenter Tan) in Panjin City, Liaoning Province, China. It was November 5, 2016, and she had just finished a long discussion with Hongbing Liu, the general manager of Carpenter Tan, about whether she should set up a third franchised store to continue to improve the sales of wooden crafts in Panjin. When her first franchised store was set up in 2012, she had been excited by and satisfied with Carpenter Tan’s franchise model. However, she had later felt that this franchise model was restricting her development, especially after her second franchised store was set up in 2014. Despite her concerns, Carpenter Tan suggested that she open a third franchised store in Panjin, where the wooden crafts market was close to saturation. If she did as requested, the third franchised store might face a high risk of losing money. Zhang—who had become very dissatisfied with Carpenter Tan’s franchise model—faced a tough choice about whether she should set up a third franchised store. ZHANG’S BACKGROUND Zhang majored in petroleum engineering at a famous university in China and graduated in 2010. She then joined the Liaohe oilfield of CNPC (China National Petroleum Corporation), a large, state-owned oil enterprise, in Panjin City. Compared with jobs in private companies, this job in a state-owned enterprise was comfortable and its income was stable. However, its monotony and inflexible work environment were insufferable for Zhang. Moreover, she did not feel it would help her career. Hence, after a consultation with her husband, she decided to resign from the job and start her own business at the end of 2011. Through this decision, she expected to gain a sense of independence and achievement in her business life and, more importantly, raise her income. However, starting her own business was full of risks and challenges for Zhang. First, as a young woman, she did not have many savings, so she could not put too much money into the business. Second, she had majored in petroleum engineering at university and had no experience in business operations. Third, she was recently married and did not want to jeopardize her family life. In sum, it was important for Zhang to find a business that suited her situation and personal interests.
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Page 2 9B18M095 WOODEN CRAFTS RETAIL AND MARKET IN PANJIN The term “wooden crafts” referred to a variety of machined or handmade wooden objects.1 Wooden crafts, such as handmade wooden combs and hairpins, were both artistic and practical. On one hand, most of the wooden crafts in Panjin were handmade by experienced handicraft designers and were finely crafted. Therefore, these wooden crafts could be used as interior decorations or as medium- or high-end gifts. On the other hand, these wooden crafts were used in daily life. For example, wooden combs could be used to alleviate work pressure, in addition to tending to hair—in traditional Chinese medicine, it was said that combing hair with a wooden comb could promote blood flow in the brain and alleviate work fatigue. Overall, these artistic and practical wooden crafts were popular with middle- and high-end customers in China. With the increase in household incomes in China, there was a growing demand for wooden crafts.2 In particular, residents in Panjin had a high consumption capacity and strong demand for wooden crafts. Panjin was located in the mid-south of Liaoning Province, and its total population was 1.4 million.3 Its per capita gross domestic product (GDP) had been second in Liaoning Province since 2010, and in 2015, the per capita GDP reached $14,156.4 At the same time, Panjin was a famous Chinese tourist city with a beautiful natural landscape and lots of scenic tourist spots.5 Thus, a large number of tourists visiting Panjin could be the target customers of craftspeople. To sum up, wooden crafts offered good market prospects in Panjin. CARPENTER TAN AND ITS FRANCHISE MODEL Carpenter Tan Handicrafts Co., Ltd., a leader in the wooden crafts industry in China, was founded in 1997. In 2016, Carpenter Tan possessed a modern production factory covering an area of 54,000 square metres in Chongqing City, and developed into a professional company undertaking the production and sales of wooden combs, mirrors, hairpins, and other wooden crafts. During its development, it won many prizes. Being an ISO 9001:2000 certified company,6 Carpenter Tan was named among the “2006–2007 Top Ten Franchise Brands of Chinese Retail” by the China Chain Store & Franchise Association in April 2007. On December 29, 2009, Carpenter Tan was listed on the main board of the Hong Kong Stock Exchange.7 Carpenter Tan started its move toward being the world’s top brand in the wooden crafts industry with the help of the financial listing. In January 2014, Carpenter Tan was selected among the “2014 Forbes China Top 100 High-Potential Listed Enterprises.” 8 In 2016, it was also selected among “China’s Top 100 Brands” for the first time.9 Carpenter Tan’s success was highly related to the establishment of its franchise model. Since March 7, 1998, franchising had been Carpenter Tan’s dominant strategy for expanding in the market. In 2001, the
1 “Strategic Partners Evaluation and Selection at Wooden Crafts Industry,” cnki.net, June 1, 2012, accessed November 19, 2017, http://cdmd.cnki.com.cn/Article/CDMD-10004-1012356975.htm. 2 “The Future of Wooden Crafts,” club.1688.com, June 28, 2016, accessed November 17, 2017, https://club.1688.com/article/61026306.html. 3 “Panjin’s Sixth National Census in 2010,” Panjin Municipal Bureau of Statistics, May 18, 2011, accessed November 18, 2017, http://tjj.panjin.gov.cn/pcgb/content/40288bd75336104e01534ea4abda0aa1.html. 4 “2015 GDP Ranking of Liaoning Province,” southmoney.com, May 31, 2016, accessed November 19, 2017, www.southmoney.com/hkstock/ggxinwen/201605/585905.html. 5 “Panjin,” youkecn.com, July 15, 2017, accessed November 20, 2017, www.youkecn.com/cityShow.asp?id=13. 6 “Introduction to Carpenter Tan,” www.mp4cn.com, July 23, 2017, accessed November 19, 2017, www.mp4cn.com/mrzixun/lxpp/2011-12-08/156555.html. 7 “Carpenter Tan Listed on Main Board of HK Stock Exchange,” investide.cn, December 13, 2015, accessed November 19, 2017, www.investide.cn/ipo/242433. 8 “2014 Forbes China Top 100 High-Potential Listed Enterprises,” guba.eastmoney.com, January 1, 2014, accessed November 18, 2017, http://guba.eastmoney.com/news,300275,97488101.html. 9 “Carpenter Tan Listed on China’s Top 100 Brands of 2016,” sina.com.cn, September 23, 2016, accessed November 19, 2017, http://news.sina.com.cn/o/2016-09-23/doc-ifxwermp3738843.shtml.
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Page 3 9B18M095 number of its franchised stores exceeded 100, and the number doubled the next year. By December 31, 2016, Carpenter Tan owned 1,281 franchised stores in China and three franchised stores overseas.10 Carpenter Tan promoted the development of its franchise model in various ways. In 2000, it introduced a visual identity system to ensure that the appearance of each franchised store was consistent. In 2001, its Franchised Store Standard Manual was put into practice to promote the standard operations of franchised stores. In 2002, Carpenter Tan held the first national franchisee annual meeting to enhance exchanges and communication with franchisees. In 2008, the Handbook of Carpenter Tan Culture was established to enrich the cultural connotation of products and create a high-end brand positioning in the wooden crafts industry. Meanwhile, Carpenter Tan constructed logistics channels to accelerate the circulation of products and reduce the operating costs of both itself and its franchisees. Carpenter Tan had formed its standard franchise model to provide branding, products, standardized training, and so on to franchisees. With the help of Carpenter Tan’s franchise model, many franchisees could set up their own franchised stores. Zhang was one of them. ZHANG’S FIRST FRANCHISED STORE Based on the good market prospects in Panjin and her trust in Carpenter Tan, Zhang decided to set up her first franchised store. In June 2012, she opened the store by following the standard franchising process (see Exhibit 1). She found that Carpenter Tan’s franchise model fit her requirements well. Store’s Cost and Profitability The store’s annual rent was ¥60,000–¥100,000,11 and its decorating fee was about ¥35,000–¥40,000. In addition, the franchise fee was ¥10,000, and the first purchase was not to be less than ¥35,000. Overall, the total investment was about ¥140,000–¥185,000, which was quite acceptable for Zhang. Generally, the product profit margin ranged between 40 and 60 per cent. According to the average level of total profits of Carpenter Tan’s franchised stores, Zhang’s store profit would be twice her salary at the Liaohe oilfield. Brand and Products After years of brand management, Carpenter Tan had become a reliable brand to customers—especially high- end customers. As a leader in the wooden crafts industry in China, Carpenter Tan provided exquisite, reliable quality products such as combs, mirrors, and hairpins. Moreover, all products were supplied and distributed directly by Carpenter Tan, which guaranteed the products’ quality and distribution efficiency. Store Location and Decoration Carpenter Tan provided a series of guidance services to its franchisees during the process of identifying store locations and decorating stores. It provided Zhang with three basic principles for identifying her first store’s location. It should be on the street of a business centre, close to a place where people gathered, with convenient public transportation. Carpenter Tan sent its professional staff to Panjin to help Zhang choose an appropriate
10 “Carpenter Tan HK0837,” Tong Hua Shun Finance, 10jqka.com.cn, December 31, 2016, accessed November 15, 2017, http://stockpage.10jqka.com.cn/HK0837/business/#result. 11 ¥ = CNY = Chinese yuan/renminbi; US$1 = ¥6.3396 on June 1, 2012.
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Page 4 9B18M095 location for her first store. Furthermore, Carpenter Tan assigned its decorating team to decorate Zhang’s franchised store to guarantee that all franchised stores had a uniform exterior and interior image. Professional Training Zhang lacked product knowledge and professional business experience. Therefore, Carpenter Tan provided professional training on product stocks, sales, and advertising using the Franchised Store Manual; it also provided professional training on product function and display using the Product Manual. Risk Security Mechanism Carpenter Tan allowed franchisees to replace unsalable products. Franchisees that would not continue their contracts could return products that had been in stock for less than one year. To Zhang, who had no experience, these policies greatly reduced her risks. After her first store launched, Zhang worked hard on everything to do with the store. During the daily process of product purchasing, displaying, promoting, and advertising, she gradually became familiar with product materials, characteristics, and functions. With great effort, she earned her entire investment back after half a year (see Exhibit 2). Zhang knew in her heart that she could not have been so rapidly successful without Carpenter Tan’s mature franchising model. ZHANG’S SECOND FRANCHISED STORE In January 2013, Zhang found that her franchised store suffered a growth bottleneck after its revenue had grown at a rapid pace for six months (see Exhibit 2). Although she promoted products through the local newspaper and on television during the Spring Festival—the most important festival in China—the revenue nonetheless stopped growing. In order to raise her personal income, Zhang began to consider setting up a second franchised store in Panjin. Carpenter Tan provided a preferential policy whereby the franchise fee would be halved if a franchisee opened a second franchised store in the same city. Therefore, in May 2014, Zhang’s second franchised store opened. Ten months later, she earned back the entire investment of the new store. In August 2015, when the revenue of her second store met a bottleneck, Zhang tried to find new ways to promote the revenue for her two stores. Although she considered several methods, none of them could succeed because of the restrictions imposed by Carpenter Tan’s franchise model. Method 1: Product discounts to attract more customers. Carpenter Tan insisted on national uniform prices, and discounts were not permitted under its franchise model. This pricing policy was also applied to its regular customers, who were expecting preferential prices. What was worse, franchisees were not able to promote sales during holidays and festivals through product discounts. Method 2: Suggesting that Carpenter Tan perform advertising through TV, Internet, etc. As a franchisor, Carpenter Tan insisted on only a word-of-mouth advertising strategy and refused to fund other strategies. If the franchisees wanted to advertise on television or in newspapers, they had to pay for the promotion by themselves. However, in the age of the internet and widespread data and information, the word-of-mouth advertising strategy was not effective in promoting sales volume.
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Page 5 9B18M095 Method 3: Reducing operating costs. Because Zhang did not have much money, maintaining control of operating costs was always the key to her franchised stores. Yet she could not further reduce operating costs, because Carpenter Tan transferred its own operating costs to franchisees. For example, although Carpenter Tan insisted on a mere word-of-mouth advertising strategy, it required its franchisees to use advertisements on TV, in newspapers, and so on, which transferred Carpenter Tan’s advertising costs to franchisees. Method 4: Adding product categories and establishing a product portfolio. Carpenter Tan strictly forbade products of other brands to be sold in its franchised stores. However, Carpenter Tan’s product categories were limited to combs, mirrors, and hairpins, which made it difficult to meet customers’ diverse needs. Zhang felt that the franchise model had greatly restricted the further development of her business. ZHANG’S THIRD FRANCHISED STORE—TOUGH CHOICE Since 2015, Zhang had felt that the franchise model greatly limited the improvement of her business and the revenue growth of her two franchised stores. However, the two stores remained profitable, so she did not give them up. On November 5, 2016, when Carpenter Tan general manager Liu visited Panjin, he suggested that Zhang set up a third franchised store in Panjin. Although her first franchised store was still profitable, the profit was clearly falling (see Exhibits 3 and 4). This was also true for her second franchised store. Moreover, the two franchised stores were close to saturating the market in Panjin, a second-tier city in China with a population of only about 1.4 million. If a third franchised store was set up, there was a high chance that it would lose money or, even worse, encroach on the market share of the existing stores. However, if she refused to launch the third store, Carpenter Tan would introduce new franchisees in Panjin. The new franchisees could seize the market share in Panjin with no additional marketing cost considering Zhang’s previous market development efforts. Zhang wondered, “Should I set up the third store?” This was a tough choice. Another idea came to mind: “Now that the franchise model has already restricted my business, it might be a good choice to quit this franchise model and try another business.”
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Page 6 9B18M095
EXHIBIT 1: CARPENTER TAN FRANCHISE PROCESS
Note: During the online requisition phase, potential franchisees provided their name, educational background, work experience, and operating plans for the franchised store to Carpenter Tan as a part of the franchisee qualification assessment. In the trail operation phase, the franchisee simulated operation of the franchised store for a period of two days prior to the official opening. The trail operation phase helped the franchisee understand the operation process. Source: Compiled by authors from an interview with Zhang, January 15, 2017.
Consultation
Online requisition
Qualification assessment
Interview
① Visit sample store ② Negotiation
③ Introduce franchise contract ④ Sign franchise contract
Identifying store’s location
Decorating the store
Trial operation
Starting business
Franchising fee
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Page 7 9B18M095 EXHIBIT 2: REVENUE OF ZHANG’S FIRST FRANCHISED STORE BY MONTH FROM JUNE 2012 TO
JUNE 2013 (IN ¥ THOUSAND)
¥ = CNY = Chinese yuan/renminbi; US$1 = ¥6.3396 on June 1, 2012. Source: Created by authors using data from Zhang.
18.45
28.56
60.21
79.50
118.45
152.60
168.50 170.23
180.34 178.95 181.59 179.64 182.50
0.00
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40.00
60.00
80.00
100.00
120.00
140.00
160.00
180.00
200.00
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Page 8 9B18M095
EXHIBIT 3: PROFIT OF ZHANG’S FIRST FRANCHISED STORE BY FROM JUNE 2012 TO DECEMBER 2016 (IN ¥ THOUSAND)
¥ = CNY = Chinese yuan/renminbi; US$1 = ¥6.3396 on June 1, 2012. Source: Created by authors using data from Zhang.
EXHIBIT 4: FINANCIAL STATEMENTS FOR ZHANG’S FIRST FRANCHISED STORE FOR SIX MONTHS (¥)
Item 2012 2013 2013 2014 2014 2015 2015 2016 2016
7–12 1–6 7–12 1–6 7–12 1–6 7–12 1–6 7–12
Revenue 607,821 1,073,253 1,095,302 1,112,182 1,088,004 1,026,950 896,403 760,541 748,804
Cost of sales 292,610 670,224 683,002 690,105 681,460 638,746 535,546 429,488 424,725
Selling and distribution expenses
103,682 110,850 114,840 120,432 123,432 124,845 125,695 126,648 128,680
General and administrative expenses
42,050 43,540 43,589 44,856 44,892 45,843 48,940 48,865 49,752
Financial expenses, net
334 543 467 643 587 578 487 632 612
Operating profit
169,145 248,096 253,404 256,146 237,633 216,938 185,735 154,908 145,035
Income tax expenses
5,074 7,443 7,602 7,684 7,129 6,508 5,572 4,647 4,351
Net profit 164,071 240,653 245,802 248,462 230,504 210,430 180,163 150,261 140,684
Note: “1–6” refers to January to June, while “7–12” refers to July to December. Source: Created by authors using data from Zhang.
164.07
240.65 245.80 248.46 230.50
210.43
180.16
150.26 140.68
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250.00
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8.
UVA-F-1347
Version 11.2
This case was prepared by Dorothy C. Kelly, CFA, under the supervision of Robert F. Bruner and Professor Kenneth M. Eades. It is intended for illustrative purposes only. Copyright 2001 by the University of Virginia Darden School Foundation, Charlottesville, VA. All rights reserved. To order copies, send an e-mail to sales@dardenpublishing.com. No part of this publication may be reproduced, stored in a retrieval system, used in a spreadsheet, or transmitted in any form or by any means—electronic, mechanical, photocopying, recording, or otherwise—without the permission of the Darden School Foundation. Rev. 12/05. ◊
THRESHOLD SPORTS, LLC Carl Frischkorn closed the door and walked to his desk. As he sat down, he began to reflect on the meeting he had just attended in the conference room of Threshold Sports, LLC. There, Frischkorn had listened as company founders David Chauner and Gerard “Jerry” Casale Jr. discussed the company’s growth plans. Among the most critical challenges before Threshold was financing. The firm’s founders were certain they would need outside financing of $500,000 to grow according to their plans, but they were unsure what type of financing would best fit their needs, how to value the firm, and how to communicate that value to outsiders. Their task over the next few days would be to find answers. For help in the matter, they had sought the input of Frischkorn, a management consultant, angel investor, and chairman of Threshold Sports.
Founded three months earlier, in March 2000, Threshold Sports was a sports-marketing and event-production company focusing on the U.S. cycling market. Partners Jerry Casale and David Chauner had formed the limited-liability corporation to buy the cycling assets of Octagon Worldwide, the sports division of the advertising and marketing firm Interpublic Group (IPG). Through the newly formed Threshold, Casale and Chauner sought to market and produce, in the United States, competitive cycling events like those found throughout Europe.
The Cycling Market
Part of the Olympic Games since 1896, bicycle racing was popular as both an amateur and professional sport throughout the world. In Europe, both indoor and outdoor racing were extremely popular among amateurs and professionals. The professional circuit in Europe ran from February through October, and included the world’s largest and most famous annual competitive cycling event, the prestigious Tour de France. The Tour, which covered about 2,256 miles over a four-week period, commanded a worldwide television audience of 1 billion viewers. In the United States, the popularity of cycling was undeniable. In 1999, U.S. retailers sold a record 7.4 million bicycles. As of 2000, approximately 73 million Americans rode bicycles— outnumbering the ranks of skiers, golfers, and tennis players combined.
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Despite the popularity of cycling in the United States and the existence of a national cycling association (USA Cycling, known as USAC), both amateur and professional cycling in the United States lagged in development when compared with other sports. Often regarded simply as a pastime or method of transportation, amateur cycling lacked the community support and organization associated with other amateur sports, such as Little League baseball, YMCA soccer, or youth tennis. Likewise, professional cycling in the United States had yet to offer the level of competition and organization available in other sports such as football, baseball, basketball, or hockey, each of which had grown into a multibillion-dollar business (Exhibit 1). Although interest in cycling as a competitive sport had grown with the notable successes of American cyclists Greg LeMond and Lance Armstrong, professional U.S. cycling had yet to develop a signature competitive series such as the PGA Tour or offer an equivalent to the Tour de France.1 Threshold Sports
Threshold sought to fill the void in U.S. cycling by managing and producing European-style competitive cycling events. Threshold felt confident it could fill this small but attractive niche because of management’s experience with event planning and relationships within the cycling world. For 15 years, COO Jerry Casale, 52, had staged cycling events, including national championship races as well as the cycling events of the 1996 Olympic Games. President and CEO David Chauner, 62, was a former Olympic cyclist and a member of the U.S. Bicycling Hall of Fame. In their collective careers as sports promoters, Chauner and Casale had been responsible for producing more than 100 professional cycling events.
On April 1, 2000, Threshold Sports obtained multiyear contracts from Octagon Marketing to host three major cycling events for the USAC: the First Union Cycling Series, the BMC Software Cycling Grand Prix, and the Saturn USPRO Cycling Tour. According to the terms of the deal, Threshold would pay Octagon an annual lease for the life of the First Union Series Title Sponsorship Agreement, while the Saturn and BMC contracts were assigned to Threshold at no cost.
The First Union Cycling Series consisted of four road races in the Philadelphia area. The
crown jewel of the series was the popular First Union USPRO Cycling Championship, founded in 1985 by Chauner and Casale. The race attracted 700,000 spectators annually. First Union Bank had already committed to sponsoring the event for $1,150,000 a year for the duration of the five-year contract. Threshold management expected the series to generate annual revenues of approximately $2 million based on sponsorships and merchandising. Threshold would earn a management fee that started at $420,000 and increased to $510,000, and would pay annual lease payments of $200,000 in 2001, increasing to $260,000 in 2005. Profits generated after operating costs, lease payments, and management fees would be split 75%/25% between Threshold and Octagon Marketing, respectively.
1 LeMond was the first American to win the Tour de France and went on to win the competition three times (1986, 1989, and 1990). Armstrong made headlines by winning the 1999 Tour less than three years after recovering from cancer. Armstrong was chosen to lead the 2002 Olympic Torch Relay in preparation for the 2002 Winter Olympics in Salt Lake City.
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The BMC Software Cycling Grand Prix was a series of four road races held in Austin, Houston, San Jose, and Boston. The Lance Armstrong Foundation managed the Austin event, while Threshold managed the other three events. According to the contract, which ran through 2003, Threshold’s annual revenue for the series would be a minimum of $1,150,000 plus a 50% profit share with USAC. Threshold also obtained an exclusive five-year license to develop and manage the USPRO Cycling Tour (PCT), a 17-event series that included both the First Union and BMC races. The Saturn automobile company had contracted to be title sponsor for both 1999 and 2000, with commitments of $700,000 for each year. For the 2000 PCT, Threshold had already attracted an additional $300,000 in sponsorships. In addition to the contracts, Threshold purchased event-staging equipment from Octagon for $65,000—less than one-third its replacement value. Prior to its purchase by Octagon, the equipment had been the principal asset of Special Events Suppliers (SES), an equipment-leasing business operated by Jerry Casale. SES leased the equipment for concerts, city festivals, and parades (including the 1992 presidential inauguration parade). One of its highest-profile and most lucrative leases was a seven-figure contract for staging the 1996 Olympic cycling events in Atlanta. Growth Prospects and Plans
In considering Threshold’s long-term prospects, the founders reflected on the success of established sports such as the National Football League (NFL), Major League Baseball (MLB), and the National Basketball Association (NBA), which had television and merchandising contracts in the billions of dollars. The key, it seemed, was branding. According to Mark Holtzman, senior vice president for Consumer Products at NFL Properties, the league’s marketing arm, “We see ourselves, like Disney or Tommy Hilfiger, as a brand that has extensions 365 days a year.”2
Threshold’s founders knew that problems in established sports—including strikes and lockouts—had created an opening for relative upstart sports such as the National Association for Stock Car Racing (NASCAR) and so-called extreme sports. Monday Night Football audiences were down 10% in 1998, in part, perhaps, because people were watching alternative sports on Disney’s sports network ESPN. ESPN’s household audiences for extreme sports such as skateboarding, snowboarding, sky surfing, and street luge had increased 119% from 1994 through 1998.3 During the same period, sponsorship revenue for extreme sports had increased from $24 million to $135 million. NASCAR’s growth was also impressive. Its television audience had increased each year since 1990, and by 1999, when it reached 250 million fans, was second only to the NFL. Sales,
2 Richard Alm, “National Football League Revamps Marketing Strategy,” Dallas Morning News, 9 September 2001. 3 Karl Taro Greenfeld, “A Wider World of Sports,” Time (9 November 1998).
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meanwhile, had grown from $80 million, in 1990, to $1.13 billion, in 1999.4 Threshold’s owners hoped that they could grow their niche in a similar fashion.
In the near term, Threshold’s founders believed that they could double revenues within three
years by developing additional USAC racing events and leasing the company’s staging equipment for noncompany events. The profit/loss projections for events and projects for the next five years are shown in Exhibit 2. The projected profit/loss statement for the firm is shown in Exhibit 3.
To reach its near-term goal, Threshold sought to stage at least one new major racing event and one lesser race in 2001. The following two years, they planned to do the same, for a total of six new races in three years. As of June 2000, the firm was in the process of developing races in Atlanta, New York, San Francisco, and Valley Forge:
San Francisco, CA Threshold was negotiating with Tailwind Sports, manager of the U.S. Postal Service Cycling Team, to produce an event in San Francisco. Threshold expected to receive approximately $1.1 million in corporate sponsorships from the event, scheduled for September 9, 2001.
New York, NY The New York City Sports Commission had endorsed Threshold to
develop the New York City Cycling Championship. Atlanta, GA Threshold had formed a joint venture with Ivory Communications to
develop a cycling event with organizations involved in the 1996 Olympic Games.
Valley Forge, PA The Valley Forge Convention and Visitor’s Bureau retained Threshold to
plan and organize a weekend festival in October 2001. Called the American Cycling Jamboree, the festival would feature competitions, exhibitions, concerts, and demonstrations.
Financing Needs and Alternatives Given Threshold’s growth plans and current balance sheet (Exhibit 4), the founders agreed that the company needed additional financing to support the first growth phase. According to management’s estimates, financing the development of the additional races would require approximately $500,000 in working capital. Because of their limited experience in finance, the principals approached Frischkorn for help in arranging the deal.
Frischkorn faced three significant challenges with regard to Threshold’s financing needs. First, he needed to determine the type of securities to offer that would best suit the company’s needs.
4 Data from National Association for Stock Car Racing and industry estimates.
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Most importantly, he needed to determine the value of the company and thus the appropriate pricing of the offering. Finally, he needed to identify potential investors he might approach with the offering. Frischkorn believed that the size, history, and character of the company favored a private placement rather than a public issue. Among the financing alternatives Threshold was considering were a common-stock offering, a convertible-preferred-stock offering, and debt financing. Common stock To raise the needed capital, Threshold could issue additional common stock to new investors. Issuing common stock to other investors would dilute the voting interests of the current equity holders, and possibly dilute the stream of reported earnings per share.5 The extent of any EPS dilution would depend on the profitability of projects funded by the new capital. Ultimately, the owners wondered whether any new equity financing would dilute the market value of their interest in Threshold. Convertible preferred stock Another option for Threshold was to issue convertible preferred stock, which, under pre- established terms, could be converted into the common stock of the company. Preferred stock carried no voting rights. Dividends could be suspended, but all preferred dividends would have to be paid in full before dividends could be paid to holders of common shares. (See Appendix for a structure under which Frischkorn believed convertible preferred stock might be issued.) Debt financing Threshold would not qualify for investment-grade debt, and would therefore have to entice investors by offering high-yield debt if it were to issue a bond offering. Paying the interest associated with high-yield debt would seriously constrain Threshold’s cash flow and thus its growth. A more likely, albeit short-term, source of debt financing would be a traditional revolving credit loan from Threshold’s bank. According to Threshold’s management, the firm’s banker was willing to loan the company the necessary funds so long as principals Chauner and Casale personally guaranteed the loans. (See Exhibit 5 for the terms under which Frischkorn believed a loan might be obtained.) Both founders had bristled at the idea of personal guarantees, and had argued that the revolving credit could provide Threshold with the cash it needed in the short term, but was not a long-term solution for Threshold’s capital needs.
5 In corporate-finance terms, “dilution” meant reduction. Its opposite was “accretion.” Dilution could refer to any of
three effects: (1) reduction in voting power, (2) reduction in such financial results as EPS, and (3) reduction in market value of the firm; these three effects were known respectively as control, accounting, and economic dilution.
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As an angel investor, Frischkorn had garnered experience with each type of financing that Threshold was considering, but in those circumstances, he had to weigh the advantages and disadvantages only from the investor’s perspective. In the case of Threshold, he had to weigh the advantages and disadvantages of each type of financing from the company’s perspective. He also had to consider the dilutive effects any deal might have on the voting control of the current owners (Exhibit 6). Frischkorn thought about some of the other private placements in which he had been involved. He recalled that the more mature companies in which he had invested had frequently chosen debt offerings because of the tax advantages of paying interest over paying dividends. Many of the younger companies, meanwhile, had elected to issue common stock because it provided flexibility in terms of paying (or not paying) a dividend. Still, he recalled a number of deals in which the issuing company had chosen to offer preferred stock because it conveyed no voting rights and allowed some flexibility regarding the timing of dividends. Placement Placing the offering presented a challenge for Frischkorn. In Frischkorn’s experience, risk- tolerant individual investors had usually provided the necessary capital for such deals even though they offered a relatively low yield compared with other investments. Risk-tolerant individual investors, interested in early-stage financing, found preferred stock attractive because of its liquidation preference. Most corporate investors Frischkorn had contacted were uninterested in providing such early-stage seed capital regardless of the tax advantage offered by preferred shares.6 Generally, Frischkorn had been successful in attracting investors for a number of the companies in which he was involved. But Threshold was different from Frischkorn’s other investments, which included both old-economy start-ups and new-economy Internet plays. He believed that Threshold would appeal primarily to investors who were cycling enthusiasts or who had personal knowledge of the firm’s key managers. He knew that he would have to screen potential investors carefully.7 Regardless of their individual circumstances or identities, all new and current Threshold investors would be interested in potential exit strategies. Frischkorn himself was keenly aware of at
6 Individual investors reported all dividends from preferred issues as ordinary income, while corporate investors could, for tax-reporting purposes, exclude from income 70% of the dividends received from preferred issues.
7 For a private placement, all investors in the offering had to qualify as “accredited investors,” as defined under Regulation D of the Securities Act of 1933. Under Regulation D, an accredited investor was generally defined as:
(i) an individual who is a director or officer of the Company; or (ii) an individual who has individual income in excess of $200,000 in each of the two most recent years, or joint
income with that of his or her spouse in excess of $300,000 in each of such years, and who reasonably expects income in excess of such amounts in the current year; or
(iii) an individual who has an individual net worth, or a joint net worth with that of his or her spouse, in excess of $1,000,000.
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least two potential means of exit: the possible sale of the business to a large advertising agency or an initial public offering. In the near term, the former seemed more likely than the latter. IPG, Omnicom Group, and WPP Group were all public companies that acted as holding companies of individual marketing firms and were actively acquiring small, branded firms. A future sale to one of these umbrella organizations could offer an exit strategy to investors, provide Threshold with certain economies of scale, and still allow Threshold to maintain its own brand identity as well as some level of independence. Given Threshold’s relationship with Octagon, such a sale seemed the most likely outcome for now. A future public offering, while still a possibility, seemed a less likely exit strategy at the present time. Valuation A significant problem for Frischkorn was estimating Threshold’s value. Based on his experience, Frischkorn knew that some investors would argue that the company was worth only what was visible on its balance sheet and would therefore suggest a traditional asset-valuation approach. In conversations, Chauner and Casale had argued vehemently that the firm was worth much more than what appeared on the balance sheet and should be valued based on its growth prospects. They favored valuing Threshold by using a discounted-cash-flow approach. Uncertain as to which valuation method would prevail, Frischkorn pointed out that any preferred-stock investor in Threshold would require at least a 20% rate of return, and a common-stock investor would probably seek returns in excess of 30%.
Complicating Frischkorn’s appraisal was the changing investment environment and its impact on valuations. As seen in Exhibit 7, the NASDAQ had endured a dramatic correction in the three months since March 2000. Internet stocks had been hit particularly hard, but the decline had affected even nontech stocks. The abrupt change in public valuations had closed the IPO window for many companies and that, in turn, had impacted private valuations. According to venture capitalists, valuations had dropped significantly from March through May. Noting the change in climate, Rick Kroon, head of Donaldson Lufkin & Jenrette Securities’ venture-capital arm, Sprout, observed, “The market will start to be more selective, and [venture capitalists will] wait until their companies are more mature before taking them public.… That’s healthier for everyone in the long run.”8 Other venture capitalists concurred: “We’re walking away from a lot of deals today that we wouldn’t have only a few weeks ago.… These companies just aren’t going to get funded, particularly by anyone involved in late-stage or expansion capital at all,” said Matthew Cowan, a general partner at Bowman Capital.9 Given the changing environment, Frischkorn concluded that angel investors buying common stock in such an immature company would require a return in excess of 30%.
8 Suzanne McGee, “Deals & Deal Makers: Sky Is No Longer the Limit for Venture-Capital Firms,” Wall Street
Journal, 9 May 2000, C1. 9 McGee, “Deals & Deal Makers.”
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While Frischkorn had been in his meeting, his associate Phil Peterson had performed some preliminary research for the Threshold deal. The report included information about current yields (Exhibits 8 and 9). It also included some analytical information about outstanding debt as well as preferred and convertible preferred securities (Exhibits 10, 11, and 12). An interesting aspect of the report revolved around Peterson’s search for “comparables.” Initially, Peterson had encountered great difficulty finding firms, particularly U.S. firms, that matched Threshold’s niche. Undeterred, he had collected information on a number of publicly traded companies, including sports-marketing companies such as Magnum Sports and Entertainment, entertainment companies such as Disney, and advertising agencies such as Cordiant Communications Group (CRI) in London; Omnicrom Group Inc. (OMC); WPP Group Plc (WPP), also in London; and Interpublic Group of Companies (IPG), the parent company of Octagon. With the help of an investment-banking friend, Peterson had broadened his search and had discovered two other companies that could be described as sports-marketing event managers: Sports and Outdoor Media International PLC, in London (SOR); and Tow Co. Ltd., in Tokyo. According to the information available through Bloomberg Financial, SOR traded on the London Exchange. Tow was a privately held Japanese company that was currently preparing for a public offering. Fortunately, Peterson’s friend had provided him with a copy of Tow’s red-herring prospectus, which included basic financial information about the company as well as information about its market and growth prospects. In an effort to estimate Threshold’s growth prospects, Peterson gathered information from Multex Data Group. According to Multex, as a group, advertising agencies such as Cordiant, IPG, Omnicom, and WPP were expected to show profit growth of 31.17% in 2001 and 15.47% in 2002, while earnings of the S&P 500 were expected to climb 1.41% in 2001 and decline 9.95% in 2002. These estimates were significantly higher than the 11% growth estimated for both Tow and its market in the company’s red herring. Peterson included summary information about all the companies, their businesses, and their financials in his report (Exhibits 13 and 14), to which he attached a note dated June 15, 2000:
Carl—Here’s the information you requested on current market conditions and comparables. In our discussion this week, you asked about EBIT multiples for private companies. Although I am unable to provide the exact reference, I recently read in one of the financial journals that the EBIT multiple for private companies is 6. Let me know if you need anything else.—Phil
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Conclusion Frischkorn sat back and wondered, How does one value an entity whose primary asset is goodwill and the leases (or rights) to produce events? How does one create and then attribute value to a “brand” such as the Pro Cycling Tour? More specifically, how much was Threshold worth based on either an asset valuation or a DCF valuation? Was one type of financing more suitable than another for Threshold? Which was most appropriate? And what type of investors would be interested in this deal?
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Exhibit 1
THRESHOLD SPORTS, LLC
Major U.S. Sports Organizations
Sports Organization 2000 Sales
(in millions) 1-Yr. Sales
Growth Employees Revenue/Employee Major League Baseball (MLB) $3,177.0 12.00% 200 $15,888,000.00 National Basketball Association (NBA) $2,164.0 126.50% 800 $2,705,000.00 National Football Association (NFL) $3,602.2 10.10% 450 $8,004,888.89 National Hockey League (NHL) $1,697.2 15.00% 289 $5,872,664.36
Source: “The NBA Shoots for the Net,” Industry Standard, 24 April 2000 (http://www.thestandard.com/article/0,1902,14064,00.html?body_page+2).
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Exhibit 2
THRESHOLD SPORTS, LLC
Estimated Event Income and Loss, 2001–05 (in thousands)
Projected Event Income 2001 2002 2003 2004 2005 First Union Series $1,700 $1,800 $1,910 $2,125 $2,525 US PRO Tour 1,200 1,350 1,525 1,700 2,300 BMC Grand Prix 1,300 1,425 1,540 1,725 2,350 Pre-Event Consulting 15 25 35 50 70 New Event 1 500 575 660 750 900 New Event 2 300 350 410 490 625 New Event 3 500 580 675 850 New Event 4 250 325 475 550 New Event 5 500 565 725 New Event 6 250 325 475 Total Event Income $5,015 $6,275 $7,735 $8,880 $10,170 Operations Cost First Union Series $1,650 $1,700 $1,785 $1,925 $1,985 US PRO Tour 1,100 1,200 1,260 1,325 1,350 BMC Grand Prix 1,200 1,250 1,315 1,385 1,400 Octagon Lease 200 225 236 248 260 New Event 1 450 475 500 550 555 New Event 2 275 300 330 365 380 New Event 3 475 500 525 555 New Event 4 225 245 255 265 New Event 5 475 510 535 New Event 6 225 250 260 Profit Share 50 $88 $113 $220 $610 Total Operations Cost $4,925 $5,938 $6,984 $7,558 $8,155 Net Event Income (Loss) $90 $338 $752 $1,322 $2,015
Note: Pre-event consulting income refers to fees generated from consulting work performed to research a new event for a municipality. Operations Cost for each contracted project includes a management fee to Threshold Sports.
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n iv
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ity t a u g h t b y
P ro
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b u la
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1 3 , 2 0 1 8 t o O
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tio n .
111
UVA-F-1347
-12-
Exhibit 3
THRESHOLD SPORTS, LLC
Estimated Fee Income and Loss, 2001–05 (in thousands)
2001 2002 2003 2004 2005 Income Management-fee income $1,150 $1,525 1,750 2,100 2,240 Special-projects income 80 80 90 105 110 Profit (loss) from racing events 90 337 752 1,322 2,015 Misc. income 2 3 3 4 3 Total income $1,322 $1,945 $2,595 $3,531 $4,368 Expenses Salaries and overhead $1,104 $1,296 $1,495 $1,719 $1,977 Special projects 35 55 60 72 85 Depreciation 11 16 22 28 34 Capital expenditures 50 50 60 60 60 Expansion expense 40 55 100 200 225 New business 24 30 60 100 200 Total expenses $1,264 $1,502 $1,797 $2,179 $2,581 Net profit (loss) $58 $443 $798 $1,351 $1,787
F o r
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in t h e c
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is in
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ity t a u g h t b y
P ro
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rs is
a c
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o la
tio n .
112
UVA-F-1347
-13-
Exhibit 4
THRESHOLD SPORTS, LLC
Balance Sheet for Fiscal Year Ended May 31, 2000
Assets Current assets Cash $379,349 Accounts receivable 363,084 Other current assets 2,900 Total current assets $745,333 Staging equipment 65,000 Total assets $810,333 Liabilities and equity Liabilities Accounts payable $133,590 Other current liabilities 9,937 Accrued expenses 322,000 Total liabilities $465,527 Equity Net income 344,806 Total equity $344,806 Total liabilities and equity $810,333
F o r
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is in
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p a ra
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rs is
a c
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tio n .
113
UVA-F-1347
-14-
Exhibit 5
THRESHOLD SPORTS, LLC
Terms of Revolving Credit Loan
Type of loan Revolving credit line Principal amount Up to $500,000.00 Term 36 months Annual interest rate Prime + 4% Current prime rate 9.10% Security Business equipment plus personal guarantee Purpose of loan Working capital Payment due date The 4th day of each month Prepayment penalty None
F o r
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in t h e c
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rs is
a c
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o la
tio n .
114
UVA-F-1347
-15-
Exhibit 6
THRESHOLD SPORTS, LLC
Current Ownership Structure
Holdings Current Ownership Class A Units David Chauner 12.0 units 40% Jerry Casale 9.0 units 30% Robin Morton 3.0 units 10% Carl Frischkorn 3.0 units 10% Loren Smith 1.5 units 5% Frank Chauner 1.5 units 5%
30.0 units 100%
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rs is
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tio n .
115
UVA-F-1347
-16-
Exhibit 7
THRESHOLD SPORTS, LLC
Equity-Market Conditions: Closing Values and Trendlines
Source: Financial Forecast Center (www.forecasts.org).
NASDAQ Closing Values June 1999 - June 2000
2,500 3,000 3,500 4,000 4,500 5,000 5,500
6/ 15
/1 99
9
7/ 15
/1 99
9
8/ 15
/1 99
9
9/ 15
/1 99
9
10 /1
5/ 19
99
11 /1
5/ 19
99
12 /1
5/ 19
99
1/ 15
/2 00
0
2/ 15
/2 00
0
3/ 15
/2 00
0
4/ 15
/2 00
0
5/ 15
/2 00
0
6/ 15
/2 00
0
C lo
si ng
V al
ue
DJIA Closing Values June 1999 - June 2000
9,500 10,000 10,500 11,000 11,500 12,000 12,500
6/ 15
/1 99
9
7/ 15
/1 99
9
8/ 15
/1 99
9
9/ 15
/1 99
9
10 /1
5/ 19
99
11 /1
5/ 19
99
12 /1
5/ 19
99
1/ 15
/2 00
0
2/ 15
/2 00
0 3/
15 /2
00 0
4/ 15
/2 00
0
5/ 15
/2 00
0
6/ 15
/2 00
0
C lo
si ng
V al
ue
F o r
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in t h e c
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is in
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tio n .
116
UVA-F-1347
-17-
Exhibit 8
THRESHOLD SPORTS, LLC
Capital-Market Conditions: Selected Interest Rates for Week Ended June 2, 2000
Yield
Federal funds 6.53% U.S. Treasury securities 3 Month 5.78% 1 Year 6.30% 3 Year 6.60% 5 Year 6.49% 30 Year 6.00% Corporate bonds Aaa 7.83% Baa 8.76%
Source: Federal Reserve Statistical Release H.15, 5 June 2000.
Corporate Bond Yields According to Bond Rating and Maturity
Maturity AAA AA A BBB BB+ BB/BB− B 1 6.77 6.85 7.19 7.79 11.26 10.29 11.04 5 7.67 7.98 8.25 8.93 10.50 11.05 12.20 10 7.62 7.98 8.27 8.99 9.74 10.94 12.26 15 7.92 8.32 8.61 9.35 9.62 NA NA 20 7.94 8.36 8.65 9.47 NA NA NA 25 7.92 8.36 8.66 NA NA NA NA
Note: Data as of 5/30/2000. U.S. Industrials include Yankee bond issues. Minimum $100 million outstanding. Source: Standard & Poor’s CreditWeek (7 June 2000): 46 (from Standard & Poor’s Fixed Income Research-Bond Corp.).
F o r
u se
o n ly
in t h e c
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P ro
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a c
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tio n .
117
UVA-F-1347
-18-
Exhibit 9
THRESHOLD SPORTS, LLC
Market Conditions
Source: The Federal Reserve Board of Governors Release H.15.
Treasury Yields January 1999 - June 2000
0
1
2
3
4
5
6
7
Ja n-
99
Ma r-9
9
Ma y-9
9 Ju
l-9 9
Se p-
99
No v-9
9
Ja n-
00
Ma r-0
0
Ma y-0
0
Y ie
ld
3 Month Treasury Yields 10 Year Treasury Yields
F o r
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P ro
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tio n .
118
UVA-F-1347
-19-
Exhibit 10
THRESHOLD SPORTS, LLC
Key Industrial Financial Ratios by Rating Category: Median Three-Year Ratios for 1996–98
Industrial long-term debt AAA AA A BBB BB B CCC Pretax interest coverage (×) 12.9 9.2 7.2 4.1 2.5 1.2 (0.9) EBITDA interest coverage (×) 18.7 14.0 10.0 6.3 3.9 2.3 0.2 Funds from operations/total debt (%) 89.7 67.0 49.5 32.2 20.1 10.5 7.4 Free operating cash flow/total debt (%)
40.5 21.6 17.4 6.3 1.0 (4.0) (25.4)
Return on capital (%) 30.6 25.1 19.6 15.4 12.6 9.2 (8.8) Operating income/sales (%) 30.9 25.2 17.9 15.8 14.4 11.2 5.0 Long-term debt/capital (%) 21.4 29.3 33.3 40.8 55.3 68.8 71.5 Total debt/capital (incl. STD) (%) 31.8 37.0 39.2 46.4 58.5 71.4 79.4 Source: Wesley E. Chinn, Adjusted Key U.S. Financial Ratios, Standard & Poor’s Research, 7 July 1999.
F o r
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in t h e c
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ra n ch
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P ro
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tio n .
119
UVA-F-1347
-20-
Exhibit 11
THRESHOLD SPORTS, LLC
Sample of Dividend Yields for Preferred Stocks, June 2000
Security S&P Rating Maturity Date
Dividend Yield
ABN AMRO Cap. Fd. II 7.125% A+ 3/31/04 9.0%
HSBC USA $2.8575 A+ 9/30/07 7.2%
Australia & New Zealand Bank 9.125%
A 2/24/03 9.3%
NB Capital 8.35% Sr. A Dep. A− 9/2/07 9.6%
LaSalle RE Holding 8.75% BB+ 3/26/07 12.5%
SEMCO Cap Tr I 10.25% BB+ 4/18/05 10.3%
AICI Cap Trust 9% B+ 9/29/02 19.0%
Host Marriott 10% B B 4/28/05 12.1%
United Dominion Realty 8.60% B BBB 5/28/07 10.8%
FelCor Lodging Trust 9% Dep BB– 5/6/03 12.9%
ONB Cap. Tr. I 9.50% Tru PS BBB– 3/14/05 9.2%
Source: Standard & Poor’s Stock Guide, June 2000.
F o r
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ra n ch
is in
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P ro
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120
UVA-F-1347
-21-
Exhibit 12
THRESHOLD SPORTS, LLC
Analytical Ratios on a Sample of Convertible Preferred Securities
Source: Bloomberg Financial and Standard & Poor’s. Notes: Financial data and calculations as of 6/15/00. Conversion ratio reflects the number of common shares to be received in exchange for one share of convertible preferred. Parity (also known as conversion parity price) is the common stock price at which immediate conversion would make sense. The premium reflects the mark-up of the convertible over parity. It is the percentage difference between the two.
Security Apache
$2.015 C Cv Pfd Chiquita Brands
$3.75 cm CV B Pfd Sealed Air
$2.00 CV Pfd A
Standard Automotive
8.50% Sr CV Pfd
Superior Telecom 8.50% TR 1 cm CV Pfd
USX-US Steel Group 6.50% cm CV Pfd
S&P rating BBB− B− BB NR CCC+ BB Dividend yield 4.03% 18.11% 3.88% 11.64% 17.36% 8.80% Conversion ratio 0.8197 3.3333 0.8846 1.0000 1.1496 1.0840 Price of convertible pfd. $50.06 $21.00 $51.50 $9.00 $27.00 $37.06 Price of underlying stock $57.25 $4.00 $54.00 $6.69 $11.13 $21.06 Parity (CV ratio × stock price) $46.93 $13.33 $47.77 $6.69 $12.79 $22.83 Premium ([CV price/parity] − 1) 6.67% 57.54% 7.81% 34.53% 111.10% 62.33%
F o r
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P ro
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tio n .
121
UVA-F-1347
-22-
Exhibit 13
THRESHOLD SPORTS, LLC
Selected Marketing and Entertainment Companies
Name Symbol1 Business Description Cordiant Communications Group
CRI (LN)
ADR:CDA
Advertising Services
A holding company whose subsidiaries operate in more than 70 countries. Businesses encompass advertising, merchandising, market research, direct marketing, public relations, and media services. Also provides services in television and multimedia production, as well as live conferences and exhibitions.
The Walt Disney Co. DIS Multimedia Conducts operations in media networks, studio entertainment, theme parks and resorts, consumer products, and Internet and direct marketing. Produces motion pictures, television programs, and musical recordings as well as publishes books and magazines. Also operates ABC radio and television and theme parks.
Interpublic Group of Companies IPG
Advertising Services
An organization of advertising agencies and marketing service companies. Operates globally in sectors of advertising, independent media buying, direct marketing, healthcare communications, interactive consulting services, marketing research, promotions, experiential marketing, public relations, and sports marketing.
Magnum Sports & Entertainment Inc.2 MAGZ
Advertising Services Provides management, marketing, and commercial endorsement agency services to various sports entities.
Omnicom Group Inc. OMC Advertising Services
Provides marketing communications and advertising services through global, national, and regional independent agency brands. Operates branded independent agencies in public relations, specialty advertising, and direct response and promotional marketing. Holds minority interests in other businesses.
Sports & Outdoor Media International Plc SOR (LN)
Advertising Services Acts as a sports stadia advertising agent to major sports rights holders in U.K. and Australia, selling ground signage and other forms of advertising at cricket and rugby grounds. Also has a sports marketing and sponsorship consultancy business.
Tow Co., Ltd.3 N/A Advertising Services
Plans, advertises, produces, and manages various types of events. Primarily manages exhibitions, ceremonies, festivals, product promotion campaigns, public service announcements, sporting events, and expositions. The company was privately held but was preparing to make its initial public offering in 7/00.
WPP Group Plc
WPP (LN) ADR:WPPGY
Advertising Services
Operates a communications services group with 1,300 offices in 102 countries. Operations encompass advertising, media investment management, information and consultancy, public relations and public affairs, healthcare and specialist communications, and branding and identity services.
1 LN indicates the stock trades on the London Exchange. ADRs are available where noted. 2 Formerly Worldwide Entertainment & Sports. 3 Initial public offering of 1 million shares expected in July 2000, to be traded on the Tokyo Exchange (JP).
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tio n .
122
UVA-F-1347
-23-
Exhibit 14
THRESHOLD SPORTS, LLC
Selected Financial Information on Comparable Companies for Fiscal-Year 1999
Symbol
FY 1999 Sales
(millions)
Shares Outstanding
(millions)
FYE Share Price
Equity Market Value
(millions) Book Value (millions)
Total Debt (millions)
Total Debt to Equity
Total Debt- to-Equity Market Value
Price to Book
Price to Earnings
EBITDA Multiplier
100-Day Volatility
(%) Beta Unlevered
Beta
CRI (LN) GBP335.80 228.80 GBP2.93 GBP670.38 (GBP40.20) GBP84.00 NM 0.13 NM 35.73 15.09 47.9 1.10 NM DIS $23,435.00 2,069.00 $26.00 $53,794.00 $21,323.00 $11,693.00 0.55 0.22 2.63 44.32 10 41.6 0.86 0.65
IPG $4,977.82 307.01 $57.69 $17,710.64 $1,846.08 $1,311.09 0.71 0.07 10.19 44.04 17.89 43.7 1.07 0.77
MAGZ $1.12 3.49 $2.00 $6.98 $6.08 $0.12 0.02 0.02 5.73 N/A N/A N/A 0.37 0.37
OMC $5,130.55 177.49 $100.00 $17,749.00 $1,676.02 $842.00 0.50 0.05 11.43 49.75 19.65 41.3 1.02 0.78 SOR (LN) GBP14.56 33.77 GBP0.83 GBP28.03 GBP12.48 GBP15.18 1.22 0.54 0.37 92.17 N/A 53.1 0.33 0.19 TOW (JP) JPY5,396.00 N/A N/A N/A JPY1,002.00 JPY1.95 0.95 N/A N/A N/A N/A N/A N/A NM
WPP (LN) GBP9,345.90 774.54 GBP9.50 GBP7,358.13 GBP195.80 GBP515.10 1.58 0.07 23.88 42.84 24.1 50.8 0.86 0.44
Source: Bloomberg Financial. Notes: NM = not meaningful; N/A = not available. Volatility reflects most recent 100 days prior to 6/1/00. Volatility and beta values for foreign securities reflect those of ADRs. GBP = British pounds; JPY = Japanese yen.
F o r
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123
UVA-F-1347
-24-
Appendix
THRESHOLD SPORTS, LLC
Summary of Terms of Hypothetical Convertible-Preferred-Stock Offering
Amount: $500,000 (maximum)
Securities: A maximum of 10 convertible preferred Units
Price per unit: $50,000 (original purchase price)
Cumulative preferred return: To be determined. Initial proposal: 10% dividend on par value which shall accrue and be payable on a cumulative and non- compounding basis. If there are insufficient funds to pay the Cumulative Preferred Return in full, payment shall be made on a pro-rata basis. The Cumulative Preferred Return shall accrue annually commencing on the closing date of this offering and shall terminate on December 31, 2005.
Liquidation preference: In the event of any liquidation, dissolution, or winding up of the Company, the holders of these Units will be entitled to receive (in preference to the holders of other interests) the initial investment less any capital distributions that may have previously been made plus all unpaid portions, if any, of the Cumulative Preferred Return.
Conversion privilege: To be determined. Initial proposal for Units to be convertible at any time into shares of common stock at a strike price of 1.5 times most recent book value per share of common.
Holder redemption right: Beginning March 31, 2005, and each anniversary thereof, Holders of these convertible preferred Units shall have the right to require the Company to redeem the convertible preferred Units.
Company redemption right: The Company may redeem any convertible preferred Units, annually, by notice within 90 days following the end of each calendar year. The redemption price will be at par value.
Mandatory tax distribution: For each calendar year Unit holders will receive a special cash distribution in an amount equal to 35% of the income allocated to such holders.
Voting rights: Holders of convertible preferred Units shall not have voting rights.
F o r
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in t h e c
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P ro
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1 3 , 2 0 1 8 t o O
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124
UVA-F-1347
-25-
Appendix (continued) Right of first refusal: In the event that a holder wishes to sell or otherwise transfer its
investment interest pursuant to a bona-fide offer from a third party, the holder shall first offer the investment interest to (i) the Company, and (ii) then to the non-selling holders, upon the same terms and conditions of the bona-fide offer.
Co-sale rights: If any holder owning more than 25% of the Company intends to sell its interest pursuant to a third party offer, the non-selling holders may include their membership interests in the sale on a pro-rata basis.
Drag along rights: If holders of membership interests that in the aggregate represent 50% or more of the Company elect to sell the Company pursuant to a sale of assets, sale of membership interests, merger or otherwise, such members may compel the remaining members to consent to, and participate in, such sale.
Pre-emptive right: All unit holders shall have a pro-rata right to participate in subsequent equity financings of the Company subject to customary exclusions.
F o r
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in t h e c
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U se
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p a ra
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rs is
a c
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tio n .
125
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9A95B013 NOTE ON FINANCIAL AND LEGAL ASPECTS OF FRANCHISING Kevin Premner and Professor James E. Hatch prepared this note solely to provide material for class discussion. The authors do not intend to provide legal, tax, accounting or other professional advice. Such advice should be obtained from a qualified professional Ivey Management Services prohibits any form of reproduction, storage or transmittal without its written permission. Reproduction of this material is not covered under authorization by any reproduction rights organization. To order copies or request permission to reproduce materials, contact Ivey Publishing, Ivey Management Services, c/o Richard Ivey School of Business, The University of Western Ontario, London, Ontario, Canada, N6A 3K7; phone (519) 661-3208; fax (519) 661-3882; e-mail cases@ivey.uwo.ca. Copyright © 1995, Ivey Management Services Version: (A) 2010-02-11 INTRODUCTION Purpose of This Note There are a wide range of publications which provide general advice to the aspiring franchisor and franchisee.1 This note is written for a course on entrepreneurial finance and consequently its purpose is to focus more narrowly on four key issues of interest to the franchisor, namely: assessing the economic and financial viability of the franchise concept, obtaining the funds necessary to finance both the franchisor and the franchisee, designing the franchise agreement, and legal considerations in the relationship between the franchisor and franchisee. What is Franchising? A franchise is a form of business organization in which the owner of a trademark or trade name (the “franchisor”) conveys to one or more independent dealers (the “franchisees”) the right to market a particular product or service, usually within a specified geographic area and subject to a number of constraints imposed by the owner. There are two broad types of franchising: product format and business format franchising. A product format franchise is a venture in which a manufacturer licenses a distributor to market its products and use specific trademarks of the manufacturer. An example of a product format franchise is a General Motors auto dealership. A business format franchise is a venture in which the licensor grants the franchisee the right to carry on a business in a specified way, in a particular location for an agreed period. An example of a business format franchise is a McDonald’s Restaurant.
1See for example, Franchising, Ivey Note #9A89D009.
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Why are Businesses Franchised? When a business expands, it can use a variety of methods to grow, such as adding branches of the same company, negotiating joint ventures with other companies, or creating franchises. Entrepreneurs often choose franchising as a growth vehicle because franchising: • provides a franchisor with an alternative source of funds (supplied by the franchisee) in addition to
traditional sources such as banks and public equity markets; • reduces the entrepreneur’s risk since investment risk is shared with the franchisee; • enables the entrepreneur to expand more quickly than other growth methods; and, • spreads the profit incentive down to the business unit level, thereby increasing unit performance and
efficiency. Individual business owners often prefer franchises to non-franchised entrepreneurial ventures because franchises have higher new-business survival rates. The higher survival rates typically stem from: • lower costs due to system-wide purchasing; • greater revenue potential due to well-known trademarks; • product access through the franchisor; and, • improved availability of financing due to a proven business concept. ASSESSING ECONOMIC AND FINANCIAL VIABILITY There are two broad considerations in assessing the viability of a franchise. First, it must be clear that the franchise being designed makes sense in general terms. Second, the proposed franchise must be financially viable for both the franchisor and the franchisee. The financial viability of the two parties depends on the nature of the franchise agreement. General Viability of the Concept In order to successfully expand a business through franchising, an entrepreneur must have a viable business concept which meets the following requirements: • product or service: a product or service that is unique, is protected by a registered trademark, and has
high sales potential, • standardization of operations: a franchisor should be able to sufficiently standardize the operations
such that a franchisee can operate with minimal franchisor involvement, • ease of duplication: a franchisor should be able to effectively reproduce the key success factors of the
prototype units (menu, locational factors, customer service) at franchised units, • business simplicity: a franchisor should be able to train franchisees in the business in a short time to
minimize less-productive training periods, and • successful prototype units: a franchisor should have several model stores to demonstrate the viability
of the business concept to prospective franchisees and investors.
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The Franchise Agreement Given that a particular franchise concept makes sense, the franchisor must design a franchise agreement that offers a reasonable return to the franchisee on his or her investment once the unit is well-established and well-managed and ensures a reasonable return to the franchisor for his or her efforts. The franchisor-franchisee relationship is interdependent in nature. Franchisors need franchisees to provide financial and human resources to operate individual franchise units. Franchisees, on the other hand, need franchisors to provide the conceptual underpinnings of the business which comprise the strategies, operating procedures, and trademarks of the franchises. While every franchise relationship is more than a contractual arrangement, the franchise agreement is the contract which stipulates how the franchise unit will operate and what the roles of each of the franchisor and franchisee will be as much as possible. The franchisor has many alternative ways in which the deal offered to prospective franchisees can be designed. Following are some of the typical issues addressed in a franchise agreement: • the duration of the relationship (typically renewals occur after five years), • the specific ways in which costs and revenues will be shared (e.g., franchise fees, advertising funds), • the conditions under which the agreement can be terminated by each party, • the allowance for the resale of the unit by the franchisee or operation of it by another individual, • the franchise territory, if the there is one, and how it is selected, • the training programs offered by the franchisor and required of the franchisee, • the marketing programs (prices, promotion expenses) required of the franchisee, and • the extent to which the franchisee must be involved in the daily operations of the franchise unit. The profitability of the franchisor and franchisee depends on how costs and revenues are shared between the two parties. A number of ways of sharing these costs and revenues are outlined in Exhibit 1. Adequacy of Potential Returns to the Franchisor and Franchisee In order to analyse the financial viability of a new franchise concept, the franchisor must estimate the revenues and costs of both the franchisor and the franchisee and then perform a return on investment analysis for both parties. If the proposed financial arrangement between the two parties leaves one of them without a viable business, then the arrangement must be modified by the franchisor until both parties are likely to be satisfied. Clearly this is an iterative process. If a satisfactory financial arrangement cannot be reached, then the economic viability of the whole concept is doubtful. ROI Analysis for the Franchisee To illustrate the financial viability of a franchise we will use data from a hypothetical Bakery Cafe which is a chain of fast food restaurants offering baked goods, specialty coffees and healthy foods. The franchisor in this case has decided to receive cash inflows from the franchisee in the form of an initial franchise fee plus a percentage of revenues which would be used to cover advertising, administrative expenses, management fees and the like. Simplified financial statements for a single franchise unit are presented in Exhibit 2. In this case, it is assumed that the firm will reach its steady state of sales by the end of the third year.
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Upon producing these statements, a franchisor would then prepare a discounted cash flow analysis to determine the return on the investment for the franchisee. In this example, the discounted cash flow rate of return is 23 per cent compounded annually. This return is over and above the salary paid to the franchisee. In practice, franchisors will sometimes divide the net earnings of an arbitrary year (usually a year during which the franchise has achieved its estimated potential sales) by the book value of the investment. The result in this case is an accounting rate of return of 33 per cent. ROI Analysis for the Franchisor Once the franchisor has determined if the return on investment for the franchisee is satisfactory, he must evaluate the return on his own investment. Again, the franchisor must prepare financial statements for the company under various performance scenarios. The franchisor should prepare these statements given a reasonable assumption regarding the number of franchise units which could be established over a period of time. In the Bakery Cafe example, the franchisor assumed that 10 franchises could be sold immediately and that there would be no further sales of franchises over the subsequent 10 years. This very unrealistic assumption is made in order to keep the illustration simple. In reality there would likely be a number of sales of franchises each year with the result that the franchisor is receiving revenues from a mix of new and mature units. Moreover, it is assumed that all units perform at the same level. In reality, there would be a fairly high variance in performance, including possible closures. The simplified proforma statements, and the accompanying ROI calculations for the franchisor are presented in Exhibit 3. Based on the data in this exhibit, the discounted cash flow rate of return is 44 per cent and the accounting rate of return is 46 per cent. This franchise appears to promise reasonable rates of return for both the franchisor and the franchisee although the return to the franchisee is lower. As discussed earlier, if the returns to the franchisee had been inadequate to attract good franchisees given the perceived risk, the franchisor may have modified the financial arrangements between the two parties to make the franchise more viable. FINANCING CONSIDERATIONS Franchisor Financing Franchisors have an advantage over other forms of business in that franchisees provide some of the capital required to finance growth of the enterprise. Nonetheless, franchisors still have financial requirements which vary depending on the nature of the arrangement with franchisees. In some cases, franchisors own all of the real estate and rent it out to franchisees. They may also own the equipment. Other franchisors require funding for inventory and accounts receivable. All franchisors incur development costs of varying kinds, from the registration of trademarks and the legal costs of designing franchise agreements to marketing research and advertising campaigns. If a franchise is in a startup phase it will be difficult to attract debt financing because like any startup business the franchise is likely to be perceived as a high risk proposition. Moreover, even if the loans are secured by fixed assets, the assets are not likely to be worth very much if the “concept” is a failure. As a result, most startups are likely to require a substantial amount of equity. After the franchise has become more established and the cash flows are more predictable, banks are likely to become more interested in providing financing. Most chartered banks in Canada utilize the account managers throughout their branch network to develop franchisors as clients, evaluate franchisors’ businesses, and make loans to franchisors.
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These account managers are supported by a central franchising group which has indirect client responsibilities which include: franchisor evaluation and consulting, development of franchisee assistance packages, and business development. Franchisee Financing Franchisors must anticipate the ability of the franchisee to obtain financing when specifying the size and nature of the investment which they will require of franchisees. In general, the chartered banks will require an equity investment by the franchisee amounting to 30 per cent to 50 per cent of the total investment in the business. The banks will relax this requirement somewhat if the franchisor is well-established and has demonstrated strong support of its franchisees, or if the funds are for the second or third franchise unit belonging to the franchisee. Franchisee Assistance Packages Franchisee Assistance Packages are standardized financing arrangements that apply to all franchisees associated with a particular company. They are developed by the central franchising groups of the chartered banks for several reasons. First, these packages contribute to the business development of the bank in that a franchisor will arrange for a package with only one bank, which will then receive preferential consideration by franchisees. Second, they simplify the banks’ lending operations by pre- evaluating the franchisors for which the packages have been developed. The loans granted under the packages are made and administered by the banks’ account managers rather than the central franchising groups. The types of loans offered in these packages include: operating loans, floating rate capital loans, fixed rate/fixed term loans, and business improvement loans. Before a chartered bank will consider developing a franchisee assistance package with a franchisor, a number of conditions must be met. Typically, banks will require a franchisor to have operated as a franchisor business for at least three years, have granted franchises to a minimum number (5 to 10) of franchisees, and have a clear strategy for developing the business. Franchisors must, in fact, sell their concepts to banks as well as to franchisees. The three critical factors which banks look for in franchise systems are: 1. A proven concept that has been providing adequate investment returns by no later than year three of
the franchise unit’s existence (returns would be considered adequate if they provide a reasonable salary to the franchisee plus reasonable profit margins),
2. A site selection process which focuses on the expansion concept of ‘Area of Dominant Influence’ — essentially, banks do not want franchisors to grow too quickly or expand into new markets before they are ready, and
3. A franchisee selection process that identifies and recruits investors who are suited to doing business within a franchise system.
Banks are now advocating that their franchisor clients consider adopting suitable psychological profiles of potential franchisees because the selection of franchisees is such a key success factor of a franchise system.
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THE LEGAL ENVIRONMENT Franchise systems are essentially contractual relationships between independent businesses. Moreover, these contractual relationships are peculiar because, in most instances, the franchisors prepare the franchise agreements with little or no input from prospective franchisees. In most contracts, the two parties will negotiate an agreement. But, in franchise agreements, this negotiation does not typically occur. The peculiar nature of these contractual agreements has led to legal concerns shared by franchisors and franchisees alike. General Legal Environment The Canadian legal system is built upon a mix of statutory and common laws at both the federal and provincial levels of government. The Canadian Constitution ensures that contract law (the basis for many laws pertaining to business and commerce) falls within the jurisdiction of the 10 Canadian provinces. Therefore, franchise law, which is based upon contract law, also falls within the legal purview of the provinces. With different sets of laws for each province, there is no uniformity in franchise law in Canada. The province of Alberta has the only legal system pertaining specifically to franchising in Canada and has become the defacto standard-bearer against which other provinces measure themselves. The Legal Environment in Alberta In the 1970s, residents of the province of Alberta became concerned with the perceived inequities between the powers of franchisors and franchisees in the establishment of new franchises. Legislators addressed these concerns by enacting the Franchises Act (1980). This Act specified a variety of information (seen in Exhibit 4) which franchisors are required to disclose to prospective franchisees in Alberta. In addition to the disclosure requirements, the Act required franchisors to file with the Alberta Securities Commission (ASC) a company prospectus or Statement of Material Facts as a means of registering with the ASC along with annual financial statements. Proponents of franchise disclosure legislation in Canada hold Alberta up as a model for franchise legislation in other provinces. Alberta’s Franchises Act was amended on November 1, 1995. The new Act addresses three concerns shared by franchise participants and franchise regulation administrators. These three concerns are: 1. eliminating the costs and time delays caused by franchise registration and the Alberta Securities
Commission review; 2. ensuring that appropriate and timely data are made available to prospective franchisees so that
informed decisions can be made; and, 3. promoting industry self-management and self-regulation. The amended Franchises Act makes five substantive changes to the original Alberta Franchise Act; • the amended act requires the franchisor to provide a disclosure document to the prospective franchisee
at least 14 days before the signing of any agreement or payment of any consideration by the prospective franchisee;
• the amended act provides for damages (or compensation) for misrepresentations made to franchisees by franchisors;
• franchisees are given the right to associate with other franchisees in any organization;
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• franchisor directors and officers are made liable for misrepresentations made to franchisees, if they were aware of them; and
• the amended act provides for self-regulation of the franchise industry by giving the Lieutenant Governor in Council the right to designate one or more bodies to govern franchising and promote fair dealing among franchisees and franchisors.
The new Act states that each party is responsible to “Deal Fairly” with other parties with respect to performance and enforcement, however, the term “Deal Fairly” was not clearly defined leaving some speculation on how this term may be interpreted in the courts. The Alberta Ministry of Municipal Affairs and Housing has jurisdiction over the implementation and enforcement of the Act. To date, no organization has been appointed as the self-regulating body. The Legal Environment in Other Provinces Although Alberta has the most comprehensive and sophisticated franchise law in Canada, other provinces have been building up their franchise laws at varying paces. The pace with which franchise law is developing is based upon both the understanding of legal practitioners in the area of franchise management and law as well as the frequency and severity of conflicts between franchisors, franchisees, and other interested parties. Without substantial conflict, there is no cause for government to intervene in the franchise industry, nor is there the opportunity for legal practitioners to advance franchise case law. Conflicts between franchisors and franchisees are most intense over the issues of misrepresentation, encroachment, and product supply. Briefly, these issues are: 1. Misrepresentation: Franchise agreements typically last five years and are very demanding of
franchisees. Accordingly, franchisees want fair and accurate information from the franchisor before making a long-term, binding decision. Misrepresentation disputes arise out of inaccurate or incomplete information provided by the franchisor.
2. Encroachment: Franchise agreements typically define the franchisee’s market area. Encroachment disputes arise out of the definition of a market area, specifically at the time when new franchisees are introduced to bordering market areas.
3. Product Supply: Franchise agreements will typically outline the product supply chain for franchisees. Product supply disputes arise when franchisees believe the supply chain is over-priced or the benefits of a supplier relationship are inequitably shared between the franchisor and franchisees.
Another force that may drive the adoption of franchise regulation is the signing of the Internal Trade Agreement in 1994 by all Canadian provinces and the federal government. The purpose of this agreement is the promotion of the free flow of people, goods, services, and investments in Canada. A harmonization of national regulations on franchising can be seen as one method of facilitating this process. The province of Ontario’s Minister of Consumer and Commercial Relations, Norman Sterling, has already indicated his belief that harmonization is desirable, however, no new legislation is pending. The Legal Environment in the United States of America In the United States, there are two types of franchise laws — disclosure laws and relationship laws. Disclosure laws require the franchisors to make pre-sale disclosures to franchisees and may require the franchisor to register the sale of franchises. Relationship laws regulate the terms of the franchise
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relationship such as the fees that will be charged to the franchisee for goods or services provided by the franchisor. The U.S. federal government does not regulate franchise relationships; however, the Federal Trade Commission does enforce regulations with respect to franchise disclosure. At the state level, 15 states currently have disclosure laws, 20 jurisdictions regulate franchise relationships, and eight states regulate both aspects of franchising. Franchising in the United States is complicated by a lack of a common definition of what constitutes a franchise. In general, a franchise is deemed to exist if the franchisor provides a “marketing plan” that provides “substantial control or assistance” to the franchisor, or if there exists a “community of interest” in which both parties have a continuing financial interest in the marketing of goods or services. There are methods of avoiding franchise regulation. For example, if goods or services sold by the “licensee” represent less than 20 per cent of the total sales of that company, the agreement is not considered a franchise. If a person or organization fails to comply with U.S. franchise laws, the implications could be severe. The franchisor may be prohibited from cancelling an agreement with a franchisee or may be forced into renewing an agreement with a franchisee that is deemed to be undesirable. The franchisor may be forced to repurchase any inventory or property from franchisees that have been terminated and may be liable for damages, attorney’s fees, and civil or criminal penalties. The differences in regulations and the potential risks associated with non-compliance suggest that any potential franchisor should review the specific laws in each jurisdiction prior to expansion into that area of the United States. The Canadian Franchise Association The Nature of the CFA The Canadian Franchise Association (CFA) is a voluntary association of franchisors, largely from Ontario, which represents the franchise industry in a number of roles. It: • acts as an advocacy group for franchises to governments, the media, and the public; • organizes franchise expositions to promote business opportunities to prospective franchisees; • provides management and legal seminars and training programs for franchisees, franchisors, and
franchise lawyers; • represents the franchise industry to international franchise organizations; and • acts as a consultant to both prospective and established franchisors and franchisees. Membership and Size of the CFA Traditionally, the CFA has represented primarily Ontario-based franchisors. However, the membership has changed in recent years to include some franchisee representatives. In addition, the Alberta Franchisors’ Institute has recently merged with the Canadian Franchise Association, thereby increasing the membership. There has also been some discussion regarding a potential merger with the Pacific Franchise Association. The CFA has approximately 300 members which amounts to 25 per cent to 50 per cent of the franchise systems, depending upon which estimate of the total number of Canadian franchise systems is used. Although the CFA is continually recruiting new members, it does screen membership applicants. F
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About 10 per cent of all applicants are rejected by the CFA’s Selection Committee based upon the franchisors’ business conduct and franchisee relations. There are two implications of the nature and membership of the CFA for franchisors. First, the CFA is the most prominent association representing franchise interests in Canada, and therefore, franchisors should probably increase their support of it to further legitimize the organization, especially as the proposal of industry self-regulation is debated. Second, the CFA is by no means the only voice for franchising in Canada, and therefore, franchisors have alternatives to which they can turn should the CFA not adequately represent them. Specific alternatives to the CFA include: the franchise trade association in Quebec, the International Franchise Association in the U.S., and other trade associations not specifically targeted at franchises. Franchisor-Franchisee Relationship Management Issues Franchisors must be cognizant of the potential for conflict in their relationships with their franchisees. As discussed earlier, encroachment and product supply are often the most contentious of issues that must be addressed throughout the franchise relationship. At the heart of any potential conflict within the franchisor-franchisee relationship are money and power. If both franchisees and franchisors are making attractive returns on their investments, then the potential for conflict is low. However, when one or the other is not earning reasonable returns, then the partner with lower earnings has the incentive to seek greater control over how the franchise generates and distributes earnings between the partners. Power & Control in the Franchise Franchise agreements limit the power and control of the franchisee in the franchise system. In fact, the limited control by the franchisee is considered to be a cornerstone of a successful franchise system. The franchise system (with a good business concept) is most successful when procedures and programs are performed identically and offered by each franchisee in the system. Thus, when a franchisee refuses to perform reasonable standard procedures or does not participate in specific marketing programs, the franchisor typically endeavours to enforce the franchise agreement for the success of the entire franchise system. Under the amended Alberta Franchises Act, franchisors would not be allowed to prohibit or restrict a franchisee from associating with other franchisees nor would franchisors penalize franchisees for engaging in the activities of franchisee associations. Because the integrity of the control systems put into place by franchisors is so important, franchisors have begun to establish mechanisms to address franchisee concerns through such vehicles as franchisee advisory councils. Alternative Dispute Resolution Mechanisms Franchisors have several incentives to resolve franchise conflicts internally. Litigation, the traditional, ultimate method of resolving contractual conflicts, is expensive, time-consuming, and public. Public disputes encourage government intervention which can have expensive and long-term implications, as is evident by the long-term involvement of the Alberta Securities Commission in franchising in Alberta. Notwithstanding the costs of litigation and the prospect of government intervention into franchising, the most significant cost of publicized conflicts between franchisors and franchisees is the potential revenue
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erosion. Fortunately, franchisors can establish Alternative Dispute Resolution (ADR) mechanisms as a critical component of franchise agreements. Exhibit 5 outlines four common ADR mechanisms, although others do exist. Despite their advantages, ADR mechanisms are not a panacea for poor franchisor-franchisee relationships. Some of the mechanisms, mediation for example, produce non-binding settlements. Other mechanisms, specifically arbitration, can be as expensive as litigation. The best strategy for prospective franchisors is to prevent conflicts from arising. Franchisors can minimize conflicts by adhering to the following guidelines when establishing new franchises: 1. Recruit and select suitable franchisee candidates. Many entrepreneurs are not suitable franchisees
because they have difficulty with accepting the requirements of the franchise agreement and relationship. Franchisors are well-advised to carefully screen prospective franchisees, even to the point of psychological profiling of prospective franchisees. Franchisors should evaluate whether a prospective franchisee is interested in obtaining the franchise to create a job for himself/herself, to secure an investment vehicle, or both. Franchisors should select those franchisees who want both an occupation and an investment vehicle.
2. Negotiate with prospective franchisees, but don’t negotiate “numbers”. Particularly with established franchises, franchisors may be unwilling to negotiate any elements of franchise agreements. However, this unwillingness is problematic for two reasons. First, the omitted opportunity to negotiate may prejudice franchisors’ cases in subsequent conflicts because the legal principle of “fair dealing” is an element of contract law. Second, franchisor-franchisee negotiation may lead to a more productive and rewarding relationship for both. The caveat not to negotiate numbers is provided to remind franchisors to avoid misrepresenting the earnings of the franchise, as well as to ensure that they set out to earn equal rewards from each franchise.
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Exhibit 1
ELEMENTS THAT DIRECTLY AFFECT CASH FLOW IN THE FRANCHISE AGREEMENT1
Element Description
Franchise fee The initial fee paid to the franchisor for the rights to the franchise unit.
Royalties The on-going fees paid to the franchisor for the franchise rights; royalties can be structured as a percentage of gross revenues, or a fixed periodic payment, or some combination thereof.
Lease/rent charges for equipment & premises
The franchisor can structure the franchise deal such that the franchisor would hold most of the fixed assets (equipment & real estate) of the franchise; if so, the franchisor will receive leasing and/or rental fees for the use of these assets.
Construction fees The management fees paid to the franchisor relating to the design, construction, or inspection of new or renovated franchise units.
Inventory/product sales The franchisor will often sell or resell product to franchisees; in these cases, the product costs incurred by the franchisees will equal the inventory sales revenues of the franchisor.
Advertising funds Most franchises will have some degree of pooled advertising; if so, the franchisor will collect advertising fees from the franchisees for the ad campaigns. Franchisors can charge management fees directly relating to the administration of the advertising campaign against the pooled funds.
Rebates & allowances Often franchisors will establish approved supplier lists and, in return for being added to these lists, suppliers will provide rebates and allowances to the franchise system. Franchisors may keep these funds for themselves or distribute them back to the franchisees based upon some formula.
Resale & renewal fees Franchisors can charge fees similar to the initial franchise fees for the assignment of the franchise by the franchisee or for the renewal of the franchise.
Service charges The management fees paid for administrative, accounting, and other services provided by the franchisor to the franchisees.
Training fees The management fees charged specifically for the training of franchisees and their employees.
Interest payments on overdue funds
Franchisors can charge interest on any overdue funds owed to them by the franchisees.
1For a more detailed discussion of these cash flow elements, please see Frank Zaid, ed. Canadian Franchise Guide. Carswell Publishers: Scarborough, ON, 1992.
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Exhibit 2
FINANCIAL ANALYSIS FOR A SINGLE FRANCHISEE
Pro Forma Income Statements
Year 1 Year 2 Year 35 Revenues1 $1,280 $1,440 $1,600 Costs
Startup2 40 — — Variable3 704 792 880 Fixed4 290 290 290 Contribution to Franchisor 160 176 192 1,194 1,258 1,362
Earnings Before Tax 86 182 238 Tax (40 per cent) 34 73 95
$ 52 $ 109 $ 143 1. Unit achieves steady state level of sales at the end of Year 3. Year 1 and Year 2 are 80 per cent and 90 per cent of
steady state respectively. 2. One-time costs to franchisee. 3. Assumed 55 per cent of sales. 4. Includes management salary for franchisee. 5. Years 4 to 10 are similar to Year 3.
Pro Forma Balance Sheets
Year 1 Year 2 Year 35
Net Working Capital1 $ 77 $ 86 $ 96 Fixed Assets2 335 335 335 Initial Fee3 25 25 25
437 446 456
Owner=s Capital4 437 446 456 1. Assumed to be six per cent of sales. 2. Each year assets are repaired sufficiently to stay at the same net value. 3. Assumed it was capitalized. 4. All earnings are paid out each year and new cash is invested to cover increases in assets. 5. All subsequent years are similar to Year 3.
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Exhibit 2 (continued)
Computation of Rate of Return Cash Flows Year 0 Year 1 Year 2 Years 3-10 Initial Fee (25) — — — Initial Assets (412) — — — Additional Assets (9) (10) — Annual Earnings 52 109 143 Net Cash Flow (437) 43 99 143 Internal Rate of Return = 23 per cent Accounting Rate of Return = 33 per cent
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Page 14 9A95B013
Exhibit 3
FINANCIAL ANALYSIS FOR A FRANCHISOR
Pro Forma Income Statement
Year 1 Year 2 Year 35 Revenues
Franchise Sales1 $250 $ — $ — Royalties & Fees2 1,600 1,760 1,920 1,850 1,760 1,920
Costs Startup3 40 40 40 Variable 800 880 960 Fixed4 160 160 160 1,000 1,080 1,160
Earnings Before Tax 850 680 760 Tax (40 per cent) 340 272 304
510 408 456 1. Ten units sold in the first year. 2. Ten times the royalty per unit from Exhibit 2. 3. This is not a cash flow. It is the write-off of the initial $400 outlay over 10 years at $40 per year. 4. Nature of fixed assets depends on such factors as who owns the real estate and equipment. 5. Years 4 to 10 are similar to Year 3.
Pro Forma Balance Sheet
Year 1 Year 2 Year 35 Net Working Capital1 $ 448 $ 484 $ 560 Fixed Assets2 200 200 200 Startup Costs3 400 360 320
1,048 1,044 1,080 Owner Capital4 $1,048 $1,044 $1,080 1. Assumed at 3.5 per cent of system revenues. 2. Each year assets are repaired sufficiently to stay at the same net value. 3. The initial costs are gradually written off over a 10-year period. 4. All earnings are paid out each year and new capital is contributed or the original investment is removed as appropriate. 5. All subsequent years are similar to Year 3 except that the startup costs fall by $40 per year.
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Exhibit 3 (continued)
Computation of Rate of Return Cash Flows Year 0 Year 1 Year 2 Years 3-10 Working Capital (448) (36) (76) — Fixed Assets (200) — — — Startup Costs (400) — — — Earnings 510 408 456 Add Back Startup1 40 40 40 Net Cash Flow (1,048) 514 372 496 1. Recall startup costs are amortized over 10 years. Internal Rate of Return = 44 per cent Accounting Rate of Return = 46 per cent
Exhibit 4
DISCLOSURE REQUIREMENTS IN ALBERTA1 1. Identifying information and business experience of the franchisor 2. Business experience of franchisor’s directors and key executives 3. Litigation and bankruptcy history of the franchisor, its directors, and its key executives 4. Description of the franchise 5. Money required by the franchisee to begin the franchise operation 6. Continuing expenses of the franchise, including payments to the franchisor 7. List of parties with whom the franchisee is required, or advised to do business, including real
estate, staffing, and management services 8. Description of franchisor assistance in financing the purchase of the franchise 9. Restrictions on the franchisee’s operation of the business 10. Requirements for personal involvement by the franchisee 11. Conditions for termination, cancellation, and renewal of the franchise 12. Constraints on site selection 13. Franchisee training programs 14. Promotional responsibilities for the franchisee 15. Consideration for third party purchases where goods are supplied on a discount or bonus
basis
1Source: The Alberta Franchise Act, 1980.
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Exhibit 5
COMMON ADR MECHANISMS IN PRACTICE IN CANADA
Neutral Expert Fact-Finding/Evaluation This mechanism is a non-binding assessment of the material facts of the conflict by a dispassionate and knowledgeable observer. The expert offers his or her opinion on which party is correct and the possible outcome of any litigation. The key to the success of this method is the credibility of the expert and his or her ability to persuade the conflicting parties to end the dispute. Mediation This mechanism is non-binding and essentially is a set of negotiations between the opposing parties with the assistance of a third party. Mediation is effective if the third party has the ability to get the conflicting parties to understand each other’s perspective. Furthermore, the mediator must be objective and have credibility with each party. In some franchise systems, the franchisee advisory council mediates conflicts between the franchisor and individual franchisees. In other franchises, ombudsmen are designated to mediate in franchise disputes. Arbitration This mechanism can be binding or non-binding and is similar to mediation, with the exception that the third party makes the decision on how the conflict will be resolved. It only works if both parties agree to the arbitration because the “loser” can contest the arbitrator’s decision in court. Arbitrated decisions do have some advantages over legal decisions. “Arbitration does have . . . other distinct advantages over litigation, including the fact that the proceedings are not public, experts in franchising and/or the underlying business can be selected as arbitrators and the parties can agree in advance upon the procedures that will govern the process.”1 Settlement Conference This mechanism is also similar to mediation but the conflicting parties provide the same information to the mediator which would be required in a litigation. The strict purpose of the settlement conference is to avoid a potential court case. Once the conflicting parties know the legal arguments and evidence of each side, they may better understand the likely outcomes of any litigation.
1Levitt, Edward N. “Alternative Dispute Resolution Mechanisms in Franchising”, presented at the Canadian Franchise Association’s 17th Annual Legal Symposium on October 28, 1993, reproduced in Fair and Foul Play in Franchising: Current Issues and Emerging Trends. Canadian Bar Association - Ontario, 1994, p. 8.
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Bibliography Books: Various. Fair and Foul Play in Franchising: Current Issues and Emerging Trends. Toronto, ON:
Canadian Bar Association — Ontario, 1994. Coltman, M.M. Franchising in Canada: Pros and Cons. Vancouver, B.C.: International Self-
Counsel Press Ltd, 1987. Felstad, Alan. The Corporate Paradox: Power and Control in the Business Franchise, New
York, NY: Routledge Publishers, 1993. Zaid, Frank (ed.) Canadian Franchise Guide. Scarborough, ON: Carswell Publishers, 1992 Periodicals: Anonymous. “Surving the Shakeout,” Financial Times. Vol. 79, No. 45, April 22, 1991. pg. A1. Anonymous. “The Future of Franchising,” Profit: The Magazine for Canadian Entrepreneurs.
Vol. 11, No. 1, March 1992, pg. 59. Van Alphen, Tony. “Few Rules in Wild West Industry,” Toronto Star. May 4, 1993. Pg. A15.
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