Mergers and acquisitions in franchising

Executive Summary

Franchising is a form of cooperation between entrepreneurs that originates from the United States and now is also growing rapidly in the Netherlands. Franchising provides the opportunity for rapid expansion with many advantages: the franchise organization can grow with a minimum equity investment, while the self-employed franchisee directly has a famous name, a proven formula and the related know-how.

Franchising is a growth strategy with many benefits for as well as the franchisee as the franchisor. It gives both parties an efficient division of labor. In fact, for the franchisor, franchising makes a rapid expansion possible, with minimum investments. These are largely borne by the franchise holders that are entrepreneurs. The franchise organization offers the franchisees facilities in the area of market research, marketing, advertising, administration, automation. But also inventory control and distribution range.

Purchasing and distribution may also be cheaper and more efficiently through economies of scale for both parties. The franchisee also makes use of a proven formula and has immediately the famous name, experience and expertise of the organization. Another advantage for franchisees is that investments are usually easier to be funded by the success and any financial guarantees from the franchisor.

As always, there is a back side. Due to rapid growth in combination with a weak franchise organization, a number of franchise organizations fail. Even with a well-organized organization and a proven success formula, expansion that has been implemented too rapidly leads to a rapid collapse. The adverse effects are incalculable, not only for the organization but for the starting small entrepreneur (the franchisee) who does not get a return on his investment.

To see how well organized these organizations are, I decided to do research on the topic of mergers and acquisitions within franchising. This led me to the Yum organization. Yum is the largest restaurant company worldwide. This claim concerns the management and control over 35,000 system restaurants. It is managing and controlling over 35,000 restaurants in over a hundred countries and territories. The brands of KFC, The Pizza Hut, Mexican food restaurant Taco Bell, Long John Silver’s or the A&W outlets are the brands that are exploited by all these restaurants owners.

In the past decade Yum has done many mergers and acquisitions. The mergers and acquisitions within franchising have never been researched before. For this reason I have chosen for this pioneering role, which I will express in this exploratory study to the causes and effects of M&A in franchising.

The reason that I chose for the organization of Yum is that it is a large global organization. This makes it possible to build a broader and global perspective to examine how causes and effects of mergers and acquisitions within franchising are linked. It was also an opportunity to research several organizations with different services or products to a wider picture. This would be much more time, so I have not chosen for this research design. In the introduction of the case study in section two of chapter three, I also added a brief description of Yum.

The findings of my exploratory study are based on investigating the causes and effects of mergers and acquisitions in franchise businesses. Therefore, I first looked at the causes by using the available data from the annual reports followed by the effects in terms of an event study. After the event study I was able to make a link between the strategy (causes) and the events (effects) that has taken place in the last decade for the business of Yum. Yum and the franchisees are constantly seeking for optimization in their supply chain and the service they deliver to their customers. Successful mergers and acquisitions consist of a number of critical business principles that have to be implemented in the core processes of the franchise stores. In chapter five I will briefly discuss these principles and what they mean for the business of Yum. These findings may also be interpreted as recommendations towards my subject of research.

1 Introduction

Franchising is a form of cooperation between entrepreneurs that originates from the United States and now is also growing rapidly in the Netherlands. Franchising provides the opportunity for rapid expansion with many advantages: the franchise organization can grow with a minimum equity investment, while the self-employed franchisee directly has a famous name, a proven formula and the related know-how.

To see how well organized these organizations are, I decided to do research on the topic of mergers and acquisitions within franchising. This led me to the Yum organization. Yum is the largest restaurant company worldwide. This claim concerns the management and control over 35,000 system restaurants. It is managing and controlling over 35,000 restaurants in over a hundred countries and territories. The brands of KFC, The Pizza Hut, Mexican food restaurant Taco Bell, Long John Silver’s or the A&W outlets are the brands that are exploited by all these restaurants owners.

In the past decade Yum has done many mergers and acquisitions. The mergers and acquisitions within franchising have never been researched before. For this reason I have chosen for this pioneering role, which I will express in this ‘exploratory’ study to the causes and effects of M&A in franchising.

My research objective is to say something useful about the key factors in franchising that lead to a successful business model. Thus, my conclusion will be based on these key factors that lead to a successful business model. When a franchisor is buying or selling a store, it is important to know where failure can be prevented and success can be enhanced.

The figure below is a visual representation of my research model.

Figure 1 A visual overview of the research model

1.1 Literature

To do the exploratory study in a correct way, it is important to identify the main components of both growth mechanisms to understand what I am actually going to do research on. I will do a thorough literature study to the main concepts and previous studies to understand both of these mechanisms.

Businesses associate mergers and acquisitions mainly with economic benefits as synergy benefits, reduce costs and a way to grow. These expected benefits are also the basis of the decision for a merger or acquisition.

Franchising means that a company (the franchisor) sells the rights for using its brand and business principles to another second company (the franchisee). But this still is not an answer on the question why a firm initiates franchising and how franchising impact different types of organizational performance.

Therefore the literature section will give a brief summary about the main concepts of M&A activities as well as a broad overview of the franchising literature that has been published.

1.2 Research Question

In this section I will further clarify my research objective. Here, I want to make a distinction between the causes and effects of the acquisition in franchise. If I can identify the causes or motives behind an acquisition, I will be able to compare the effects per category per company as described below. 

Looking at causes it is clear that companies can grow more rapidly through mergers and acquisitions, rather than expand their production capacity. This is one of the main reasons why many companies get the majority of their growth from mergers and acquisitions get. In addition to this growth pattern, creating shareholder value is another main motif. This shareholder value is achieved by exploiting the opportunities arising from a merger or acquisition such as economies of scale, access to new technologies, products and services and markets. These cost motifs often have a dominant position. Through acquisitions, production efficiency and lower costs can take place. If average costs decrease with larger production is known as economies of scale. In addition, companies can realize cost savings as cheaper products together than in individual companies (economies of scope). In addition to the causes or motives which form the basis of most mergers and acquisitions, also the effects have been described in the used literature.

Looking at the effects it is clear that companies have many reasons for dealing with mergers and acquisitions but that practice has shown that not all mergers succeed. There is much literature devoted, in which success rates often are not greater than fifty percent and the performance of the companies after the merger has become worse than before. There are roughly two different methods used for determining the success of a merger or acquisition. The most commonly used method is quantitative; the performance of the share of the merged company is compared with the performance of the shares of comparable companies. Another method is qualitative, where the leaders of the companies are asked in interviews if the merger has been proved successful.

If any successful or non-successful effects have been detected there could probably be a cause for this effect. Therefore, my research question is:

“What are the causes and effects of mergers and acquisitions in franchising?”

When I separate the causes and effects, I can compare any success of another. This way I can identify motives and choices can lead to the most positive effects. Based on these conclusions, I can make recommendations to further research.

Also, I will give an introduction of the case study that will take place in the next section. Also my expectations regarding the outcomes of the case study will be given further explanation. Therefore I will identify the main parameters on which I will compare the two mechanisms with each other.

1.3 My approach and the structure of the thesis

After the introduction in chapter one, my thesis really starts with the subject of mergers and acquisitions in franchising. Because the main idea is to do research on the causes and effects, I studied lots of literature on this subject.

In the second chapter I will describe the literature I used for this thesis. I distinguish 2 types of literature. The first part of the literature is about the main concepts of mergers and acquisitions. The second part is about the franchising literature. For both M & A as well as franchising there has been a lot of research published. The interesting thing of my exploratory research is that both areas have never been combined previously. In this chapter, I will give a summary of the main concepts of both mechanisms.

The third chapter I will describe the data and sources that I used for the case study in the fourth chapter. Since not everyone is familiar with this type of study, I will quickly describe the main concepts of it. Readers that are familiar with the concepts of a case study could skip this section and head forward to chapter four.

Further reading to the fourth chapter will give a description of the actual research. Here, I will deal with a case study of the company Yum that have businesses in franchising. In order to do this I will use data obtained by using the software from Thomson ONE Banker. The fourth section will give an overview of all the mergers and acquisitions that Yum has done in the past decade. I calculate the abnormal return of the share and compare this return with the market and the industry.

As I indicated I will do research on the company Yum on the basis of a case study of their mergers and acquisition. I will separate the causes and effects and use four steps to progress to a conclusion. For this research design I used the annual reports of Yum, and analyzed them. This company owns fast food restaurants of the franchise labels A&W, Kentucky Fried Chicken, Long John Silver, Pizza Hut and Taco Bell. First I will look at the causes in the sections 1 and 2.

1. The strategy of the company

The strategy of the company in the annual report can be found in the notes to the financial statements. In the annual report of Yum, The formulation of the strategy is reflected in the section entitled "Letter to shareholders" on page 2 of the annual report of 1998. Also, I looked at the annual report of 2007 to point out the development of the strategy. Thus, I will point out the company's strategy in section three of chapter four.

2. The growth of the company

In this step, I will analyze how the company grew. I will analyze what part of the growth is autonomous (do more of what the company already did) and what part of the growth caused by acquisitions (growth purchase). This information I gather through the software from Thomson ONE Banker. With this software it is possible to see what acquisitions are made by Yum in the past decade. This software also discloses the status and value of the deals. I will link this information with information from the annual reports. In this way I can gain deeper understanding of the growth. I will develop and process the data into tables and graphics in order to display the business growth.

Because I separated the causes and effects in my research design, section 3 and 4 will deal with the effects.

3. Financing growth

There are several ways to finance a merger or acquisition. In this step, on the basis of the report, I will describe how the various mergers and acquisitions have been financed. Thomson ONE Banker discloses the value of the deal. The explanation of the funding of the deals can be found in the section "Management's Discussion and Analysis of Financial Condition and Results of Operations" under the heading "Consolidated Cash Flows". The financing of these deals in numbers is included in the "Consolidated Statements of Cash Flows". I will process the data into tables and graphics in order to display the financing of the growth.

4. The performance of the company

Finally, I will use an event study to see what the performance of the company has been. This is very important to see how the above steps have effect. I will start with an analysis of the share value. Also, the event study shows the performance of Yum in the market and in the industry. For the last one, not all the data was available. All the data is reflected in the annual reports. I will this process these data in tables and graphics. With the event study I linked the data from Thomson ONE Banker and DataStream.

Chapter 5 will give the conclusions of my research. In a three page summary I will give the outcomes and recommendations of my research. My conclusion will be based on the key factors of successful franchising. When a franchisor is buying or selling a store, it is important to know where failure can be prevented and success can be enhanced. With this thesis both franchisee as franchisor could be able to benefit from the sources I analyzed.

2 Literature Review

For both M & A as well as franchising there has been a lot of research published. The interesting thing of my exploratory research is that both areas have never been combined previously. In this chapter, I will give a summary of the main concepts of both mechanisms. In the final thesis I will further go into literature study to identify the different parameters that I want to work with to de the exploratory research.

2.1 M&A literature

Businesses associate mergers and acquisitions mainly with economic benefits as synergy benefits, reduce costs and a way to grow. These expected benefits are also the basis of the decision for a merger or acquisition.

During the 20th century, the United States had five waves of mergers and respective acquisitions. Each of these five periods was associated with economic growth, followed by a period of recession. The European history of mergers and acquisitions is remarkably shorter than that of the United States. For Europe they can only speak of two waves that are parallel to the last two periods in the United States. But in order to understand these waves, one must identify possible motives for these mergers and acquisitions. Most of the literature distinguishes the following causes for M&A activities;

2.1.1 Synergy

Synergy is one of the most cited reasons for companies to engage in a merger or acquisition. Synergy means that the combined company is more profitable than the sum of the two individual companies. When a merger or acquisition has a positive acquisition value (NAV), it is supposed to be economically. The NAV is defined as:

NAV = VAB – (VA + VB) – P – E

VAB – (VA + VB) stands for the synergetic effect. If this term is positive, then the merged company is worth more than the sum of the value of the two individual companies. P symbolizes the buyer pays the premium and E the costs related to the acquisition or merger.
Synergy effects can be defined broadly as well as narrowly. The broad definition also takes into account the effect of bad management to be replaced through better management in a merger or acquisition. However, the more narrow definitions do not take into account this management effects. Synergy can be divided into operational synergies and financial synergies.

2.1.1.1 Operational synergy

The main source of operational synergy is the cost reductions arising from merging two or more companies. This cost reduction may result the existence of economies of scale or economies of scope. Economies of scale are the benefits that large companies have experienced since their fixed costs spread over more units and thus they have lower production cost per unit than small companies. Companies can both internally and externally grow to an optimum size for which the cost per unit is minimal. Through mergers acquisitions companies can grow externally. Economies of scope are the possibility for a company to create a set of input factors to a wider range of products to be offer. When a company is too small, this is not possible and therefore companies can grow through mergers and acquisitions to become a company that can enjoy these benefits.

2.1.1.2 Financial synergy

Financial synergy occurs when the cost of capital of a company drops by merge or by taking over another company. The cost of capital can be reduced after a merger or acquisition. This is the case if the cash flows of businesses are not perfectly correlated and the volatility of cash flows of the company has narrowed. A lower volatility makes the company less risky for investors and hence a lower premium is questioned. This effect is also known as “debt coinsurance” (Higgins and Shall, 1975). These authors argue that there is no additional value created by financial power, but that just different distribution among the creditors and shareholders. In other words creditors get more and the shareholders less. There have been some empirical studies that confirm this hypothesis, but others contradict this. In addition to debt coinsurance, there are other benefits that large companies experienced in financial markets. For example, large companies are seen less risky than small firms, making it easier to them to access financial markets and having a lower cost of raising capital.
Finally, the fixed costs associated with the collection of capital are equal to large and small companies, but the cost per unit of capital is lower for the large companies.

2.1.2 Diversification

Companies diversify through mergers or acquisitions. In this way they are able to lower the risk to investors and thus reduce the cost of capital. The reduction of this risk was explained by financial synergy.

Another reason why companies want to diversify through mergers and acquisitions is to enter more profitable industries. But there are two major drawbacks linked to expand in this way. First, the acquired or merged company which is now operating in a profitable industry has no guarantee that this industry will retain its abnormally high profits. Secondly, the abnormally high profits can only continue to the long term if it is difficult for other companies to enter this industry. Since firms are only able to buy companies from sectors which can be accessed easily, such merger will not have abnormally high profits.

Companies can diversify both a related and an unrelated merger or acquisition. The last option is called conglomerate. Rutherford (1992) defines conglomerate mergers or acquisitions as transactions in which two or more companies from different industries and that not belong in the same production do merge. In the third merger wave in the 60s conglomerate mergers and acquisitions were very popular for several reasons.

2.1.3 Increasing the market share

The most important goal when companies integrate horizontal, is an increase of the market share. They speak of a horizontal merger or acquisition when the concerned companies all belong to the same industry (Rutherford, 1992). Companies want to increase their market share because together with product differentiation and market barriers to entry for a company, it provides market power. The stronger the market powers of an enterprise, the more its ability to self-determinate the price and keeps it above the competitive price. The market power of an enterprise is determined by the structure of the market in which it is active. If there are many companies are operating, then this is called a competitive structure and all firms are called price takers. The other extreme is only one company and therefore there is a monopoly. Forms in between are monopolistic competition and oligopoly. Horizontal mergers and acquisitions can be transferred to a pure competition monopoly. This phenomenon was clearly visible at the end 19th century in the first merger wave.

2.1.4 Geographic expansion

When a company does no longer see growth opportunities in the region its active, it may be a solution to expand the activities to a new region. This expansion can be done in two different ways. The first possibility is to start a company from scratch in the selected region. However the expansion to a new region could also take place through an acquisition of a similar company that is already active in that region. This last possibility is again a horizontal merger or acquisition.

2.1.5 Supply chain forms

A supply chain is created through vertical integration. They speak of a vertical integration where the companies do not belong to the same industry, but several steps are within the same production chain (Rutherford, 1992). First, a backward merge or take over can take place. This means that a company closer to the supply of inputs, is taken over. The security in relation to the supply is the main motivation for such mergers or acquisitions. If the company does not own its supplier, then the relationship with its supplier suddenly ends. This brings additional costs. An example of this is that prices for the inputs of the future supplies can be higher than current prices. A second reason for a company to vertically integrate with its supplier is the need for specialized input factors of production. The company is totally dependent on the suppliers for specialized input factors. When the relationship with the supplier ends, the company faces high costs to adapt the production to new input factors. Companies can also forward merge or take over to get closer to their customers. Since companies often better compete after a merger to better compete, the consumer can also benefit from it.

2.1.6 The hubris hypothesis

Roll (1986) argued that mergers and acquisitions not only be based on economic founded reasons, but also personal motives of managers often play a role. This hypothesis of Roll explains why managers sometimes pay a premium for a company that really is correctly valued. The reason why these premiums paid at least is the fact that these managers estimate their own valuation higher than the valuation of the market.

If these are the causes or motives for M&A activities then these causes must have some consequences or effects. Since franchising has become more visible in the current business landscape (Combs, 2004), it became easier to compare several parameters within the mechanism franchising in order to draw some conclusions.

2.2 Franchising literature

Franchising means that a company (the franchisor) sells the rights for using its brand and business principles to another second company (the franchisee). But this still is not an answer on the question why a firm initiates franchising and how franchising impact different types of organizational performance.

Equity joint ventures and strategic alliances do differ from franchising. They can distinguish two characteristics in which franchising differ from them. The First typical characteristic of franchising is clear feature. Franchising occurs in businesses where the service needs to be done near the actual customers. This is the case for example for a hairdresser. This leads to replication and geographic spread of the service-providing outlets. Another key feature is that the business contract between a centralized principal (the franchisor) and decentralized agents (franchisees) contains a unique equilibrium of responsibilities, decision rights, and profits. It is the franchisor that has to set and implement standards for performance in the whole chain. The franchisor also has to select and approve its current and future franchisees, approve outlet locations, manage brand image, and coordinate activities such as purchasing where scale economies are available (Caves & Murphy, 1976).

The attention of a spectrum of researchers has been captured by the phenomenon franchising. For this reason it has been researched several times from different perspectives. It can be seen for example from the perspective of entrepreneurship. From this perspective franchising is a vehicle for entering business ownership (Shane & Hoy, 1996). Another example is the perspective of marketing. From this perspective franchising is defined as an important distribution channel (Kaufmann & Rangan, 1990). Other research has been done from the perspective of economics. The economic perspective says that franchising is a leading venue for understanding the structure of contracts (Lafontaine, 1992). Franchising has also been researched from the perspective of strategic management. In this light, franchising is an important organizational form (Combs & Ketchen, 1999)

The mainstream of published research about franchising finds is basis in either resource scarcity or agency theory. The first perspective is the perspective of resource scarcity. Viewing from this perspective towards the phenomenon, franchising is seen as a mechanism to ease financial and managerial constraints on growth. The agency theory perspective is different. This perspective defines franchising as a mechanism for improving the alignment between rewarding fees or incentives on a chain wide level.

2.2.1 Resource scarcity

The researchers Oxenfeldt and Kelly (1969) published a scientific article about resource scarcity. They conclude that firms franchise with the goal to gain access to scarce resources. In particular the financial and managerial resources (local decisions and market knowledge) are popular. This is done with the underlying thought of rapid expansion. A younger firm has more difficulties in raising capital for growth by the traditional financial markets for example with public stock offerings.  Raising capital for growth from existing operations is also very difficult. Other difficulties are the development of necessary managerial talent and knowledge of the local market (Katz & Otheyn, 1992). According to some other researchers rapid expansion may also be essential to build the economies of scale in purchasing and advertising necessary to effectively compete with more established firms (Caves & Murphy, 1976, Castro Giovanni & Combs, 1994). For this reason, firms are looking for access to the capital and managerial resources that are provide by franchisees when they build and manage outlets. This is even the case when returns might be higher for the outlets owned by the firm (Oxenfeldt & Kelly, 1969). The resource scarcity model that has been proposed by Oxenfeldt and Kelly (1969) is very clear. The firms turn to franchising because of the urgent need to benefit from economies of scale. This pushes the firms to expand at a higher rate than if they would only use internal resources. With the achievement of the economies of scale, expansion slows down. This leads to the fact that franchisors shift their focus on maximization of the returns. Since firm ownership seems more profitable, the franchisor will buy back its franchised outlets with the highest profits. A mature chain would slow down franchising and become primarily owned firm in the end, according to Oxenfeldt and Kelly (1969). Future studies have used franchisor age, chain size, growth rate and to measure resource scarcity, like Oxenfeldt and Kelly (1969). These studies looked at how the variables affect the proportion of franchised outlets. Some of the other studies have focused on resources like capital. However, there was a question that different researchers asked themselves. This question was if capital scarcity could be an independent factor for franchising. The assumption here is that franchisee capital is not as expensive as passive capital from sources such as for example stockholders and lenders (Norton, 1995; Rubin, 1978). Franchisees are not able to diversify their risk, they have to put their entire capital in one, or just a few outlets. For this reason capital from franchisees is considered too costly. The result of this is that franchisees that rationalize, ask for a premium on their capital above regular expectations, for the risk they take (Norton, 1995; Rubin, 1978). Since franchisees invest in their own capital, there has been a strong financial incentive (Minkler & Park, 1994). The motivational difference might be spot by passive investors that want a risk premium before they invest in firm-owned chains (Lafontaine, 1992). Another reason franchisees might sell capital at a lower rate than passive investors, could be the privately held information that franchisees possess (Combs & Ketch, 1999, Martin & Justis, 1993). The investors on the passive side, which have to rely on publicly available information, face greater uncertainty. This results in the raise of the risk premium of passive investors.

2.2.2 Agency Theory

We speak of an agency relationship whenever the first actor, the principal, is giving power to the agent, the other actor. It is the principal that should expend resources (called agency costs). This is to insure that the agents will act in the interests requirements they set (Eisenhardt, 1989, Jensen & Meckling, 1976). This is under the assumption that agents are self-interested and possess different goals than the principal's goals. The structure of a franchise chain offers the firm to choose who can serve as their outlet managers. These could be either an employee paid a salary. The other servants are the Franchisees that obtain the right to the profits of the outlet after royalties and other expenses. This also leads to an agency problem. This is because the franchisor delegates the power to make a decision to a local outlet manager. The interest of this local manager will not be maximal aligned with the interests of the franchisor (Rubin, 1978). There are two types of agency problems: vertical and horizontal.

Vertical agency problems are about the relationship between the franchisor and franchisees. Horizontal agency problems are related to the relationship between the franchisees themselves and between the franchisees and the managers (Combs et al, 2004).

In vertical agency problems we can distinguish problems caused by the franchisee and problems caused by the franchisor. Franchisees have to deal with inefficient risk spread since a large part of their personal financial resources is invested in the same store. This creates the possibility of filibuster behavior (free-riding) in relation to expenditures that are expected by them. Savings on product quality or advertising expenditure are not inconceivable. From the moment that the franchise contract starts, the franchisee could also start to show opportunistic behavior. In some cases, the franchisor offers the franchisee an available real estate property to carry out its activities. If the franchisee suddenly decides that he will only pay less than the fair rental fee to pay, the chance that the franchisor will admit to this are high. The costs to enforce the contract are higher than the benefits. A franchisor that wants to avoid free-riding and opportunistic behavior of the franchisee may consider building own stores instead of franchising. However, also working affiliates does not always avoid potential vertical agency problems. The administrators or managers often earn a fixed salary, so they are not exposed to the incentives of performance-related income of the franchise holders. Consequently, managers are more likely to avoid their real work and try to get additional benefits from their position (Brickley & Dark, 1987).

2.2.3 Vertical agency problems caused by the franchisor.

As the franchisor's responsibility remains responsible for the value of the brand, he can show filibuster behavior due saving expenditures on quality, national advertising or the provision of training for management assistance of its franchisees. Moreover the franchisor cannot hold arrangements for example when opening franchise units too close to each other. Further a franchisor can show opportunistic behavior after the completion of the contract at the expense of the franchise holders. Suppose that the franchisee recently invested a lot of money in the establishment of his store. If the franchisor can threaten the termination or non-renewal of the contract before the end of its useful life of the investment, the franchisee is likely to accept higher franchise fees when the value of the return is low in alternative use of the investment (Brickley & Dark, 1987).

2.2.4 Horizontal agency problems.

Control problems between the franchisees themselves, the managers and between the franchisees and the managers are much less frequently discussed in the literature. However, these problems do rise up in practice. There may be filibuster behavior between the franchisees themselves because of the increasing mobility of customers.

The franchisees may be tempted to drop its commitment to respect the quality standards within the network, assuming that the customer will buy the product or service through a positive experience in a related franchisee. A similar possibility is that too few franchisees invest in advertising because they rely on the distribution of the impact of advertising spended by other franchisees within the chain (Brickley & Dark, 1987, Carney & Gedajlovic, 1991, Combs et al, 2004).

Since the franchisee is legally considered as an independent entity, the franchisor cannot control this entity via the classical control mechanisms that are used within an organization. Below, I discuss below the majority of the formal and informal control mechanisms in franchising. In this context I am also discussing the role of a dual distribution strategy and the constitution of a master franchisee.  To avoid vertical and horizontal agency problems within the franchise chain, and if necessary to resolve these problems, the franchise contract is crucial. First, the contract specifies issues, making franchisees know what they should focus on. In other words, the contracts allow self-control in a specified form. In addition, the contract contains certain regulation on the operation within the franchise network, but also the conditions for ending the franchise agreement. Also behavior control is a formal control form in franchising. Because of the independent character of the franchisee it cannot be used in the same degree as branches. Towards franchisees, franchisors use mystery shoppers and audits by franchising consultants to demonstrate their control. Since franchisees do not automatically have to share all their financial information to the franchisor, extensive output control is rarely possible. However, for calculating the periodic royalty fee the franchisee has to present its monthly income. This allows limited output control to the franchisor. Most of the complaints given by customers that are dissatisfied are giant source of information of which the franchisor can benefit. More than often, the franchisor places its contact details on the invoices of the franchisees, so he can be contacted in case of complaints.

Benchmarking plays an important role in franchise networks. Here a dual system consisting of both franchisees and branches create a useful tool to control the franchisor. When comparing the performance of the franchisees with the branches, internal competition will arise in the network. As a high performance in a new branche will set the standard for the others, the pressure will systematically go up. At the same time, franchise network parties can draw inspiration from the comparison of implemented innovations that sometimes is the initiative of the company and other times is the initiative of franchisees (Bradach, 1997; Brickley & Dark, 1987, Combs et al, 2006; Dante & Nasr, 1998). Building on the formal control play informal basis and social control a decisive role within franchise chains (Bradach 1997). In the first place franchisees are carefully selected (Doherty & Alexander, 2006; Jambulingam & Nevin, 1999). It is not unusual for operational managers within the chain to grow towards a franchisee. If the franchisor has very good experience with this manager, there’s also a great confidence in the former manager. Because of the same key factor - confidence - some franchisees also become master franchisee of a region. It gives the franchisor the feeling that he controls the risks inherent to the selection process (Bradach 1997). Second, the franchisor provides training and support to the franchisees. Especially services, marketing and technical skills are addressed. Besides much of the technical knowledge, also the business culture within the chain is given trough by this network of franchisees (Combs et al, 2006, Michael, 2000, Quinn & Doherty, 2000). A third aspect concerns account management and providing communication between the franchisor and its franchisees. Several times a year, the franchisor and the franchisee come together to discuss business in meetings. Moreover affiliated franchisees often unite in franchise councils. Some of the elected represent the total group of franchisees within the chain. The franchise councils have frequently contact with the franchisor. Within a Franchise Board, several topics will be discussed, ranging from the strategy of the chain the specific challenges the chain is facing (Bradach, 1997, Combs et al, 2006). The exchange of information between the franchisor and the franchisee is thus an important indirect form of control (Dante & Nasr, 1998).

Kidwell et al (2007) show that interaction between the franchisor and franchisees, increased formalization and decentralized decision making associated with less filibuster behavior by the franchise holders. Dahlstrohm and Nygaard (1999) found that cooperative interaction between franchisor and the franchise holders reduces the negotiation costs and that formalization helps reduce opportunism. As has been discussed in terms benchmarking above, a dual distribution strategy offers that branches and franchise outlets combine specific opportunities for management control within the chain. Because of the flexible and decentralized structures, franchisees can follow a strategy of flexibility and local adaptability. Their method is more exploratory, which is useful in a heterogeneous and complex environment. The management control systems of branches stimulate the company mainly to the exploitation of existing routines, rather applied in a homogeneous and simple environment. Therefore branches will pursuit predictability and control (Yin & Zajac, 2004). Because their research shows that a dual chain leads to the best performance, Sorenson & Sørensen (2001) recommend franchisors to follow this dual strategy. However, at the same time, they admit that the optimal mix of units depends on the heterogeneity of the environment which the chain is facing.

2.2.5 Effect studies

The literature distinguishes different degrees of market efficiency. Looking at the weakest form of the theory, we can say more about the disclosed information. The weak form of efficient market theory tells us that the capital markets only information relating to reflect the past. In the semi-strong form, is that the capital markets reflect current information. Testing this hypothesis will be supported by empirical research on the immediate impact of certain events, such as results announcements, dividend payments, profit forecasts and merger proposals on stock prices. In the strongest form of market efficiency, it is there that the operators active efforts and self-information gathering by means of fundamental analysis on the state of the listed companies and the economic situation in general. Empirical research has shown that even the most educated institutional investors systematically fail to outperform the market. In that raises serious doubts about the likelihood of strong efficient capital market hypothesis.

3 Data & Methods

This chapter gives an overview of the data and methods I used to shape my exploratory research. Besides data from different sources, I also conducted a case study.Part of this case study was also an event study to the price effects on stock after announcements of mergers and acquisitions done by Yum.

In section 3.1 I will indicate what data I have used and what sources I used.In section 3.2 I explain briefly what a case study is and why this method has been selected.Then I explain in section 3.3 how I did the event study.

This chapter contains a description of the research methods.The results of the event study are listed in table 9 in section 9 of chapter 4.The full descriptions of the announcements of the mergers and acquisitions done by Yum can be found in Appendix A in the back of my thesis. The press releases in the appendix has been taken over directly from Thomson ONE Banker.

3.1 Data & Sources

Since my thesis also contains a case study about the company Yum, I collected as much as possible data about this company.

In the last part of my thesis I have conducted an event study and calculated the abnormal returns of Yum relative to the market and to the industry per event. For this event study I used various sources. For the dates of the rate information I used ‘DataStream’ and ‘CPRS’. For the dates of the various events I used Thomson ONE Banker software. This data has been collected with the help of the data team in the library of Erasmus University.

For the calculations regarding Yum’s system breakdown and relative revenues I used the annual reports of the past decade. Furthermore, these annual reports also have been used to collect information about the strategy of Yum and the financing of its M&A activities.

3.2 Case Study

Because I wanted to look at the causes and effects of the mergers and acquisitions of Yum, I decided to use a research method called the case study. For this case-study I will analyze the strategy, growth, financing and performance of Yum. This section briefly explains the principles of a case study and gives a short introduction on the case study I did on Yum.

A case study is a study where the researcher tries to fully understand one or more spatially limited objects or processes.These objects or processes could include an organization or a company. There are several ways a case study can be designed.I will not deal with all these possibilities but I will discuss the techniques used by me.

An important feature of a case study is the research units used in case study.In the case of my thesis, I examined only Yum and thus using a single 'case'.This may have different consequences for my further research design.In the first place such that a quantitative analysis will be tricky in the context of comparing and calculating with quantitative data of only one case.For this reason I extended my case study with an event study to say something meaningful about the quantitative data.The next section explains the event study further.

Since I knew little of the topic I chose for an exploratory research design.The choice for the QSR industry (fast food) is quite logical because these different cases are all very similar.This enables me to minimize most common variation in the results.Whenever I had chosen for a less comparable industry, it could have been difficult to achieve general and descriptive, meaningful conclusions.

In the case of Yum, I investigated the causes and effects of mergers and acquisitions to gain deeper insight into the success factors of a franchise. As a starting researcher the case study had to offer me some very interesting opportunities.The first advantage is that it is quite easy to work out a case study within manageable proportions.This compared to a survey in which more research units are desired.Another great advantage is the applicability of a case study. The case study is applicable in almost any situation.In an experiment or survey I linked to having more research units or on moral or practical objections to encounter.

3.3 Event Study

For this research I will have to conduct an event study. This event study is needed to gain insight into the effects (volatility) of the press releases. This data will be used to analyze the correlation between the causes and the effects in mergers and acquisitions in franchising.

Usually the stock rate has a specific volatility. The impact of the press release will influence this specific volatility. The stock rate after the influence of this is known, because it is the rate presented in the stock rate index. The impact of the press release is the variable I want to calculate and the volatility if there had not been a release is a variable I can only estimate. Therefore, I will calculate the abnormal return with the stock rate after a press release, in order to see if there are any commonalities.

For this research I will have to conduct an event study. This event study is needed to gain insight into the effects (volatility) of the mergers and acquisitions of Yum. This data will be used to compute the correlation between this data and the MSCI world index.

Usually the stock rate has a specific volatility. The impact of the press release will influence this specific volatility. The stock rate after the influence of the merger is known, because it is the rate presented in the stock rate index. The impact of the press release is the variable I want to calculate and the volatility if there had not been a release is a variable we can only estimate.

The stock rate, after a press release is calculated as follows (Abraham [1999]):

ARit = R it * E(R| No press release)

ARit is the abnormal return for firm i on time t, ergo the impact of the press release. Rit is the actual return which is stated in de stock rate index and the equation E(Rit|No press release) is the variable we have to estimate. Abraham (1999) states that the E(Rit|No press release) can also be written down as:

R it = αi + βi (Rmt) + εit

However Abraham (1999) uses αi and βi which are values derived from the Center for Research on Security Prices (CSRP) value-weighted index of all securities in time. These are set up by the University Of Chicago School Of Business.

This part of my research will result in (positive and negative) abnormal returns from press releases on the stock rates of Yum.

Iwant to examine the time span of the abnormal average return. I will use a time span of 1 day before until 1 day after the disclosure.

For each release I will take the date and then we analyze the abnormal return ARit, per time span. In order to make a valid comparison between de different abnormal return, we use the average abnormal return 1 / nARit, where n is the time span. We will look at the average abnormal return per time separately as well as the cumulative average abnormal rate of return of the five time spans (Abraham,1999).

4 Case study

In this part of my thesis I will look at the causes and effects of the mergers and acquisitions of Yum. For this case-study I will analyze the strategy, growth, financing and performance of Yum. This section begins with a short introduction of Yum.

4.1 Description of the company

Yum is the largest restaurant company worldwide. This claim concerns the management and control over 35,000 system restaurants. It is managing and controlling over 35,000 restaurants in over a hundred countries and territories. The brands of KFC, The Pizza Hut, Mexican food restaurant Taco Bell, Long John Silver’s or the A&W outlets are the brands that are exploited by all these restaurants owners.

The most popular brands were the Kentucky Fried Chicken, The Pizza Hut. Next to that came the brand of Taco Bell and Long John Silver’s restaurants. Worldwide, these brands all dominate in their own category of food. Of the over 35,000 restaurants, 22 percent are operated by the company itself. Another part, which is 72 percent of the whole, will be operated by franchisees and unconsolidated affiliates. The other 6 percent, the rest, will be under responsibility by licensees.

The restaurant business of Yum has been split into three reporting segments. These are the United States Division, the International Division and the China Division. The last mentioned division, the China Division consists out of the mainland of China. Next to China also Thailand and the outlet stores of KFC Taiwan are in the same region. This leads to the fact that the International Division is all the other countries of their global activities. The China Division and the International Division both experienced very strong growth. They now represent more than 50 percent of the operating profits of the company. The business division in the United States has to operate in a highly competitive marketplace. This may result in lower profit growth, but still produces constantly strong cash flows.

As written in the Introduction I will use a 4-step program to analyze the causes and effects of mergers and acquisitions in franchising.

4.2 Competition

The Quick Service Restaurant industry (QSR) is the industry where all fast food restaurants come together. As a part of this industry, Yum is primarily competing with McDonald's, Domino's Pizza, and Burger King Holdings.  Other direct competitors of Yum are Darden Restaurants Inc., Starbucks Corp., Brinker International Inc, Autogrill S.p.A., Wendy's International, KFC Corporation, Whitbread, and OSI Restaurant Partners. The last five companies in this list are private companies. Since these companies are all having stores around the World trough a franchising model, they can be compared with Yum. They also have the same core product, in other words they all sell fast food to their customers. In this light my research on Yum is representing the entire industry.

Because Yum is in the QSR industry, it has to deal with commodity prices, health concerns, and intense competition. The most important ingredient for Yum is the chicken. But also other commodities like for example beef, flour and beverages are very important commodities. This means that if commodity prices rise there will be competition that makes it hard to respond. This could be done for example by setting higher prices. Also issues as health and obesity are a constant factor of concern in this industry.

4.3 The strategy of the company

By looking at the strategy of a business you should be able to determine the kind of mergers that they will probably do. As reflected in the literature section, there are certain objectives to do a merger or acquisition. I will briefly describe what the strategy of Yum was in 1999 and 2008. These strategies are also disclosed in the annual reports on the website of Yum.

For 1999 Yum has its focus on a key strategy. These are:

“Consistent Same Store Sales Growth with a Portfolio of Three Leading Brands

The primary way Yum is measured in the industry is by consistently delivering same store sales growth. In 1999, Yum delivered strong combined U.S. same store sales growth of 4 percent, on top of 4 percent combined growth in 1998. Yum is committed to consistently delivering 2–3 percent combined same store sales growth, year after year. Importantly, their unique portfolio of three leadership brands enables them to deliver these results in the U.S., even if one of their brands is temporarily experiencing some ups and downs. Their intention is to have all three brands clicking at the same time; but it’s a unique strength to have a portfolio of leading brands where stronger performance by some can offset any short-term softness at others. In addition to their existing products and continued operations improvement, a key driver of same store sales growth and one of their most important achievements in 1999 was their new product success.” (Annual report, 1999, page 4)

For 2008 Yum has its focus on their key strategies. These are:

“Build Leading Brands in China in Every Significant Category

The Company has developed the KFC and Pizza Hut brands into the leading quick service and casual dining restaurants, respectively, in mainland China. Additionally, the Company owns and operates the distribution system for its restaurants in mainland China which they believe provides a significant competitive advantage. Given this strong competitive position, a rapidly growing economy and a population of 1.3 billion

In mainland China, the Company is rapidly adding KFC and Pizza Hut Casual Dining restaurants and testing the additional restaurant concepts of Pizza Hut Home Service (pizza delivery) and East Dawning (Chinese food). Their ongoing earnings growth model includes annual system-sales growth of 20 percent in mainland China driven by at least 425 new restaurants each year, which they expect to drive annual operating profit growth of 20 percent in the China Division.” (Annual report, 2007, page 3-9)

“Drive Aggressive International Expansion and Build Strong Brands Everywhere

The Company and its franchisees opened over 850 new restaurants in 2007 in the Company’s International Division, representing 8 straight years of opening over 700 restaurants. The International Division generated 480 million US Dollar in operating profit in 2007 up from 186 million US Dollar in 1998. The Company expects to continue to experience strong growth by building out existing markets and growing in new markets including India, France, Russia, Vietnam and Africa. Their ongoing earnings growth model includes annual operating profit growth of 10 percent driven by 750 new restaurant openings annually for the International Division. New unit development is expected to contribute to system sales growth of at least 5 percent (3 to 4 percent unit growth and 2 to 3 percent same store sales growth) each year.” (Annual report, 2007, page 3-9)

“Dramatically Improve U.S. Brand Positions, Consistency and Returns

The Company continues to focus on improving its U.S. position through differentiated products and marketing and an improved customer experience. The Company also strives to provide industry leading new product innovation which adds sales layers and expands day parts. They are the leader in multibranding, with nearly 3,700 restaurants providing customers two or more of their brands at a single location. They continue to evaluate their returns and ownership positions with an earn the right to own philosophy on Company owned restaurants. Their ongoing earnings growth model calls for annual operating profit growth of 5 percent in the U.S. with same store sales growth of 2 to 3 percent and leverage of their General and Administrative (“G&A”) infrastructure.” (Annual report, 2007, page 3-9)

“Drive Industry-Leading, Long-Term Shareholder and Franchisee Value

The Company is focused on delivering high returns and returning substantial cash flows to its shareholders via share repurchases and dividends. The Company has one of the highest returns on invested capital in the Quick Service Restaurants (“QSR”) industry. Additionally, 2007 was the third consecutive year in which the Company returned over 1.1 billion US Dollar to its shareholders through share repurchases and dividends. The Company is targeting an annual dividend payout ratio of 35 to 40 percent of net income.

In the case of Yum certain exclusive or protected area’s have to be granted to a selective group of franchisees. This is done because in theory, the franchisees seem to be willing to invest in areas if there’s less competition from their own brand. Yum has to be careful that it does not make areas to exclusive by granting it to just one entrepreneur. This could influence the market penetration. With larger unserviced or underserviced areas, Yum could weaken its network. Therefore Yum should focus its strategy on the potential market penetration of an emergent market and use that information to grant exclusive or protected area’s to its franchisees.” (Annual report, 2007, page 3-9)

4.4 The growth of the company

In this section I will further look at the growth of Yum. I also will look in the equilibration of the profits between their own stores and the stores of the franchisees. The restaurant business of Yum has been split into three reporting segments. These are the United States Division, the International Division and the China Division.

4.4.1 System units growth

Yum’s strategy can be seen in the number of stores and their allocation. This was examined by putting together the annual reports of the last ten years. The annual reports from the last decade disclose this information. In the overview below we can see the growth per segment as mentioned before.

Table 1 System Units Growth of three reporting segments

By making a graph of these numbers we can easily see the relative market share of each shop. As we see Yum has started to exploit Long John Silver’s (LJS) and A&W since 2001. As disclosed in the annual report of 2002; “As we expand Taco Bell and KFC by adding Long John Silver’s and A&W under the same roof, we expect to take volumes to an average of at least a 1.1 million US Dollar per restaurant. As we do, we plan to make Long John Silver’s and A&W national brands and dramatically increase their marketing clout”.

From 2001 Yum discloses information about their brand stores in China. In the table below I give an overview of that data. Below the data you can find the visual graph of it. In the table and figure we can see that only the brands of KFC and Pizza Hut are playing a major role in China. After a year, the growth slowed down a little, but was consistent. A little further in this section I will analyze how this instant growth since 2001 has been established.

4.4.2 System UNIT Breakdown of the United States

In the overview below you can see the breakdown of system units for the United States. The other tables provide the same overview for the international and China division.

Table 2 System unit breakdown United States for period 1998-2006

Below I will make a graph for every brand in the United States. The first one will be the graph of the system unit breakdown of stores of Kentucky Fried Chicken. After that the graphs of the other brands in the U.S. follow.

In figure eight and nine we see the visual representation of the start of the exploitation of Long John’s Silver and A&W. These figures can be interpreted as a visual representation of the strategy of Yum.

Figure 9 System unit breakdown A&W in period 1996-2006

We can see a decrease of the total number of stores for all the brands except KFC. This can be further analyzed by looking at the International system unit breakdown in the next section. As described in section 4.3 the strategy in 1998 was to have three strong brands. But compared to the strategy in 2008 described in the same section, the activities of Yum had to be more global. As one of the key strategies states ‘Build Leading Brands in China in Every Significant Category’. Because of this Yum moved its activities from the US to other parts in the world. There should be no misunderstanding about the fact that A&W is not a new brand. Since 2002 it is controlled by Yum (Tricon at that time) as one of its brands. Before 2002, A&W served American hometown favorites since 1919. The slowdown in the growth has to do with the fact that Yum was building down the own company stores. Also, it had to do with the further development of co-branding opportunities. Not every outlet location had the opportunity to put multiple brands in one outlet store.

4.4.3 System unit breakdown - International

As the numbers and graphs tell us, the number of company stores decrease while the number of franchised stores increase. Furthermore, I also did the same analysis for the data of the International and Chinese division. The graphs of the system unit breakdown in these divisions can be found below.

Table 3 System Unit breakdown International for period 1998-2006

In order to let all the operations been overseen by a single senior manager, PepsiCo drew together its restaurant divisions in the nineties. Also a major share of the back office operations became part of the responsible manager. This included payroll, data processing, and accounts payable. In the first month of 1997 PepsiCo decided that they wanted to spin off this restaurant division and create a new publicly traded company. The name of that company was Tricon Global Restaurants Inc. and was focused on the fast food industry. The board of directors approved up on the fact that shareholders received a new share. The deal was that a shareholder could receive one share of the new company for every ten shares of the old company. Also the SEC approved this deal and it was completed on the 6th October in 1997.

The graphs of KFC, Pizza Hut and Taco Bell show that these brands did very well after this merger in terms of System Unit Breakdown. The mother Tricon directly started to bolster the revenue and profit of these brands by implementing new business concepts. Another strong believe of the Tricon formula was to have very close relationships with the actual franchise stores.

Tricon started selling off the company owned stores for Taco Bell to their franchise holders. A possible explanation for this is that these franchisees are already known with the Tricon formula. As I discussed in the theory part of this thesis;” Others contend that franchisee capital might not come at a higher risk premium. Franchisees have a powerful financial incentive because they invest their own capital; employees confront weaker incentives (Minkler & Park, 1994).”

Another example of this is Pizza Hut. Many of the Pizza Hut stores were offered back to franchisees of Tricon. Also their corporate office managed all the activities from its new location in Dallas, Texas (US). In 2000, KFC began activities in Vietnam and Guadalupe.

Since Tricon wanted to become a leader in the QRS-industry, its management worked out several strategies to face and deal with the other competitors. Early 2000 their supplier AFD Inc. went bankrupt. This was solved by another company that bought the supply company. Tricon faced a claim in 2003 of 30.1 million US Dollar. This was due to a conflict about a stolen advertisement with a speaking monkey.

In 2002 Tricon changed its name to ‘Yum! Brands Inc.’ because they wanted their shift to a multi-branding strategy reflected in their name. It must be mentioned that the official Yum name contains an exclamation point (!). In this year Tricon also made a 320 million US Dollar deal with Yorkshire Global Restaurants Inc. to combine the Tricon activities with Long John Silver’s restaurants and A&W restaurants. This resulted to almost 2000 stores that offered at least two of Yum’s Brands.

Since 2002 it is controlled by Yum (Tricon at that time) as one of its brands. For the China division there’s a different pattern than in the United States. From the data in table 3 it becomes clear that there are an increasing number of A&W franchisees in the China division. The number of LSJ outlets remains more or less constant. Because of the deal that Tricon had with Pepsi, LSJ and A&W switched from Coca-Cola to Pepsi. For a company that sells food since 1919, changing the recipe is a very big step since their customers get served something different. Also other challenges had to be faced in China. There was heavy competition from Mc Donald’s and other local (and international) competitors. Worldwide there became more attention to the healthy nutrition values of fast food. Next to that there was a risk of an outbreak. This concerned the outbreak of a bird flu epidemic.

Since Yum wanted to strengthen their position in the China division, the growth in figure 13 and 14 is very logical. According to the multi-branding strategy that Yum has, the number of combined stores will grow with the introduction of LSJ and A&W.

4.4.4 System Unit breakdown China

Below is the data table for the China division. No data about this region has been disclosed before 2004. There was no data for LSJ and A&W at all.

Table 4 System unit breakdown China for period 1998-2006

The company did also concentrate on its international activities. China, the United Kingdom, Mexico, and Korea were seen as the best possible options for international growth. In China the number one market leader was KFC with almost a 1000 stores.

The first Quick Service Restaurant within the borders of China was KFC. In 1987 the first store was opened in Beijing. With 200 restaurants in 1997 and currently over a thousand stores employing 50000 people, KFC is the absolute leader. It was not Mc Donald’s but KFC that opened the first drive-thru restaurant. In this way KFC was able to anticipate on the growing needs for luxury of the Chinese people. Since 2006 Yum opened more than 1000 new international restaurants per year. With their portfolio of leading brands they were able to create an equilibrium between the turnovers of the US and China.

The growth of Yum in overseas areas can easily be called strong. China is a Yum division since 2005 due to its overwhelming success and rapid expansion. Nowadays Yum is the dominant QSR company in the China division. They own twice as many restaurants as for example McDonalds. The international and China divisions both established 25 percent operating profit growth in the year 2006. This is seen in contrast with the US division that struggled in the same period. Taco Bell also had some struggles for example an outbreak of E. coli in the year 2006. Next to that there has been a rat incident in the year 2007. When Taco Bell same stores sales dropped 11 percent, the situation was merged to the other difficulties faced in the US. This all together resulted in a 2006 same store sales decreased 3 percent as well in the company owned as for the outlets owned by franchisees. The plans of Yum are to make a turnaround in the US. They intend to do this by re-franchising. Also the introduction of new recipes is part of the strategy. The quality of all the restaurants also is part of this turnaround. Since over 59 percent of the revenues of Yum are represented by the United States, the first priority must be a turnaround in this region.

4.5 Ratios Worldwide Sales

In this section I already looked at the growth of the different brands. Also, I looked how this growth has been divided into company stores and franchisee stores. In order to see which of the stores is most profitable, I will look at their sales. If the sales between company stores and franchisee stores have a different ratio than the ratio of the system unit breakdown it’s considered more profitable. Below is a table of the system sales in the U.S. per brand. There is no data for 1998. For example, in this table we can see that in 2006, 1,4 billion (equal to 26,42 percent) of the KFC revenues have been generated by company stores at 3,9 billion (73,58 percent) from the franchisee stores. In the next section I will examine ratios of the system unit breakdown for the company stores as well as for the franchisee stores. If these ratios are not the same, it shows us that one of the two concepts is more efficient in generating profits.

Table 5 System sales United stated for period 1998-2006

4.6 Relative system breakdown

In the table below I processed the ratios of the system unit breakdown for the company stores as well as for the franchisee stores. For example, in 2006 19 percent of the KFC stores are company stores and 81 percent of the stores are Franchise stores. As it is shown in the table above, 19,27 percent of the stores are responsible for 26,42 percent of the revenues. This indicates that the KFC company stores are more efficient than the KFC franchise stores where 80,73 percent of the stores is only generating 73,58 percent of the revenues. For LSJ and A&W there was no data available before the year 2002.

Table 6 Relative system unit breakdown United States for period 1998-2006

If we now compare these two tables we can see that there are differences in generating profits. In the table below I processed these differences. It becomes very sound that in 4 of 5 brands the company stores are more profitable. The company stores of KFC, Pizza Hut, taco Bell and LSJ generate respectively 7,15, 3,53, 3,58 and 8,79 percent more revenues compared to the franchise stores. A&W is the apparently the only brand where the franchise stores are performing more efficient than the company stores. In 2002 we can see an equal situation for LSJ, which after 2002 turned around. The rest of the brands show the same pattern from 1999 until 2006. One of the key explanations for this can be the refranchising strategy, which is mentioned in the annual reports. I will further explain the idea behind Yum’s refranchising strategy in the section below.

This table shows the relationships between the percentages of company ownership versus revenues for the US. I simply combined both tables above and subtracted them from each other.

Table 7 relationships between company ownership and revenues in the US for period 1998-2006

4.7 Refranchising

Looking at Yum’s refranchising activities between 2001 and 2002 it is clear that this has been decreasing. This means that the new stores of LJS and A&W are new stores. In the overview below gives an overview of the refranchises over the years 1998 – 2006.

Table 8 Overview of refranchising in period 1998-2006

The above overview is of the refranchising Yum did. Yum sells Company restaurants to existing or new franchisees. They do this in areas where geographic synergies can be reached. Mostly these are also the locations where their overall operating performance can be improved. At the same time Yum keeps ownership of the key outlets in the United States and International markets. The reason for these refranchisings is that they reduce their reported company sales and restaurant profits while increasing their franchise fees. The proceeds from refranchising increase the level of cash available to fund discretionary spending.

4.8 Financing growth

There are several ways to finance a merger or acquisition. In this step, on the basis of the report, I will describe how the various mergers and acquisitions have been financed. Thomson ONE Banker discloses the value of the deal. The explanation of the funding of the deals can be found in the section "Management's Discussion and Analysis of Financial Condition and Results of Operations" under the heading "Consolidated Cash Flows" in the annual reports.

An amount of 432 million U.S. dollar net cash flow came from investing activities.A year earlier, in 2006, this was a sum of 476 million U.S. Dollars. This downward trend has been caused by simultaneous activities that lapped. First, in 2006, there was the acquisition of the remaining interest in their Pizza Hut U.K. unconsolidated affiliate. Second, there were proceeds from selling their interest in the unconsolidated affiliate in Japan. This took place in the last month of 2007. Since the proceeds from refranchising will differ every year, they partially cause the downward trend in net cash flow. Next to that, there has been an increase in capital spending in 2007.

The consolidated subsidiary in Japan was sold in December 2007.This was an amount of 128 million U.S. dollars (this amount was included changing exchange rates).The owner was an international subsidiary.However, this subsidiary works with a fiscal calendar that ends a period earlier than that the consolidated periods of Yum ended. The reporting of this event is consistent with their historical approach of reporting during the initial period. This will result in pre-tax gains. This means that the sale of this investment has gains of some 87 million US Dollar that will be accounted in the first quarter of 2008. The proceeds of this deal were moved from their international subsidiary to the U.S. in the last month of 2007. This results in the report of these proceeds in their consolidated statement of cash flows.

The fiscal year ends on the 29th of December 2007. On this date they close the books for that fiscal year. On the balance sheet, this cash is reported in accounts payable. It will also get reported under other current liabilities. Furthermore, it is interesting to mention the net cash that was involved in investing activities. This was 476 million US Dollar in 2006. A year earlier, in 2005, this was a sum of 345 million U.S. dollar. This upward trend was the result of some acquisitions. One of these acquisitions include the remaining interest in Their Pizza Hut U.K. unconsolidated affiliate. The other was the acquisition of the ‘Rostik’ brand and all the intellectual properties in Eastern Europe that was associated with that.

In 2007 Yum used 678 million US dollar in financing activities. A year earlier, in 2006, this was a sum of 670 million US dollar. This was the result of a more expensive share repurchases. Another reason was higher dividend payments. This increase was for a part the result of the net borrowings that increased. In 2006, Yum used 670 million US dollar in financing activities. A year earlier, in 2005, this was a sum of 827 million U.S. dollar. The decrease was caused with on the one hand net borrowings that increased. At the other hand the decrease was driven by share repurchases.

4.9 The performance of the company (Event study)

According to the data of Thomson ONE Banker, from 1999 until 2009 there have been 21 events related to Yum’s mergers and acquisitions. In the table below I give a brief overview of these events. In section 3.2 I explained how I calculated the returns in this overview. The data I collected has been used to compute the correlation between this data and the MSCI world index.

Usually the stock rate has a specific volatility. The impact of the press release will influence this specific volatility. The stock rate after the influence of the merger is known, because it is the rate presented in the stock rate index. The impact of the press release is the variable I want to calculate. As mentioned before, the volatility if there had not been a release is a variable I can only estimate. The complete overview of the table 9 below can be found in appendix A.

Table 9 Major Acquisitions of Yum During period 1998-2009

4.10 Analysis of the events

By adjusting for the returns that come from the fluctuations in the prices in the whole market I can find the abnormal return. This is the abnormal return that is attributable to the event being studied.

After analyzing the data, 6 out of 21 events had a negative abnormal return compared to the entire market. Every time this counts for the market it also counts for the industry. Except in the event of 03-17-2003, when the industry (-1,69 percent) had a negative return while compared by the entire market (1,30 percent) there was a positive return.

The highest abnormal return of 6.47 percent was achieved in the event of 01-24-2008. The event with the lowest abnormal return was on 11-06-2008 and was -5.83 percent. Also, three of the negative abnormal returns are found in the period from 2000 until 1998, this means that 50 percent of the negative returns are found in 20 percent of the entire time span of the event study.

Yum did takeover Tricon Global Restaurants. The Yum franchise organization owns it and operate three brands. These brands are the well known names Taco Bell, Pizza Hut, and KFC. It can be considered fascinating that neither one of these brands is in the burger and fries field. This makes them able to dominate their own share of the fast food market to operate.  In the Mexican food it is Taco Bell that has a 64 percent share. For chicken, the KFC has a position of 46 percent in the market. Another giant is the Pizza Hut. They carry around a share of 15 percent of the market. This is as big as the whole next largest chain.

In 2002, the mother organization bought two new restaurant brands. These were the outlet stores of Long John Silver's and A&W. The acquisition was the start for letting the name Yum Brands grow.

From the beginning, it has been very good for investors. The stock of Yum has been up to a cumulative 71.8 percent. This was in a period that the S&P 500 only had a performance rate of -4.4 percent. A former chief executive of KFC showed great leadership for the company. At least much of what investors consider as very good. Under his leadership over the past five years Yum boosted its profits, paid off debt, and became an impressive innovator in their menu offerings. Even in 2003, in the face of intensified industry-wide price competition. In that year it was Yum that has been the only one that could stand the declining estimates of earnings in the year before.

4.11 Events related to Yum’s strategy

Each year, Yum's strategy is disclosed in its annual report. This strategy will change a little each year. Based on the newly formulated strategy, mergers and acquisitions sometimes have to be done to achieve these goals. All mergers and acquisitions are therefore in line with the strategy. Yum will not have stores in Peru as its strategy is a bigger market share in China.

In general, most of the abnormal returns are positive. This can be explained from the idea that investors apparently agree with the strategy or direction of Yum. When abnormal returns were negative then this is the result of trade in the share. When the price drops, it is more supply than demand. Apparently, there are relatively more shareholders who have sold their shares. There can be several reasons for that according to the theory.

Regarding the strategy of Yum it is clear that Yum offers low prices on a competitive and capital-intensive business. If Yum is comparing the low prices to its peers, often called the competitors in the same industry, some remarkable positive points stand out. Below, I will start with the positive ones;

Yum has the highest Return On Invested Capital (ROIC) of the industry. In terms of capital efficiency, Yum and its franchisees are leading in the QSR industry. Capital efficiency is the most important regarding business excellence. Compared to its peers,the companygenerated a much higher return on invested capital. Its higher ROIC signifies that Yum is a superior operator. This means that Yum is using its resources more productively than the peer Group of competitors.

Yum earns most of its money with the franchise fees. The biggest part of the profits of quick-service restaurant companies comes not from selling food but from franchise fees. The business of Yum generated around 800 million US Dollar annually from fees that were paid by its franchisees. The number of fee income is a gross margin in excess of 90 percent. Its Franchisees have to pay an upfront fee and in return for that they get the franchise rights. Next to this there is a continuous fee which is calculated with a percentage of the annual sales of the franchisee. With doing business in this way, Yum is able to hold the economic benefits of the outlets, no necessary capital investment needed. This Works similar as the concept of Coca-Cola. They sell only the high-margin soda concentrate. In this way they leave the asset-intensive distribution to its bottlers.

Yum has a strong international growth potential. In many countries that are considered key countries, the overall market leader is Yum. This includes for example China, Mexico, Korea, and Thailand. The number of international restaurant units is now around 11,000. These are split in about 60 percent KFC and 40 percent Pizza Hut. Yum intends or at least has the ambition to add another 1,000 units per yearin the future. Yum is very good at exporting its brands. For example KFC,the chicken companyopened its 1400th restaurant in China. This happened 22 years since its first restaurant in China in 1987. Today 150 Chinese cities have a KFC restaurant. In this context it has become the largest QSR player in China. Next to that it is also the oldest and most popular player in the market. Moreover, they are even more popular than brands such as Nike or McDonald's.

Yum is focusing on their ‘Multi-branding strategy’.Compared to the international field, the quick-service market in the United States is more mature. Yum has its own way to capture market share and stimulate profitability. Yum combines two of its brands to a new concept in a single restaurant. This is known as what Yum refers to as "multibranding". These innovations result in higher sales profits. Combinations like for example KFC with Taco Bell and Taco Bell with the Pizza Hut have around 20 percent higher unit sales than most of the single-brand restaurants. Stimulating unit sales is improving the economics of these kinds of stores. In the beginning of 2002, almost 5 percent of the worldwide locations of Yum were multi-branded. Because of their good results, Yum is aims to eventually offer two brands in most of its locations. To further build on the company's multi-branding strategies other brands like Long John Silver's and A&W have been bought.

But this opportunity should also be used to point out a negative point of the business of Yum; the cash consumption trap of their franchising model.

In order to remodel the current restaurants and build new restaurants, Yum must have access to capital. Yum uses the substantial capital expenditures it still has for these activities. Since their ownership concerns 21 percent of the system-wide unit restaurants, the free cash flow position becomes an important variable. Yum not always had positive free cash flow position. The cumulative free cash flow has even sunk at only 12 percent. This is meant relative to the cumulative reported net income. This means that Yum's reported net income was not optimal. It can be said that it was overstating the amount of money that was meant for the shareholders. Yum makes good returns on invested capital. This means that every dollar reinvested into its business will result in long-term value creation. The other side of the medal is that the value of a business also knows another calculation. This calculation starts with the amount of cash that could be generated in its life-time. Then you only have to calculate the net present value (NPV) of that amount by discounting the amount back to the present value of it. Unfortunately, this means for Yum that it is not likely that there is cash available because of its great capital investments. This comes down to the fact that money can only be taken out of the business when expansion slows down.

5 Conclusion

Now I've looked into the causes and effects, I conclude that franchise networks are a complex phenomenon. Although it is possible to create growth through mergers and acquisitions in response to global trends, stakeholders constantly have to make different choices regarding the potential control problems and the main control mechanisms. An example of these choices could include for example the formality of control. This means that formal control mechanisms have a mandatory role while informal control mechanisms mainly supportive role. Another type of choice is for example the degree of duality. This boils down to the fact that franchisees can and should be flexible to adapt to local needs, while the branches have to behave in a predictable manner to the existing implemented routines. Also ‘centralization’ can play an important role. By centralization are meant the decisions about what rights and obligations to the franchisor to leave the franchisees (e.g. marketing).

Franchise networks can be developed in a balanced way if the right choices are made. This is not easy, because little research has been done about franchising from a management control perspective. The existing literature goes from strategic and marketing related perspective. Empirical research has primarily been done for on Anglo-Saxon situations. Moreover, there has been done little study to management controls. These studies pay more attention to context factors. This could be for example determining the nature of franchising (distribution, manufacturing and service). Another example could be the level within the value chain (business to business, business to consumer).

My research has shown that franchising is a complex phenomenon. The literature showed that in addition to market effects also many other factors are relevant to the value of the company. This usually means that there is many management control needed. This phenomenon is increased by the acquisition or opening of new branches.

The current business environment is an environment in which strategy and management resources are constantly changing over time. Relationships with customers and suppliers had become increasingly important. The business principles of a business like Yum can act as an example of the optimization of these relationships. Yum and the franchisees are constantly seeking for optimization in their supply chain and the service they deliver to their customers. With an agreement towards each other they all contribute to the long-term relation which influences all factors of the business and protects its supply chain.

The event study showed that most of the mergers and acquisitions of Yum had a positive effect on its stock price. This indicates the trust that investors have in Yum based on new disclosed information. To gain the trust of investors an enterprise has some sort of asset that investors receive as value adding. In the case of Yum this asset is the mutual commitment of the franchise holder and its franchisees to the optimization of their relationship with customers and suppliers. The positive results disclosed in the event study show that Yum is clearly successful in managing these processes. Below I will further discuss the key factors to this success on the basis of the literature I studied and summarized in chapter two. Because of their mutual commitment, the franchise holder and its franchisees have been subject to certain constraints. This principle of commitment and constraints are the basis for an agency problem mentioned in the discussed literature in chapter two but also form the basis of the franchise structure. The structure contains the protection mechanism for the franchisor and its franchisees. It also contains the elements that are very important for the success of the franchise network growth. This boils down to a number of critical business principles that have to be implemented in the core processes of the franchise stores. This network structure can only be managed successfully with a number of control mechanisms and exclusive engagements between franchisor and franchisee.

Because of the dependence between franchisees, the franchisor controls the quality and service that the franchisees are responsible for. This control is a key factor for success and is defined by a limited scope of products that a franchisee is allowed to exploit. Also, the franchisor is also responsible for the uniform character of its business. Nevertheless, the franchisor can decide to experiment with regional variation. Like the business of Yum, there has been a shift from the US to other regions in the world. This means that the group of customers is diversified and therefore, variations in the menu can be the perfect source of innovation within the franchise network.

Another important key factor to successful franchising of Yum is the control that the franchisor does on other resources. The equipment, fixtures and furniture (also known as the operating assets) are all purchased by certain sources. These sources, and the other goods and services that a franchisee needs for the exploitation of its store, are all controlled by the franchisor. Several reasons can account for doing this. The first reason would be the necessary control on the quality and uniform image of the franchisors business. Other reasons could be to become a profit center or protect inside information.

Control is also done on the franchisee's premises. The control of the franchisee's premises can be critical to the supply chain of other franchisees. By having control over the premises, the supply chain can hold because the premises are still in the network even when the franchisee is not. A control mechanism as mentioned does increase the franchisors capital requirements. Local or regional malls often require at least some financial guaranty by the franchisor of the franchise network. This all boil down to the fact that the franchisor is controlling which entrepreneur is doing business on a certain location. For a business as Yum this type of control can become a serious policy issue. Because of the transfer of the premises, also its value may be transferred to the franchisor. Because of this transfer without a guaranty of contract renewal, the risk that a franchisee will only milk out the business is very reasonable. This could cause severe damage to the franchise network. In order to prevent this there has been a policy established to realize the location Goodwill of the business of the franchisee. This can be done by the sales of the business to another approved franchisee. This means that the franchisor has given a contract renewal to a new entrepreneur without losing the value and benefits of the premises.

In the case of Yum certain exclusive or protected area’s have to be granted to a selective group of franchisees. This is done because in theory, the franchisees seem to be willing to invest in areas if there’s less competition from their own brand. Yum has to be careful that it does not make areas to exclusive by granting it to just one entrepreneur. This could influence the market penetration. With larger unserviced or underserviced areas, Yum could weaken its network. Therefore Yum should focus its strategy on the potential market penetration of an emergent market and use that information to grant exclusive or protected area’s to its franchisees. This also means that there can be more conflict between the franchisees. Yum should develop internal policies to solve most of these conflicts in early stage. These policies could exist of regulation for growth decisions of the network of the payment of fees to compensate franchisees that have been influenced by others.

Franchisors as Yum should also maintain a close relationship with its franchisees. This often means that an exclusive relationship has to be guaranteed. This must be done to prevent franchisees from investing in the business of its competitors. It can also be helpful in protecting inside information and business knowledge from being used by other competitors.

In conclusion the exploratory study I did is based on investigating the causes and effects of mergers and acquisitions in franchise businesses. In order to gain deeper understanding of mergers and acquisitions in franchising, I did a case study of Yum. Therefore I first looked at the causes by using the available data from the annual reports followed by the effects in terms of an event study. After the event study I was able to make a link between the strategy (causes) and the events (effects) that has taken place in the last decade for the business of Yum. The goal of the strategies of Yum was to have a leading role in terms of growth and development. Because of the benefits of economies of scale, franchising is a popular and fast vehicle for realizing growth. The need for growth causes attraction to new and existing franchisees. In order to reach the goal of the strategy Yum needs to focus on the successful implementation of their strategy. Mergers and acquisitions take place in order to innovate and further grow. In the case of Yum, most of the mergers and acquisitions had a positive abnormal return in the event study. This means that investors react positive on the news of a possible takeover. To gain trust from potential investors and keep the trust of current investors, Yum has to keep up with their customer service level. The effects of the mergers and acquisitions are that Yum has to manage and control the entire chain of outlets of their brands very well. With this conclusion I gave the recommendations for successfully managing the causes and effects of mergers and acquisitions in franchising. With the key elements of successful management and control in franchising, I want to conclude the final chapter of this thesis.