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Franchisee Survey Report.

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Franchisee Survey Report

Table of Contents I. Background 2

II. Survey and findings 4

A. Franchise performance 4

B. Impact of global economic conditions on franchises 6

C. Major development challenges to franchisees 8

D. Trends and forward-looking prospects 9

III. Conclusion 10

Contacts 11

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I. Background

Until the year 2005, only PRC enterprises were allowed to operate as franchisors in China. Foreign franchisors were required to establish foreign-invested enterprises or form joint ventures with Chinese partners. Use of the franchisor's trademarks, IP, and supplier networks was achieved only through "a series of independent contracts ." (Franchise Update, 2005) For foreign franchisors, this delayed much adoption of the franchising model in China for two decades.

The requirements were not a burden on domestic franchisors, of whom there were more than 400 in over 30 industries, with over 1,000 outlets across the country by the end of the year 2000 (Access Asia, April 2007). This was the same year in which Yum! Brands first experimented with franchising in China, although they had been operating in the country since 1987.

Enactment of commercial franchising regulations in 2005 legalised operations for foreign-owned franchisors. The legislation has allowed these franchisors to operate normally as long as they can demonstrate a well-developed business format and provide continuous operational guidance, technical support, business training and other services to their franchisees. The prospective franchisor must directly operate two of their branded locations for over a year. However, this requirement generally applied only to new entrants; if a franchisor had master franchisees or unit franchisees in China prior to the Measures' effective date (1 February, 2005), such a company would be allowed to continue operations. (Franchise Update, 2005)

The new regulations immediately opened doors to franchisors. By August 2008, 151 provincial franchisors and 546 transprovincial franchisors had filed under the law in various retail businesses, food service, laundry, education, and hotel management. (Xinhua News, 18 August 2008)

The new opportunities presented by the regulation are conditioned by the fact that "some franchise enterprises had already [been] in operation before" the law was enacted, using unregistered trademarks and patents. In addition, a few major Western companies such as Yum! Brands had already taken the steps described earlier to get a head start in the China market before 2005.

Rapid changes in the ways ordinary Chinese work, travel, shop, and live are raising the profiles of both international and homegrown brands. As the nation of 1.3 billion becomes more interconnected by travel and communications networks, and as China’s consumers of goods and services venture farther from their home neighbourhoods, these customers begin to seek out symbols that indicate reliable quality and value. Just as the Western consumer has discovered, Chinese are beginning to find these attributes in recognisable brands that they know and trust. For prospective business owners, profiting from the trust invested in a brand has led to arguably the most prolific business development scheme in the last one hundred years: franchising. And as franchising becomes both widely scattered and deeply imbedded in the Chinese culture, it is beginning to spawn new, authentically Chinese brands alongside Western brands.

The seeding of new franchises continues despite the current unfavourable economic environment. China has also proven to be difficult ground for maintaining intellectual property rights and for weeding out reputational threats to international brands. These are all challenges to both franchisors and franchisees. For this report, Deloitte surveyed and interviewed franchising stakeholders, primarily franchisees in China, with the assistance of the China Chain Store & Franchise Association. Our findings:

Profitability had not been affected by the global financial situation, and a majority of respondents •expected their own profitability to improve in 2009.

Three out of four franchisees are satisfied with their franchisors.•

The leading concerns of franchisees were (a) intense cost pressure, (b) a shortage of skilled managers, •and (c) cannibalistic competition among franchises operating under the same brand.

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For the franchisees, the law opens the gates to working with world-renowned brands that had previously been directly owned. While some have been operating in China already as directly-owned entities, in many cases their global reputations were established under the franchising model, with which they are very comfortable. As the growth of retail and personal consumption in China is a well-known story, these brands may be expected to aggressively push to expand their networks among and beyond the eastern population centres, creating new opportunities for franchisees.

Meanwhile, franchisees will find prospects among the new and growing Chinese franchises for food, education, physical fitness, and hospitality. These franchises have the home field advantage of familiarity with the Chinese culture, so that localisation of overseas brand collateral is not the hindrance that if often presents to foreign franchisors. In businesses such as food service, where supplier relationships and bargaining power benefit from economies of scale, purchasing a franchise is a more sure route to success than starting business on one's own.

Different paths for franchisorsFranchising in China has not been the right choice for all foreign franchisors. Although the 326 cafés in their native Taiwan are all franchises, 85 Degree's planned 90 to 100 Mainland cafés will all be directly owned to control quality ("Café chain spin-off may bring in HK$900m", South China Morning Post, 2 March 2009). The Asia-Pacific market place has seen low profitability for Subway, a strong competitor among the overseas fast foods chains, due to a cultural mismatch: "Bread and sandwiches simply are not staples of the Asia-Pacific diet (Datamonitor, September 2008)." This has not forestalled Subway's plans to multiply the number of their franchises by tenfold to 1,000 nationwide, including 100 outlets in Shanghai and neighbouring Jiangsu Province (Shanghai Daily, 12 September 2008).

Other overseas brands in the China market continue to operate under the kind of master franchisee arrangement that was frequently followed before enactment of the franchising law. For example, many 7-Eleven stores, Cold Stone, Mister Donut, and Starbucks locations in China are operated through master franchisee President Chain Store Corp (PCSC), a subsidiary of President Enterprises Corp in Taiwan. The owner-operators of these outlets are sub-franchisees of PCSC. The company plans "to open as many as 300 7-Eleven stores in Shanghai over the next five years" ("7-Eleven opens Shanghai stores", Shanghai Daily, 30 April 2009).

Hospitality and lodgingGlobally, franchising is attractive among property developers as an alternative to developing property for sale. This has not escaped the attention of developers in China who have partnered with overseas hospitality brands.

The Chinese hotels and motels industry grew at a compound annual growth rate (CAGR) of 15.6% through the period spanning 2004–2008 (China – Hotels and Motels, Datamonitor, January 2009). Overseas brands have been operating in China throughout this period. These include InterContinental Hotels Group PLC, whose brands include Holiday Inn; and Marriot International, whose brands include Marriott Hotels and Resorts, JW Marriott Hotels & Resorts, the Ritz-Carlton, and Renaissance Hotels & Resorts.

Another hospitality company, Wyndham Worldwide Corporation, operates Wyndham Hotels and Resorts, Ramada Inn, Days Inn, Super 8, and Howard Johnson hotels in China among its worldwide locations. Currently, Wyndham has more than 170 franchising hotels in China, including 34 Ramada Inns. The 1,000-room Ramada Hotel & Suites in Boao, Hainan, will become the world's largest Ramada Inn when it opens in December 2010 ("Wyndham to open 2 Ramada hotels in China," China Knowledge, 22 April 2009). Wyndham's Howard Johnson International Group plans to open 100 hotels in China by 2010 and has signed contracts with more than 70 partners ("Developer checks into hotel industry," Shanghai Daily, 29 November 2008).

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II. Survey and findings

These developments, coinciding with China's dramatic economic growth, present a wealth of opportunities for franchisees — not only in fast food and hospitality, but in education, fitness, and various other enterprises for which franchising is a demonstrably successful model. In April 2009, the China Chain Store & Franchise Association and Deloitte surveyed a sample of franchisees to take a measure of their experience, success, and continuing interest in the franchising model.

The survey was conducted in two phases: Phase I was a questionnaire survey designed based on previous cooperation between Deloitte and the China Chain Store & Franchise Association, and upon Deloitte's understanding of the franchising industry. The experience and opinions of franchise managers and the owner-operators of those franchises were solicited through an online questionnaire. In Phase II, telephone interviews were conducted with selected franchisees in representative industries and geographic locations.

Deloitte's report findings below are grouped as follows: (a) franchise performance; (b) impact of global economic conditions on franchises; (c) major development challenges to franchisees; and (d) trends and forward-looking prospects. Respondents were concentrated in the hospitality and education industries, with a lesser incidence of franchised gyms and clothiers reporting.

A. Franchise performanceTo understand the current performance of the franchisee's business operations, the survey was designed to examine franchise profitability, franchising models, franchising fee payment models, the proportion of franchised outlets to total outlets, and attitudes of franchisees toward franchisors.

Survey findings showed that franchisees are generally profitable, with an average gross profit margin of 34% in 2008. Hospitality and education franchisees were both profitable, with some variation between the two.

Profitability of hospitality franchisesNotably, the profitability of budget hotel franchisees fell significantly in 2008. Data show that the average gross profit margin of interviewed hotels was 37% in 2008, 28% down from that of 2007. Rising operational costs, falling average occupancy rate and irrational investment seem to be main causes for this decline.

Rising operational costs: According to the China Budget Hotel Report 2008 released by the China Hotel Association, the average investment cost of budget hotels opened in 2007 was 18% higher than that of hotels opened in 2006. Meanwhile, the average annual salary of hotel managers rose by 24% in 2007 due to resource constraints as hotel chains rapidly expanded, further reducing the profitability of budget hotels.

Falling average occupancy rate: Due to a slowing business environment and the diminishing quality of locations, the average occupancy rate has dipped. Research data show that budget hotels in bustling cities such as Beijing, Shanghai, and those of populous eastern China endured considerable declines in their average occupancy rates, from approximately 85% to 80%.

Over-investment: Given the budget hotel industry boom in recent years, investors have tended to set unrealistic expectations for investment returns, particularly in cities such as Beijing, Shanghai, and Guangzhou.

Profitability of education franchisesThe average gross margin among surveyed education franchises was about 30%. Cash flow remained steady as prepayment for services is standard.

Franchising modelsUnit Franchising is the dominating franchising model, accounting for 66% of all franchisees examined, followed by Area Franchising Development, at 28%; the rest use Master Franchising.

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Figure A.2. Proportional Shares of Franchised Outlets and Corporate-Owned Outlets

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The survey also found that industries exhibited different combinations of franchising models. Business replicability is one of the main reasons for the difference. For instance, in the garment industry, high product standardisation makes it easier to replicate and manage the business, therefore it is more appropriate for franchisors to develop their own markets through unit franchising.

Franchise Fee Payment Model Most franchisees interviewed said that they paid an initial franchising fee plus a fixed monthly or annual management fee. Other payment models include revenue sharing and profit sharing.

Proportion of Franchised Outlets to Total OutletsFor franchisors, the proportion of franchised outlets to total outlets is currently higher than that of directly-owned outlets. This was due to the rapid expansion franchisors have carried out over the past few years, and because they regard franchising as an effective strategy for rapidly entering the market.

Attitudes of franchisees towards franchisors Altogether, three out of four of the franchisees interviewed were satisfied with their franchisors. Twenty-seven percent of the respondents were very satisfied and 48% marked "satisfied." Most franchisees recognised the franchisors' business development efforts, such as providing standardised store floor plans, distributing standard operations manuals, and constant field inspection and onsite coaching. Despite the risk of implementation gaps, franchisees were generally satisfied with these efforts.

Unsatisfied respondents (24%) expressed optimism about the industry prospects and were willing to continue the business.

Figure A.1. Percentage of Different Franchise Models

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Unit Franchising Area Development Franchising Master Franchising

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Figure B.1. Impact of Financial Crisis on Business

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Figure A.3. Satisfaction of Franchisees towards Franchisors

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B. Impact of global economic conditions on franchisesIn the current economic environment of global financial distress, all industries have been affected to different degrees. To better understand the impact on franchisees, a section of the survey was dedicated to this issue.

Franchises are not unaffected by the crisis, but the survey findings indicated that the overall impact on this industry may be relatively minor.

Forty-four percent of the respondents believed that the financial crisis had not exerted a substantial negative impact on their business, and 41% of the respondents believed that the financial crisis will only have a short-term impact on their business and will not affect their long-term profitability.

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Figure B.2.

34%

2008 Average Gross Margin

37%

2007 Average Gross Margin

-3%

Change

The survey findings also indicate that the average gross profit margin of franchisees in 2008 remained relatively high, although slightly lower than that in 2007, which further validates the view that the franchising industry is only affected by the financial crisis to a limited extent.

Mid-to-low end franchisees show stronger revenue growthMid-to-low end brands are positioned to fulfill consumers' basic needs which are more inelastic; therefore, franchisees in these segments have earned relatively stable revenue even through the economic downturn.

Effects on different economies within ChinaInfluenced by pessimism about global economic prospects, Chinese consumers are becoming more conservative. Some consumers have reduced their spending on big-ticket items such as electronics, and some people who might have been inclined to purchase high-end brands are switching to mid-to-low end brands. However, our survey respondents in western China reported that the crisis had not yet negatively affected their businesses.

The economies of inland cities are less dependent on export markets, thus, the impact of the financial crisis on these cities has been delayed. The economic growth in coastal cities has diminished with the closure of a number of small and medium-sized enterprises because of the depressed export market; yet inland cities continue steady growth without significant changes in the local residents' consumption patterns. Similarly, domestically-focused retailers responded that they had not suffered much during the crisis, with many viewing it as a short-term issue.

In addition, the purchasing power of inland residents has been strengthening in recent years, while the commercial development in these regions has not yet reached full speed. Hence, even though consumer demands may deteriorate in the near future, it may not significantly affect the franchisees' business.

Sector impactsIn the survey, some garment franchisees said that the financial crisis had actually stimulated their sales, because many consumers who previously purchased brand-name products were shifting to their brands, which were aimed at the middle-income segment.

A similar situation also occurred in the budget hotel sector. Guests who under normal circumstances might stay at luxury hotels are opting for budget hotels. As a result, budget hotel chains with high brand recognition and extensive networks are increasingly favoured by enterprises and individual customers. These new customers, to some extent, have offset the negative impact of a falling average occupancy rate mentioned under Franchise Performance.

Education franchises targeting MNC employees have been adversely affected. However, declining rents and real estate prices have lowered the costs for education franchises generally; and the recession-resistant nature of this industry has attracted more attention from potential franchisees.

Franchisees are optimistic about 2009 According to the survey findings, 46% of the franchisees believed that their gross profit would rise in 2009, and 39% believed that they could at least maintain the same level of profitability as in 2008.

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Figure B.3. Expectation of Average Gross Profit Growth in 2009

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TotalUp 0-9% Down 0-9%Up 10-19% Up >20%

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C. Major development challenges to franchiseesIntense cost pressure, a lack of skilled managers, and cannibalistic competition among franchises under the same brand are the top three challenges facing franchisees.

Intense cost pressureA majority of the interviewees attributed high cost pressure to the high initial franchising fees they were charged. Franchisors with established brands usually charge a high initial franchising fee, significantly constraining the profitability of their franchisees. In addition, many franchisors charge fixed monthly or annual management fees, regardless of the franchisees' operating performance. A franchisee is required to continue paying these fees even when it is operating at a loss.

Unskilled managersWith the rapid expansion of business, franchisees' needs for qualified managers are also rising. However, it is difficult to recruit high-quality personnel because the compensation in retail and service industries is relatively lower than other industries, while the workload is usually heavier. Lack of systematic vocational training for retail and service industries is another obstacle. Some franchisees have tried to train managers by themselves, but found it time-consuming and prevented them from meeting other development needs of the business. Franchisees are further challenged by the high turnover rate for their employees and managers who demonstrate skill on the job. As the result of the fierce competition and resource shortage, talent-poaching among industry players is common.

Some interviewees also mentioned that managers assigned by headquarters lacked sufficient ability and experience in store management, and attempted to implement strategies that proved inappropriate and pre-mature for the outlets' current business models.

Cannibalistic competition and reputation riskSome interviewees mentioned the competition among stores of the same brand resulting from concentration of franchisees in close vicinity as a significant challenge.

It was also reported that there are franchisees who do not follow franchisors' requirements thoroughly, or who sacrificed the quality of products and services in order to reduce costs, harming not only the brand image but other franchisees' business. (See also Insufficient standardisation below.)

Other challengesInadequate franchisor support: In addition to the above challenges, another frequently-mentioned issue was inadequate support from franchisors. Most franchisees suggested that franchisors could enhance brand-building efforts and provide more staff training. Other areas for improvement included instructions on store layout, product development, site selection, and membership programs.

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Insufficient standardisation: Many franchisees pointed out problems in standardisation. Although franchisors have provided standardised products and detailed guidelines for operations, standardisation still was not implemented thoroughly and consistently, which was perceived likely to constrain the industry's development.

Some hotel franchisees said that the franchisors usually had two sets of implementation requirements: a basic standard and an optimal standard. Such flexibility often led to a situation where some franchisees only met the basic requirements, resulting in inconsistency in operations and management.

Some garment franchisees pointed out that variance in franchisees' competencies and long-term business development goals would affect their understanding and implementation of the standardisation process. The interviewees believed that franchisees with more than one outlet of the same brand generally had stronger capability, more ambitious development goals, and stronger loyalty to the franchised brand. Therefore, they could implement standardised operations better than those with only a single outlet.

Similar problems are particularly severe in education franchises. Firstly, education content is the core product of an education franchise, which is delivered by teachers. However, it is difficult to ensure consistent delivery due to disparities in understanding and performance among teachers. Secondly, the nature of education makes it more difficult to standardise than other franchise industries—education is a process featuring interaction among teachers and students with uncertain results. Such a process cannot be easily standardised.

D. Trends and forward-looking prospectsMost franchisees expect to see sustainable growth in sales during the next three years.

From the survey, 81% of the interviewees expected to achieve a measure of sales growth in the next three years. Another 15% of them believed that they could maintain their current income level.

Figure D.1. Estimated Sales Growth Rate in 2009-2012 by Franchisees

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Budget hotel franchisees seemed more conservative in their business expectations. Forty percent of the interviewees estimated that they could only maintain, not raise their revenue level in the next three years. They believed that the market was reaching saturation—aggressive competition has emerged in some regions, and the industry has been restructuring. Therefore, they anticipate that it will be hard to maintain the high growth rate of recent years.

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The proportion of franchised outlets is likely to decrease The survey data show that franchisors are more inclined to expand their business by establishing new outlets in the coming three years. Fifty-one percent of the interviewees indicated that they would expand mainly through directly-owned outlets (including establishing new outlets and taking over competitors' outlets). Consequently, it is likely that the proportion of franchised outlets may decrease in the next three years.

Figure D.2. Estimated Sales Growth Rate in 2009-2012 by Franchisees

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Open self-ownedstores

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(N=41)

The survey also found that franchisors with an IPO plan have purchased back their franchisees' outlets with mature operations, or are preparing to do so in the near future, in order to become the controlling shareholder and consolidate the financial statements. However, it seems that most franchisees are not aware of or clear about the buy-back plan; some of them seem reluctant to comply, as they prefer to control their own outlets and maximise their own profits from business operations.

III. ConclusionDeloitte conducted this survey in cooperation with China Chain Store & Franchise Association, hoping to identify relevant issues and help franchisors to better understand the market and grasp potential opportunities. The survey findings overall indicate a resilient franchising industry.

• Franchisesareprofitable,andtheirownersexpectthistocontinue.Franchiseesgenerallyregardfinancial risks to their own business resulting from global conditions as temporary and minimal.

• Mostfranchiseesaresatisfiedwiththeirfranchisors.

• Mostchallengestofranchiseesareshort-term,andcouldberemediedbychangesinpolicyandmorecareful oversight by franchisors.

Franchisees' insights indicate the following considerations in regard to specific challenges:

• Franchiselocationsshouldbeplannedtoavoidcannibalizingeachother'ssales.

• Franchisorsshouldbeawareofsubstandardpracticesofsomefranchiseesthatputtheirbrandsatrisk, and should take corrective action.

• Standardisationisinconsistentlydeliveredatfranchises,andforserviceindustriesincludingeducation,may be difficult to achieve.

The industry maintains strong growth momentum and most franchisees are positive about their own prospects. Therefore, we have reasons to expect that franchising in China will continue to grow.

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Contacts

Eric Tang Managing Partner Tel: +86 755 3331 0991 Email: [email protected]

Eric Tang is the leader of Audit and Consumer industry in Deloitte Shenzhen Branch. With 20 years of auditing experience, he has served clients in the industries of technology, media and telecommunication, manufacturing, consumer electronics/products and consumer sectors, including US listed companies, MNCs and Hong Kong listed enterprises. Eric has rich experience in areas of public listing, enterprise restructuring and strategic acquisition. He is the associate member of HKICPA and fellow member of ACCA and AICPA.

Alan MacCharlesPartner Tel: + 86 21 6141 1658Emai: [email protected]

Alan is a Partner of Deloitte & Touche Financial Advisory Services, and has been based in Shanghai since 2006. He heads Deloitte's Commercial Due Diligence business for Mainland China. He has experience in both strategy and commercial due diligence in North America, Europe and China markets. He has conducted over 50 CDD assignments in China in covering a range of industries, including Retail, Financial Services, Health and Fitness, Hospitality and Leisure. Alan holds a MBA from London Business School.

Ellen Fang Associate Director Tel: + 86 21 6141 1628 Email: [email protected]

Ellen Fang has 8 years' working experience in management consulting and investment advisory services with several management consulting companies. She currently serves as an associate director in our Commercial Due Diligence Team.

She has provided consulting services concerning corporate strategic development, M&A, due diligence and promotion of management performance to many companies in various industries, with rich experience in the above areas.

About CCFAFounded in 1997 and registered at the Ministry of Civil Affairs, China Chain Store & Franchise Association (CCFA) is the only industrial association of retailing & franchise industry in China. Currently, it has 800 enterprise members, 160,000 outlets, including domestic & overseas retailers, franchisers, suppliers, and relevant organizations. The total sales of its Top 100 member enterprises exceeded RMB 1 trillion in 2007, with more than 100, 000 stores in total. Member companies cover over 50 different industries and sectors such as food & beverage, retail and service, and most member enterprises are famous Chinese retailers, foreign-funded franchisors operating in China as well as key suppliers and relevant intermediary organizations. With the goal of "Lead the industry, Serve members, Requite society and Realize self-improvement", CCFA participates in policy making and coordination, safeguard the interests of industry and members, and provides a series of professional trainings and industry development information and data for its members and establishes platforms for communication and cooperation. CCFA is dedicated in promoting the development of franchise business in China.

Thank you to Christina Han, William Hillis, William Hutchinson, Warren Li, Yan Ming, Lavi Tuo, Crystal Wang, and Windy Zhong.

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Franchisee Survey Report.

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Deloitte refers to one or more of Deloitte Touche Tohmatsu, a Swiss Verein, and its network of member firms, each of which is a legally separate and independent entity. Please see www.deloitte.com/cn/en/about for a detailed description of the legal structure of Deloitte Touche Tohmatsu and its member firms.

Deloitte's China practice provides services through a number of legal entities and those entities are members of Deloitte Touche Tohmatsu (Swiss Verein).

We are one of the leading professional services providers in the Chinese Mainland, Hong Kong SAR and Macau SAR. We have over 8,000 people in eleven offices including Beijing, Dalian, Guangzhou, Hangzhou, Hong Kong, Macau, Nanjing, Shanghai, Shenzhen, Suzhou and Tianjin.

As early as 1917, we opened an office in Shanghai. Backed by our global network, we deliver a full range of audit, tax, consulting and financial advisory services to national, multinational and growth enterprise clients in China.

We have considerable experience in China and have been a significant contributor to the development of China's accounting standards, taxation system and local professional accountants. We also provide services to around one-third of all companies listed on the Stock Exchange of Hong Kong.

These materials and the information contained herein are provided by Deloitte Touche Tohmatsu and are intended to provide general information on a particular subject or subjects and are not an exhaustive treatment of such subject(s).

Accordingly, the information in these materials is not intended to constitute accounting, tax, legal, investment, consulting, or other professional advice or services. The information is not intended to be relied upon as the sole basis for any decision which may affect you or your business. Before making any decision or taking any action that might affect your personal finances or business, you should consult a qualified professional adviser.

These materials and the information contained therein are provided as is, and Deloitte Touche Tohmatsu makes no express or implied representations or warranties regarding these materials or the information contained therein. Without limiting the foregoing, Deloitte Touche Tohmatsu does not warrant that the materials or information contained therein will be error-free or will meet any particular criteria of performance or quality. Deloitte Touche Tohmatsu expressly disclaims all implied warranties, including, without limitation, warranties of merchantability, title, fitness for a particular purpose, noninfringement, compatibility, security, and accuracy.

Your use of these materials and information contained therein is at your own risk, and you assume full responsibility and risk of loss resulting from the use thereof. Deloitte Touche Tohmatsu will not be liable for any special, indirect, incidental, consequential, or punitive damages or any other damages whatsoever, whether in an action of contract, statute, tort (including, without limitation, negligence), or otherwise, relating to the use of these materials or the information contained therein.

If any of the foregoing is not fully enforceable for any reason, the remainder shall nonetheless continue to apply.

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