Lee Schafer: Proposal to sell off Buffalo Wild Wings outlets is no slam dunk

Buffalo Wild Wings reports its quarterly results this week, when it should have more to say about whether it wants to dump most of the restaurants it owns to franchisees. A vocal critic among its investors seems to think doing that is a no-brainer.

In fact a transition like this could only look like an easy call to somebody who has never tried it. That is not making itself a different restaurant company, it is making itself a different business. Of course, sometimes trying for a dramatic transformation doesn't go that well.

The activist investor pushing this refranchise idea is Mick McGuire of Marcato Capital Management, a San Francisco-based fund manager. At last count, Marcato and affiliates owned about 5.2 percent of Buffalo Wild Wings' stock.

McGuire has suggested quite a few things for the to-do list of Buffalo Wild Wings CEO Sally Smith, but his core argument in a presentation attached to securities filing was insisting the company have nine out of 10 of its locations owned by franchisees by 2020.

Golden Valley-based ­Buffalo Wild Wings right now is more of a hybrid. As of last quarter, the company owned about 600 Buffalo Wild Wings restaurants and some taco and pizza restaurants, too. Nearly 600 more Buffalo Wild Wings locations were owned by its franchisees.

It is important to note Marcato isn't talking about changing much but the financial structure. Why? Building a typical Buffalo Wild Wings restaurant takes maybe $2.3 million in capital. Signing up a franchisee to open a new unit takes approximately 0 dollars in additional capital.

In effect, Marcato is arguing that most of the value in a restaurant company like Buffalo Wild Wings isn't the money that can be made selling beer and chicken wings to customers in a building. The value is in the intangible assets like the name on the sign and an instantly recognizable look and feel.

For example, if a competitor opens across the street and weekly sales dip 15 percent, that will reduce the franchise fee 15 percent. But that sales reduction might be enough to flip a restaurant from nicely profitable to losing money. Better that risk is borne by some independent business owner.

On a spreadsheet this makes some sense, so why hasn't the company already agreed to do it? Through a spokesman, executives declined the opportunity to talk about it, being just days away from an earnings announcement. But they have several good reasons for being cautious about this plan.

For starters, a quick look around finds examples of where the strategy worked fine and others where it did not. Nearly 10 years ago another company took over Applebee's with all the confidence in the world to "refranchise" the restaurants. It took nearly five years to find owners to take them all. The operating results have been mixed.

The juice retailer Jamba Inc. has more recently decided to do the same thing, buying into an "asset-light strategy" proposed by its activist shareholders. Its stock price has declined roughly 30 percent since January 2015 when the settlement with activists was announced.

Buffalo Wild Wings would likely find out what the Applebee's new owner did, that it is not easy to line up qualified owners to take over 500 or more restaurants. One challenge is that owning restaurants is no longer a business for mom-and-pops.

Provided good operators with ample bank accounts can be enticed to bid for restaurants, a fair price has to be reached. Without the chance to discuss this with management it is a little hard to know what that is, but a rule of thumb suggests that a franchised operation is worth less than a restaurant company as a whole. That is, a dollar earned in a franchise location is worth less in the market than a dollar of earnings for the parent company.

Selling off restaurants, then, will be a little like a kid with a collection of 10 rare marbles worth $10, eager to raise money for a movie ticket, selling off the marbles one at a time for 75 cents each.

In addition to avoiding these challenges, the company also has a good argument that continuing to own and operate restaurants makes it a better restaurant innovator. It is dealing with the headaches of running a business, solving problems like hiring when the labor market is tightening, that leads to invention. In the last decade, only in 2009 did company-owned locations fail to beat the same-store sales growth figures of ­franchisees.

Finally, the firm can explain to shareholders that the perennial problem in business is not having too much capital, it is having too few good investment ideas. That is what explains the cash total of the S&P 500 members swelling to about $1.5 trillion.

Last year, Buffalo Wild Wings bought 41 franchised restaurants in one deal for about $160 million, a purchase price that seems steep. The company has a better story for investors by describing a typical deal. And typical means a new Buffalo Wild Wings that costs about $2.3 million to build, while the average unit generates just under $600,000 a year in cash earnings.