Cup of sorrow: the brutal reality of Australia's franchise king

Julia Banks will never forget the panic attacks. She still finds herself waking up in the middle of the night, heart pounding and mind racing, from the stress of running a Donut King franchise in Marsden, Queensland. As debts and losses mounted, Banks and her husband John lost their savings and family home.

"It's pretty well destroyed our lives," she says.

The Bankses started their Donut King store in early 2015 under a franchise agreement with Retail Food Group (RFG).

Gold Coast-based RFG is the country's biggest food franchise operator, whose brands include Donut King, Brumby's, Gloria Jean's, Pizza Capers, Crust Gourmet Pizzas and Michel's Patisserie. It has a market capitalisation of about $800 million and claims to have more than 2500 stores.

Julie Banks suffered panic attacks after buying a Donut King.Credit: Tash Sorensen

"We were told it was a gold mine, but from day one it was losing money," recalls Banks.

In November the couple reached breaking point. They cleaned the store, packed up the doughnut maker and coffee machine and took staff to a Christmas lunch at Sizzler to break the news that they had closed permanently.

"It was heartbreaking, but what could we do? We had run out of options."

The Bankses are one of hundreds of franchisees who have been financially devastated after signing up to one of the high-profile franchise brands under the RFG umbrella.

Illustration: Matt Golding

Days after closing, John Banks wrote to RFG's managing director, Andre Nell, telling him his Donut King had joined the growing list of stores that had either been closed, sold at a massive discount to its purchase price or become a "ghost store" – where RFG is still on the hook for rent but the shop does not open its doors to customers.

John Banks asked Nell to buy back the store the Bankses had bought for $230,000 via an agent hired by RFG, arguing the company had sold them a lemon. Banks says they were given the sales figures for the store as part of the sale process, but only when they signed on were they given financial accounts. Those accounts revealed, they say, that their newly purchased store was in fact losing $120,000 a year under RFG management.

"We question whether a reasonable person would consider that RFG and its representatives acted in good faith when making this sale," he wrote.

John is yet to receive a response, but RFG did send him an invoice for the latest rental payment due.

This network has created a lot of human misery. They're all unhappy. I haven't met a happy one.

Michael Sherlock

This is the reality of life inside the RFG juggernaut.

Growth by acquisition

Since listing on the ASX in 2006 at $1 a share RFG has, for most of that time, produced record profits, double-digit returns on equity and fat dividend payouts for shareholders. In 2015 RFG stock hit $7.15. It built a reputation as a franchise amalgamator as it spent more than $500 million in the past decade on 15 acquisitions including Crust Gourmet Pizzas, Pizza Capers, coffee chain Gloria Jean's, Café2U, DiBella Coffee and Hudson Pacific, a food manufacturer and distributor.

That scale has also seen it become one of the country's largest coffee roasters, as it sells to its Brumby's, Michel's and Gloria Jean's franchisees. In an Australian franchise sector estimated to be worth $146 billion in sales, and where there are four times as many franchisors per head here as in the US, RFG had become a serious player.

But it seems this phenomenal growth has come at a cost. A three-part investigation by Fairfax Media into RFG has uncovered a brutal business model that is pushing franchisees to the wall.

Former chief executive Tony Alford at the time of the company's listing on the ASX.Credit: Robert Rough

There is systemic wage fraud as franchisees do whatever it takes to make ends meet, the use of sham employment contracts and the underpayment of overseas workers hired on holiday visas.

The series also looks behind the man who floated RFG, Tony Alford, a Tasmanian- born accountant who has made hundreds of millions of dollars as the major shareholder in RFG and related businesses. It is under his leadership that RFG added to its brands and expanded overseas.

As part of the investigation, Fairfax spoke to many current and former franchisees and workers. It obtained confidential franchise agreements and financial accounts, disclosure documents, marketing fund reports and internal correspondence between RFG and franchisees. It trawled through court cases and court records to piece together a complete picture of RFG.

Signs of stress

The evidence of gouging and underpayment comes as RFG's balance sheet is starting to show signs of stress. In June a UBS note suggesting RFG may need to restate its accounts to meet new accounting standards sparked a market slump of 11.3 per cent.

Chairman Colin Archer then issued a warning at the company's annual meeting late last month, saying that RFG had become the target of "relentless" short selling by hedge funds hoping to drive down the share price. Archer also used the meeting on the Gold Coast to announce a company-wide review aimed at ensuring franchisees were paying staff correctly.

Some of the problems facing the stores are linked to the well-documented problems shopping centres have faced over the past few years.

But much is attributed to a squeeze on franchisees from crippling fees, rising labour costs as well as higher rent and food imposts.

At the same time franchisees claim reduced support from head office as RFG attempts to cut costs to preserve margins.

They complain of too little product innovation, too little advertising and, in the case of Michel's, poor quality food.

This spoiled cake was received by a franchisee.

Documents show some stores are manipulating their sales to try to avoid the royalties charged by RFG on every transaction. Fairfax Media can reveal RFG has been trying to manage this problem by hiring mystery shoppers, conducting audits and hiring a surveillance firm, Quantum Corp, to write observation reports that effectively spy on franchisees.

Fairfax has sighted documents that show the observation reports itemise the time of sale, type of sale, whether it was cash, takeaway or dine-in and who served the customer.

In the document cited, part of the audit involved using mystery shoppers. If franchisees were caught they were issued with threatening letters including demand for a payment of a franchise service fee and marketing fund contribution.

The network is littered with franchisees who have lost their homes, suffered marriage breakdowns and decimated retirement savings. Many lament that when they tried to sell their stores there were no buyers.

A single mother in her late 40s running a Gloria Jean's franchise left the system last year, losing everything, and is now working evening shifts at McDonald's to make ends meet. She declined to be named for personal reasons.

In May a Donut King franchisee offered to sell a store in Currimundi, Queensland, for $1 after failing for a year to find a buyer.

There are others who have come forward despite fears of reprisal because they are desperate and want their plight aired.

One of those happy to speak is former Brumby's founder and former managing director Michael Sherlock.

Michael Sherlock is the original founder of the Brumby's bakery chain. and is unhappy with how the business has been run by new owners RFG.Credit: Jason South

Sherlock sold the Brumby's franchise network to RFG in 2007 for $46 million and says he is surprised it has taken so long for the stories to come out.

Sherlock says a good franchise business is based on happy franchisees.

"This network has created a lot of human misery," he says. "They're all unhappy. I haven't met a happy one."

Wherever he looks, shops are for sale or empty.

"How many stores are trading is the question?"

Open stores

RFG bought Brumby's at a time when there were 321 stores in the chain and had plans to grow. Now, according to RFG's most recent full-year results, there are fewer than 246 stores.

This figure doesn't identify how many of those stores are not currently trading, with RFG declining to provide any further detail.

Sherlock believes RFG should have had 600 Brumby's stores by now. Instead, franchisees have either walked away or become "dinosaur franchisees".

These are "poor people", he explains, who have "got old, they still own it and they can't sell it, so they've just got to keep working.

"It was their nest eggs, their retirement, that they were going to sell or give to their children."

When Sherlock sold his stake in Brumby's he kept seven stores, but under the RFG model they started losing money. He extricated himself from the last store 18 months ago, at Kenmore Village in Brisbane. It was debadged and sold for just $10,000.

Sherlock says one of his stores went from making a profit of $100,000 a year to a loss under RFG control. He blames a rise in the cost of goods, a decline in head office support and a lack of innovation of products.

"It is run for shareholders, not franchisees," he said.

"The model is to cut out all the overheads, get rebates, charge lots of fees and keep shareholders happy."

Store numbers

At least 200 stores have closed in the past 12 months. A number of Pizza Capers are available for sale. Currently there appears to be no Pizza Capers stores in Victoria.

Michel's and Brumby's stores are closing all over the country and, while Gloria Jean's is struggling as competition intensifies in the speciality coffee shop sector.

Wayne Hong a franchisee who owns the Michel's Pattiserie store in Knox Shopping Centre says his dream was ruined.Credit: Joe Armao

Wayne Hong, who has a Michel's franchise at Knox Shopping Centre in Melbourne's eastern suburbs, says he will leave when his agreement runs out in six months.

"They treat us like dogs," he says.

"It was a dream to have my own business, but it turned out they treat us like shit."

Devi Trimuryani, who has a Michel's in Newcastle, tried to leave last year but couldn't find a buyer.

After buying a Michel's Patisserie in 2012 she has torched her life savings and racked up debts of $100,000 to Retail Food Group.

"I worked hard and saved up every dollar and it is worth nothing," she says. "I don't want to cry, but I don't know what to do."

Michel's Patisserie owner Devi Trimuryani says she wants to sell.Credit: Marina Neil

"I tried to sell the business last year but who's going to buy a store that loses money?"

Fairfax can also reveal hundreds of stores are for sale, or about to go on sale, on websites including Gumtree and Seek.com.au, as well as in local Chinese-language newspapers.

As recently as December 3, Seek listed 40 Brumby's stores for sale and 37 Michel's stores for sale, while 21 Pizza Capers –- more than a quarter of the total network, according to Pizza Capers' website – are also on the market. There are also 23 Crust stores, 43 Donut King stores and 51 Gloria Jean's stores for sale. While some are new businesses, the bulk are for resale.

For industry insiders, any franchise network with more than 10 per cent of stores for sale is thought be under pressure. Fairfax Media estimates 17 per cent of Gloria Jeans stores are for sale; at least 25 per cent of Pizza Capers are for sale.

Fairfax Media sent RFG a series of more than 50 detailed questions on the day of its annual meeting. They included asking how many stores were for sale and how much of the network that represented. RFG also was asked the number of stores in each brand losing money, the number of stores in each brand breaking even, the number of terminations and the average sales per brand.

Challenging market

RFG did not respond in any detail. Instead, it issued a short statement saying it recognised its franchisees were operating in a challenging and evolving retail market, particularly in shopping centres.

"The livelihood and profitability of franchisees is of the utmost importance to RFG, and consequently it is focused on driving enhanced outcomes for franchisees," the statement says.

Retail Food Group chairman Colin Archer (left) and managing director Andre Nell at the company's annual meeting where a review was announced.Credit: Dan Peled

It reiterated that it had appointed Deloitte to conduct a business-wide review of its franchise operations.

"In addition, RFG has recently completed an extensive engagement process with its franchisee community to better understand where it can improve franchisee outcomes and enhance service delivery," RFG says in the statement.

It says "numerous" initiatives have already been implemented to drive improved franchisee outcomes. "In any franchise system, franchisor and franchisee outcomes are intrinsically linked," it says.

"As a consequence, RFG is focused on ensuring it provides the right type of support, informed by direct feedback from franchisees and independent third-party experts, to ensure positive outcomes are achieved across its franchisee networks."

RFG pre-empted Fairfax's investigation on Thursday when it released an update on what it describes as its "business-wide review". It also tried to reassure nervous investors by maintaining its forecast of 6 per cent "underlying" net profit growth for the 2018 financial year.

The company said the review, which will be conducted by accountants at Deloitte over two years, would focus on the domestic franchise operations to ensure its business model was "appropriate for a retail market which remains challenging, particularly for shopping centre tenants".

"RFG already has in place a number of proactive measures to inform, support and educate franchisees to ensure they are aware of their obligations as employers," RFG said. "Deloitte is also evaluating the company's complementary monitoring and supervision framework in relation to managing franchisees' employee entitlement compliance."

The problem for many franchises is that this has come all too late.

Desperation and hopelessness

Michael Fraser and Maddison Johnstone played a key role in Fairfax Media's expose of rampant underpayment of workers at convenience store giant 7-Eleven in 2015 and also helped unveil similar problems at Domino's earlier this year.

Michael Fraser and Maddison Johnstone visited 100 stores.Credit: [e-mail]

They run an assistance and support business for disaffected franchisees called Franchise Redress and spent 30 days on the road from October 25 this year monitoring the RFG network of brands, visiting more than 100 stores in Victoria, NSW and Queensland.

In its report, titled RFG: The Zombie Brandchise​ Network, Franchise Redress said most of the franchisees they spoke to blamed RFG for the poor performance of their stores.

"In our investigations into other franchise models, we have never seen such desperation and hopelessness in large numbers. While conducting this investigation, five franchisees we encountered in a two-week period abandoned their stores. In the case of two stores, this happened right in front of us," the report said.

Many of the stores they visited were for sale, most at a heavily discounted price to the purchase price or the price advertised.

"The stores had been on the market for a very long time – in some cases, over a year," the report said.

"It is not uncommon for an RFG franchisee to say: 'I have already lost hundreds of thousands of dollars, but if I can just walk away without having to continue paying the lease, I will be happy.' "

Franchises say RFG Group is built on their suffering.

Franchisees told Fraser that RFG acquired a brand, decimated the franchisee support staff, renegotiated supplier deals and collected "kickbacks" to the detriment of the franchisee's profit line, milked every possible cent out of the franchisees, before finally allowing the brand to die.

"The franchisees' overall conclusion was that RFG was not in business with their franchise partners. Instead, they were solely in business with themselves," the report said.

Of the Donut King franchisees Franchise Redress spoke to, most were averaging below $10,000 a week in sales, leaving next to no money to cover labour, rent, cost of goods sold and other expenses. The report quotes one Donut King franchisee saying her teenage staff members earned more a week than she did.

"Unfortunately, across the Donut King network, it was common to hear that franchisees were not able to draw an income, but still had to pay exorbitant franchise and marketing fees," the report said.

Don't buy RFG

A similar experience was echoed by independent investment advisers Barefoot Investor, headed by financial expert Scott Pape, which visited a number of franchised stores after RFG refused to discuss the business.

In a report published last December, Barefoot Investor said it spoke to some franchise owners under the guise of being "two dumbstruck blokes" thinking about buying a RFG franchise, to get their opinion. They found many franchisees were unhappy.

The report quoted one franchisee saying RFG was "a pack of arseholes". The report said "the same things that make RFG such an attractive business for shareholders are what makes buying an RFG franchise a terrible investment for a store owner".

The report concluded it wasn't worth buying the stock.

"Having been on the road trip and broken bread (OK, donuts) with franchise store owners, I really don't want to make money off their backs."

The franchise sector is a $170 billion industry. Many people who buy into a franchise have little or no experience in business and buying into a franchise lowers the risk.

As Barefoot Investor says, it is marketed as a business in a box. However, franchise agreements can be complex and legalistic and difficult to understand. Sometimes agents don't give them the full accounts until they have signed the agreement. Sometimes the financial accounts provided understated labour costs due to rampant wage fraud.

Royalties reaped

A critical element of the RFG business model is that is based on franchisees growing sales not profit. Head office takes a percentage, or royalty, from every sale, regardless of whether the store is generating a profit or loss. The royalties can be as high as 7 per cent, depending on the brand.

Franchisees also have to contribute to a marketing fund, which is also charged as a percentage of sales. This can vary between 2.5 per cent and 6 per cent, depending on the brand. Between royalties and marketing fund fees, this can account for up to 10 per cent or more of gross sales.

Alongside a store's purchase price, which can be as high $700,000 there also is a franchise fee for the right to use the RFG brand, a training fee that can be more than $10,000 for a course run by RFG, and administration fees for the preparation of documents. There are rental costs, computer fees, project management fees and utilities. All up, it cost thousands, if not tens of thousands of dollars a year.

RFG also makes money from the raw food it sells to franchisees (it recently purchased Hudson Pacific, which supplies frozen foods, cheese and dairy). As a wholesaler and speciality coffee business it sells coffee beans to brands including Gloria Jean's, Michel's and Donut King.

It is not unusual for operators to sell to franchisees, but many complain they could buy a similar product much cheaper at the local supermarket. One current Gloria Jean's franchisee, who declined to be named for fear of reprisals, says they pay $26 per kilo for Gloria Jean's beans, while a kilo of coffee beans branded Gloria Jean's was on special at Coles recently for $20.

Rebates claimed

The company also makes money from rebates, which are financial incentives provided by suppliers to retailers.

Industry sources estimate that RFG generates tens of millions a year in rebates from suppliers. RFG would not address this issue with Fairfax.

By taking such fat rebates RFG arguably is removing one of the key financial benefits of being part of a franchise system, which is buying power.

RFG also makes money from buying stores back for a fraction of their original sale price and then placing the same stores back on the market for hundreds of thousands of dollars.

Franchisees also have to pay one-off costs. Once again, this is not unusual, but there are questions about whether they are reasonable in the case of RFG.

In November, Gloria Jean's franchisees were told they had to upgrade their hardware and software. They were told one terminal would cost an estimated $5224, plus a software licence of $1080 per year. Given the low levels of profitability this is a lot of money for many franchisees.

Gloria Jean's franchisees have also been told that the brand will be getting a refresh, including a new logo, new smaller cups and stores refurbished.

A video sent to franchisees describes the strategy as: "masstige: prestige to the masses".

It would appear prestige comes at a price. New menus, new retail skins will cost between $85,000 and $155,000 while new layouts will cost anywhere from $150,000 to $375,000. The video shared customer research of the new menu, based on 103 people surveyed. The aim is to have 350 stores by 2020 making 50 million cups.

Gloria Jeans is embarking on a rebranding.Credit: James Brickwood

At its height Gloria Jean's had 500 stores and served 64 million cups, but now has only 300 stores and sells 32 million cups, according to the video.

Ex-franchisee Donna Kilpatrick became part of a group of rebellious franchisees in 2015 that believed they were being oppressed and treated in an unfair manner. They raised concerns that the franchisor RFG had breached its obligation under the Franchising Code of Conduct to act in good faith.

Kilpatrick left in late 2015 after failing to sell the business.

"The impact on my life has been incalculable," Kilpatrick says.

"I have separated from my husband … I worked 12 or more hours a day, seven days a week, for many years and walked away from a business I paid $270,000 for with $35,000. I still have a mortgage on my house. I signed up to work hard and was willing to do that. However, to work hard for no reward is soul destroying."

She likens an RFG franchise to a financial trap. Her agreement was up for renewal and she could not afford to pay it, or pay the required refurbishment costs. She is one of many who have been forced to move away.

Most RFG franchise agreements expire every five years. Each time the agreement is renewed or sold, RFG collects a franchise fee.

Some franchise renewal fees cost up to $50,000 depending on the brand. Across a network of 2500 stores, this equates to tens of millions of dollars collected in extra profit.

With so many franchisees baling, RFG has started offering deals and loans to entice them to stay, as too many stores for sale depresses the valuation.

Sharing growth?

A telltale sign that franchisees are being squeezed is to look at the network sales generated by franchisees and compare it with the operating earnings (also know as earnings before interest, tax, depreciation and amortisation) generated by RFG, which is rising.

In its bakery brands, RFG has actually made more money, with EBITDA per outlet has increasing from $45,600 in 2014 to $54,100 in 2017. Over a similar period the number of stores, particularly in Michel's, has fallen, which suggests a squeeze.

Network sales generated by franchisees at Michel's collapsed from $170 million in 2013 to $120 million in 2017, yet EBITDA generated by RFG from these franchisees went up from $15.5 million to $15.7 million. One explanation would be that RFG is taking a larger piece of the pie. RFG refused to comment.

Network sales at Donut King fell from $166 million to $160 million between 2013 and 2017. However, EBITDA generated by these same franchisee fees and other fees rose materially from $12.7 million to $17.4 million over the same period.

It seems unlikely this trend can continue indefinitely and cracks are appearing in RFG itself. These include the amount of receivables (outstanding invoices and money owed by franchisees) of 90 days or more, which now represents 16 per cent of pre-tax profit.

Receivables rose in 2017 by 109 per cent and sales grew only 49 per cent, which suggests the company has a higher proportion of sales uncollected and outstanding at balance date. (Part of the increase in receivables relative to sales is due to a change in business mix from Hudson Pacific, which they bought in FY17.)

There also has been a significant lift in advances to franchisees to fund store acquisitions and refurbishments. The vendor finance balance was restated to $6.8 million in 2015, $11 million in 2016 and $16 million for 2017.

The UBS report and the restatement of its accounts raised concerns about transparency. The restatement was partly due to a retrospective write-down of six brands – Pizza Capers, The Coffee Guy, Esquires, Big Dad's Pies, DCM Coffee & Donuts and bb's Cafe – most of which have been absorbed into other brands.

The restatement was also due to a change in the way RFG must now treat expenditure previously charged to marketing funds (but not collected).

It was revealed in its annual accounts that RFG was never justified spending money out of the Michel's marketing funding on supply chain efficiencies that it was never justified spending. It was booked as a receivable and passed on as a cost to franchisees. When franchisees couldn't pay it, they wrote it off.

Some industry sources suggest that if RFG had applied the new accounting policies in previous periods, profits announced to shareholders would have been lower.

Michael Sherlock is surprised it has taken this long for problems to emerge.

"If you put the pressure on and squeeze, squeeze, squeeze, then what's left? People have to survive, you know?"

Quality falls

Paul Rubini's family, including his sister and brother-in-law, bought a bb's Cafe in Robina on the Gold Coast from RFG in September 2006 for $490,000. They couldn't survive.

In 2010 they spent $150,000 refurbishing the store, then another $142,000 in 2014 when told to convert it into a Michel's Patisserie. "Our hands went underwater and then the head as a result of the refurbishments," he said.

But customer complaints started ballooning as they had to buy Michel's products, which were delivered frozen and required decorating.

Rubini isn't the only Michel's franchisee complaining about the quality of products they have to sell. Many complain about broken biscuits, battered cakes and questionable icing.

Photos sighted by Fairfax include a chocolate cake that looked like mould spores were growing off it, while another had a human hair stuck in the cake.

This cake was delivered with a hair on it claims a franchisee.

Another shows a child's birthday cake that was broken and smeared over the box as well as biscuits in the shape of a gingerbread man that were broken in half.

For Rubini, the store became insolvent and they closed on July 6 this year, owing $350,000 in bank debts. "We couldn't catch up and we couldn't sell it because it was losing so much money."

RFG recently posted the store for sale for $300,000, plus stock at value – not a bad earner for RFG given the family walked away.

The family hopes there isn't a sucker big enough to buy the store and all the misery that comes with it.

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