The market has been roaring over the past few months, but there are still major macroeconomic issues looming in the background. I consider myself a value investor, but I'm also very cognizant of how big macro issues can undermine value. We saw this in the Great Depression and with the recent financial crisis, and there are still numerous currents that could undermine value in the next few years.
The eurozone crisis, Japan's currency interventions, and China's real estate bubble are just a few of the macro issues that people should pay attention to. In the next 12 - 24 months, however, I believe that the Affordable Care Act (frequently called "Obamacare") will be the greatest obstacle to economic growth in the United States.
There are several issues in the ACA that could hamper economic growth moving forward. For this series, I am focusing on five of them:
(3) Restrictions on employment,
(4) Higher costs associated with low-skill workers, and
(5) Restrictions on high-deductible insurance plans
In my first article, I looked at some of the direct taxes implemented by the ACA and how historical tax increases had harmed private domestic investment and consumer spending. In my second article, I examined how the ACA's subsidies could create a cost-spiral, and lead to large stealth taxes.
For this article, I want to look at the employment related impacts of ACA. My view is that some provisions of the law will not only increase prices of certain goods and services, but that it's also likely that the restraints on trade will result in many lower- and lower-middle income Americans having less disposable income. This could potentially harm consumer spending, which could be a drag on GDP growth.
29ers and 49ers
The Affordable Care Act is over 2,700 pages long and complex enough so that it will be difficult for anyone to fully comprehend its impacts. Buried inside those 2,700 pages are two particularly notable rules when it comes to employment standards:
(1) The Over 50 Rule
(2) The 30-Hour Rule
The "Over 50 Rule" requires that businesses provide insurance coverage to all full-time employees, if they employ 50 or more employees. The "30-Hour Rule" defines a "full-time employee" to be an employee working more than 30 hours per week. Because of the heavy costs of complying with Obamacare, many companies are going to try to minimize their exposure to the law. That's why these two provisions are so critical.
To understand how dramatic the impact can be, imagine you run a restaurant with 49 employees. Your profit margins are likely razor thin at 4% and you bring in about $2 million in revenues each year. That gives you a profit of $80,000. Assuming an ACA-compliant healthcare insurance policy costs about $4,000 per year (likely a low-ball estimate), that means that the moment you hire Employee #50, you are potentially subject to $200,000 in new costs. Alternatively, you can pay a $2,000 tax per employee, which would lower the cost to $100,000. Either way, your $80,000 profit just turned negative unless you can pass on the cost increases. For this reason, many small businesses will stay under 50 employees.
Companies that are well over the 50-employee threshold won't be able to turn back the clock. They can, however, limit their employees' hours to 25 - 29 per week, thereby minimizing their exposure to the ACA. As a recent commenter on one of my articles stated, these two provisions will create "29ers" and "49ers"; 29ers being employees who can't work more than 29 hours, and 49ers being companies that can't hire more than 49 employees.
The Lives of Restaurant Workers
The ACA will dramatically impact many sectors of the economy where low-skilled labor is the norm. This list will include construction, agriculture, retail, and restaurants. For this article, I want to focus on restaurants primarily because it's simple to find publicly available data on labor costs.
Restaurants are also a sector I'm intimately familiar with. I worked in the pizza industry from age 15 to age 24, at both Domino's Pizza (DPZ) and Papa John's (PZZA). It helped pay my bills for many years, and I worked in virtually every role possible, with about every schedule possible. In certain summers, I worked 45+ hour weeks. During one of my most hectic semesters in undergrad, I scaled back to one long 10-hour shift.
You might not think that working 10 hours per week as a delivery driver could support someone, but I averaged about $15 per hour (even when minimum wage was only $5.15), living in East Tennessee, where my rent was only $375 per month. In one Friday night shift, I could normally pull in anywhere from $125 - $175. It was enough to scrape by while I was in undergrad school.
This brings up an important point. I made about $15 per hour at the time, but 2/3 of that was coming from tips and commission. I'm not sure how Waffle House or Applebee's waitresses fare, but I imagine it's an even more lopsided ratio for them, given that servers' minimum wage is typically lower in most states. While I often worked part-time to get through school, many people working as servers, delivery drivers, and cooks work full time. If Obamacare results in hours being cut for many employees, it could result in significant pay cuts.
The Restaurant Industry and the ACA
Nearly every company in the restaurant industry will want to minimize their exposure to the ACA. Darden, the holding company for Olive Garden and Red Lobster, announced in October that they would experiment more with part-time employees to avoid Obamacare's costs. Darden is one of the largest dine-in restaurant chains in the US, and their experiment resulted in a bunch of negative publicity and a significant backlash. They eventually backtracked, but don't be surprised if they move forward with their plans anyway, only without talking about it as much.
Darden may have generated negative buzz, but that's primarily because it's one of the largest and most well-known chains. In reality, the vast majority of restaurants and retail focused companies in the US will try to find ways to minimize their coverage under the ACA. They will have little other choice, because they'll be forced to pass on menu price increases otherwise.
That brings up the next question: if restaurants are forced to provide coverage, how much will menu prices have to rise, and how much will this affect demand?
Average Wages at Restaurants
In order to answer some of these questions, I looked at the 10-K filings of several restaurant companies. The goal is to deduce their average wage expense per employee and try to ascertain how the ACA would impact overall wage expenses. This might give us some ball-park estimates of how reliant upon full-time labor these firms are, as well as the extent of price increases in the upcoming year.
There are several notes and caveats here:
(1) I focused on companies that had a significant number of corporate-run stores. It's much more difficult to get franchisee-related info.
(2) These figures include a mix of corporate office personnel, management, and store-level employees (clerks, cooks, waiters, etc). However, all companies in this data set are dominated by store-level employees, making them more useful for analysis.
(3) Some of these figures are taken from FY 2011 filings and some are taken from FY 2012 filings. This might make a minor difference, but I suspect it wouldn't significantly impact the results.
Here are the results:
The bottom three rows might need to be explained. The first one, labeled "Avr Wage @ 2000 hours" is merely the average cost per employee divided by 2,000 hours. If we assume that most employees work 40 hours per week, this should be a reasonable estimate of the average wage.
The second bottom row is labeled, "Avr Hours @ $7 / hr." This assumes that the average employee makes $7 per hour in wages and benefits, in order to estimate the number of hours worked by the average employee. The third bottom row is similar except I used a $9 / hr assumption. I suspect that McDonald's (MCD) and Papa John's are closer to $9 or $10 per hour average, since they cannot use servers' minimum wage, but some of the others might be closer to that, as well.
Obviously, these are imprecise estimates, but they at least give a sense of which companies are more reliant upon full-time labor. The data also shows how susceptible these companies may be to the impact of the ACA.
Glancing over this, it appears that Denny's (DENN), Brinker (EAT), Darden (DRI), and Cracker Barrel (CBRL) all rely significantly upon full-time labor. Sonic (SONC) is borderline in that camp. Papa John's and McDonald's definitely appear to rely more upon part-time labor.
For every dollar of revenue made by Denny's, it spends nearly 41 cents on wages and benefits. Cracker Barrel and Sonic are in similar territory, with CBRL spending 37 cents and SONC spending 36 cents on wages and benefits for every dollar of revenue generated.
McDonald's and Papa John's appear to be the least susceptible to labor costs of the bunch. Brinker and Darden appear to be in the middle, but based on the hour projections, they also appear to be the most dependent upon full-time labor.
Now, let's take a look at menu price increases.
Menu Price Increases
The ACA is likely to result in menu price increases at most restaurant chains. The extent of these increases depends upon how much of their labor force becomes subject to the ACA's standards. For this exercise, we'll look at a few different scenarios, including a few that assume that every employee will become subject to the ACA.
I had to make a few assumptions in this analysis. The first is that the average healthcare policy costs $4,000 and that this translates to about $2 per hour for an employee. This seems reasonable.
The second assumption is more difficult. We need to estimate how much demand will decline as a result of price increases. I decided that for every 5% in price increase, there is a 1% drop in demand. Whether this is reasonable or not is difficult to say without watching this experiment unfold in real time.
Based on this, I plotted out five different scenarios. The first scenario assumes that all employees are subject to the ACA and that the companies all decide to pay the $2,000 tax, rather than insure their employees. The 2nd through 5th scenarios merely plot out percentage increases in wage and benefit expenses, ranging from 10% to 25%. Theoretically, if most of these chains insured all of their employees, they'd be at the high-end of that range (20% - 25%), but since there will be significant avoidance, I suspect that in actuality, we'll see most of these chains at the low end at around 10%.
Here are the results:
If we assume the 10% scenario is the most probable, and the underlying assumptions are reasonably accurate, then this suggests that we'll see price increases between 3% to 5% at most restaurant chains. If restaurants decide not to take steps to minimize exposure to the law (as Darden claims it will not), then we could see price increase ranging from about 7% to 12%.
On a $20 ticket, the 'avoidance' scenario suggests that the price would rise to around $21.00. The 'full-coverage' scenario suggests that the price would rise to around $22.00. These aren't massive increases, but in a time when restaurants are already struggling to grow profits, it is likely to have some negative impact.
Restaurants Will Adapt --- Employees Will Struggle
My expectation is restaurants will adapt fairly well to the ACA within the next 12 months. Many of them will pass on menu price increases, but most of them will minimize the impact of this by re-arranging their schedules, working employees less, and possibly by hiring more part-time workers.
The bigger impact will be on the employees. If you are a full-time waitress, what happens when your hours get cut from 35 - 40 hours down to 25 - 30 hours? Ten hours per week over fifty weeks comes out to 500 hours for the year. If you average $10 per hour in tips and $5 per hour in cash wages, that comes out to about $7,500 for the year. That's a decline of 25% in annual income. That's not a small chunk of change for someone who's scraping by.
What it will mean is that many restaurant workers will have to find other part-time work elsewhere to make ends meet, and that's not necessarily easy in an environment with such high unemployment. It's worth mentioning that restaurants aren't exactly the most flexible of institutions when it comes to scheduling, meaning that many restaurant workers will have to deal with significantly lower wages as a result of the act.
This brings us back to consumer spending. While I expect that the ACA will require restaurants and retail chains to raise prices somewhat, I expect the bigger impact will be on the consumer spending end. Many employees will be impacted by restaurants and retail firms re-arranging hours in order to avoid the requirements of the ACA.
Consumer spending makes up about 71% of GDP. This means that any hit it takes can have an inordinately large impact on the economy.
(click to enlarge)
With the implementation of a 2% payroll tax this year, coupled with many of the stealth taxes in Obamacare, most Americans will have lower take-home pay in 2014 and 2015. Add on the fact that a chunk of Americans will see lower gross wages as a result of Obamacare's "full-time employee" definition, and you get a scenario where it's completely plausible that consumer expenditures will stagnate.
We already saw subdued growth in consumer spending in 2012, with a 3.6% increase. That might not sound so bad, but that's a nominal increase (we'd expect it to jump with inflation), and it's also well below the post-World War II average of 7.0%. This is by no means disastrous, but it does suggest that if consumer spending growth slows down, we'll have to make up for it either via greater domestic private investment, more exports, or more government spending (where we're already stretched to the limit).
Economies are Complex Beings
Of course, consumer spending isn't the only driver of the economy. I expect that Obamacare will hamper spending and investment somewhat, but it won't necessarily stop a rebound in housing, nor halt America's progress towards becoming a big energy exporter. For these reasons, even if the ACA has a highly detrimental impact, it won't automatically create a recession.
As an investor, I've found that one can often understand the impact and dynamics of a certain event, but it's more difficult to figure out how it will affect the bigger picture. Yes, restaurants and retail will be adversely impacted by the ACA. Yes, low-skilled employees will suffer as their companies are forced to pare back their hours. But none of this is likely to stop the impact of the large stimuli being created by both the US Federal government (running large budget deficits) and the US Federal Reserve Bank.
In the 1920's, while most of the American economy thrived, the agricultural sector was in depression. In the 1990s, when America went through the tech boom, commodities were in one of the worst busts ever. Don't be too surprised if we see parts of the economy suffer from ACA, but see other parts (such as housing, banking, and oil / gas) hum along.
Conclusions and Upcoming Articles
Obamacare will likely hit restaurants with a double-whammy. It will force most restaurants to raise menu prices, while tax increases (and stealth tax increases), coupled with the ACA's effective hour restrictions, will result in lower disposable income for the average middle income consumer. Overall, could harm profit growth in the restaurant sector over the next 12-24 months, as well as have an adverse impact on long-term GDP growth.
In my upcoming articles, I'll look at how the act impacts healthcare savings accounts and high-deductible plans, as well as take a broader view on how it could slowly squeeze the economy.
Additional disclosure: Author is short on a bucket of restaurant stocks, including SONC and DRI.