The Affordable Care Act could have a negative impact on the restaurant sector in 2014. There are two big reasons for this. It's likely that ACA compliance will increase costs for most restaurant chains, which will ultimately result in higher menu prices. While most chains will minimize their exposure to the law by cutting back employee hours below the 30-hour threshold, it's still likely that we'll see menu price increases in the 3% - 8% range.
Price increases will hurt, but I suspect that the even bigger impact will come from a hit in consumer spending, that could result from higher direct taxes, as well as higher stealth taxes (in the form of higher insurance premiums) that could hit middle-income consumers. This "double-whammy" of higher prices and lower disposable income could hit restaurants particularly hard, since dining out is often one of the easiest places for consumers to cut back.
In a previous article, I examined how the ACA could impact the restaurant sector ("How Obamacare Could Harm Growth in 2014, Part III"). I've also given a detailed analysis of one restaurant chain that could make a good short based on this thesis (Why I'm Short on Sonic, Part I, Part II, and Part III). However, predicting how large macroeconomic forces will play out is a very tricky game. For instance, the ACA could lower GDP growth, but be offset by gains in the housing market and oil / gas exports. For this reason, the better strategy is often to go long on one company, while shorting another, and I'm interested in finding companies that will perform well on a relative basis.
If history tells us anything, there is one particular restaurant that could stand to benefit from Obamacare: McDonald's (MCD). Regulation often helps the biggest players in a given industry in numerous ways. For one, by imposing higher up-front costs, it creates new barriers to entry. While it's true that the ACA exempts companies with under 50 employees from compliance, this should really only protect a small handful of one-unit restaurants. Any fast-food restaurant with 2+ stores is at a disadvantage versus the big players.
Regulation also has the tendency to create more fixed costs in an industry. Companies with higher-volume are able to spread these new costs amongst a larger number of units, which gives them economies of scale. As we will see, McDonald's has a big advantage on this front, and while its restaurants may suffer a little bit from Obamacare, it should fare much better than many of its competitors.
It's All About Volume
There are economies of scale in the fast-food restaurant industry, even though variable costs make up the bulk of expenses. The biggest fixed cost for most restaurant chains is rent. If a restaurant has a monthly lease, the cost normally stays the same whether it opens 24/7 or only for Friday and Saturday night dinner rushes. If the lease costs $5,000 per month and the restaurant pulls in $250,000 per month in revenues, then rental costs make up a paltry 2%. On the other hand, if a restaurant only pulls in $30,000, then rent will cost 16.7% of revenues. For this reason, restaurants that can achieve a higher volume of sales do have an advantage.
Food costs are the biggest variable cost component for fast-food. So long as management adheres to prudent inventory management, the cost for beef in a hamburger should be about the same whether a restaurant makes 100 per day or 10,000 per day. Obviously, there are some advantages to volume buying, and it can provide additional bargaining leverage, but the differences are not that huge.
Labor is a bit trickier. Theoretically, labor is variable, but reality is more complex due to labor utilization. Most restaurants have a bare minimum staff level to keep stores open. This is a semi-fixed cost. At a bare minimal staffing level, labor is often unproductively utilized, but there's no other option. As volume picks up and labor becomes more productive, labor costs become more variable.
Mandatory wage increases throw a kink into the system. If the Federal government requires a $2 per hour wage increase for all employees, labor costs will rise, but productivity will not. In this sense, labor regulations can create more semi-fixed costs, and make volume sales more important.
The ACA is similar to a minimum wage increase, but more complex. It raises wages about $2 per hour for full-time employees. It also creates more complexity and legal compliance costs. However, unlike a minimum wage increase, it can be avoided by shifting workers to part-time status (i.e. under 30 hours under the ACA). Regardless, it will make labor more expensive and less flexible; thus making volume more important.
Average Store Revenue Growth
There's been a very interesting evolution in the fast-food industry over the past decade. McDonald's has dramatically outpaced its rivals in volume of sales, as best exemplified via average store revenue growth. The chart below charts average store revenues for publicly-traded fast-food franchises. On top of Mickey D's, I've included Sonic (SONC), Jack in the Box (JACK), Wendy's (WEN), and Carrols Restaurant Group (TAST). The latter is the largest Burger King (BKW) franchisee in the United States.
While McDonald's growth has been uneven, and there have been major differences between growth in company-owned stores and franchised stores, we can nevertheless see that over the long-haul, McDonald's has significantly outpaced its rivals.
In 2012, the average McDonald's annual store revenue is somewhere between $2.5 - $2.8 million. Wendy's comes in second, around $1.48 million, with Jack in the Box in third, around $1.35 - $1.5 million. Burger King (via Carrols) lags behind a bit at $1.25 million. Sonic comes in last with average annual revenue around $1.0 - $1.1 million. While we have limited data here for some franchises, it's clear that McDonald's had a lead in 2001, and has dramatically expanded that lead in the 11 years since.
This becomes particularly interesting during the 2007 - 2010 period when two trends occurred in the US market: (1) minimum wage increases, and (2) "The Great Recession". The latter harmed consumer spending at restaurants, causing many chains to struggle. The impact of the former is less clear.
Minimum wage was increased from $5.15 per hour up to $7.25 per hour during a 2-year period. Is it just a coincidence that McDonald's gained so much market share during these wages increases? The issue is up for debate, but I suspect that McDonald's may have partly benefited from the minimum wage hike, while most other fast-food chains suffered. While it's true that the minimum wage increase raised costs for McDonald's, it hit competitors harder, meaning McDonald's gained on relative terms.
CPI-Adjusted Revenue Growth
Another way to measure volume growth is to look at inflation-adjusted revenue growth. While it's an imperfect measure, it should prove fairly reliable over a long-term horizon. Below, we can see the CPI-adjusted growth for MCD, TAST, SONC, and JACK.
Here you can see that from 2003 - 2012, there was very little real growth in average revenues for any of the three chains outside of McDonald's. While the other three chains grew between -0.8% and +0.4%, McDonald's company-owned stores grew 4.8% in CPI-adjusted terms, and the franchised stores grew 1.0%.
Since 2007, McDonald's has outpaced its rivals, as well. Indeed, it's the only one in the group that has grown in CPI-adjusted terms, with company-owned stores growing revenues 1.1% and franchised stores growing 3.3%.
Unfortunately, there are lots of privately-owned companies out there that we have no public data for (e.g. Five Guys), but this at least suggests that while the traditional fast-food chains are suffering in the aggregate, McDonald's has held up much better than most, and now has a major advantage in volume.
Labor Expense as a % of Revenue
McDonald's volume advantage plays out on its income statement in the form of lower wage expense as a percentage of revenue. The chart below looks at average wage expenses for seven different restaurants, including the five we've already examined. I also added Papa John's (PZZA) and Krispy Kreme's (KKD) Kreme Works LLC Subsidiary to the list, as well. (One caveat: Carrols data is based on FY 2011 results due to a big acquisition in FY 2012 that would likely skew results.)
We can see from this data that McDonald's seems to have a sizable advantage over its publicly-traded competitors. Its wage expense is only 25.3% of revenues, whereas the industry norm would appear to be more in the 29% - 32%, with Sonic being a bit of an outlier at 35.7%.
The other takeaway here can be found in the last row, which takes an educated guess at "average hours worked per employee" based on a $9 labor wage. From this, we can see that McDonald's workforce appears to be more part-time than many of its competitors, which should make the transition under the ACA easier for it.
Of course, labor is only one part of the cost equation. McDonald's also has a large advantage when it comes to "other operating expenses", which typically includes more fixed-costs such as rent. McDonald's other operating expenses as a percentage of revenue for company-owned stores has fallen from 24.9% in 2001 to 22.6% in 2012; a sizable improvement that likely has a lot to do with its higher volume of sales over times.
The Positives and Negatives
If McDonald's has certain economies of scale that make it less vulnerable to the impact of things such as minimum wage increases and the upcoming implementation of the Affordable Care Act, it's appeal to consumers is still vital. Unfortunately, that's a bigger question mark.
We've seen much growth in the "better burger" chains that include companies like Five Guys, Red Robin (RRGB), In-N-Out, and Smashburger. We've also seen growth in sandwich franchises, such as Subway, Quizno's, Firehouse Subs, and Which Wich. Based on this, there seems to be a shift towards quality, and somewhat of a shift to fast-food alternatives. Though, McDonald's saw great growth during the downturn, things have seemed to reverse a bit over the past 18 months, with revenue growth stagnating.
Whether McDonald's can keep up with trends is not an issue I'll explore much in this article. Suffice it to say, however, that it has a lot of importance to McDonald's future profitability. I will say that McDonald's has adapted to changing consumer preferences much better than some of its competitors, and you can see that in the results.
If McDonald's has the potential to perform better than other fast-food chains in 2014 due to the implementation of the ACA, that still doesn't necessarily make the stock attractive. We need to look at valuation first to see if it makes a good investment.
The good news is that McDonald's 3.0% dividend yield looks attractive right now. The bad news is that its 5.4% earnings yield looks much less attractive. McDonald's payout ratio for FY 2012 (based on diluted earnings) was 53.5%, which is high. In its last quarter (Q1 2013), the payout ratio increased to 61.1%, up from 56.9% the year prior. 3% yield might be great if McDonald's was only paying out 30% - 40% of its earnings, but seems rather subpar when it's paying out over 60%. Unless one is expecting a significant amount of growth, this does not look particularly promising. That said, we'll dive deeper.
In order to understand McDonald's valuation better, let's take a look at the balance sheet.
The last line is Tangible Common Equity per Share. This is the important metric, but since balance sheets are created at "cost" rather than "intrinsic value", we need to adjust things. I typically look at recurring free cash flows (FCFS) and apply a multiple to it to value a firm's operating assets, which includes everything other than cash. McDonald's large capex (relative to depreciation) and stable earnings history, however, makes it a better candidate for an earnings multiple. McDonald's earned approximately $5.5 billion in both FY 2011 and FY 2012, so we'll use that as our baseline and apply a multiple. For instance, if we apply a 15x earnings multiple, we get the results below.
Tangible common equity ["TCE"] per share represents the equity valuation, which is $64.57 based on a 15x earnings multiple. There are many reasons to believe that this is too low. Most notably, McDonald's weighted average cost of debt is only 4.0%. After adjusting that for taxes, it falls to around 2.6%, which is about as low as it gets.
McDonald's has also achieved higher than average earnings growth. The chart below looks at the annualized earnings growth rate in diluted earnings per share ["DEPS"] for three time periods (11-years, 6-years, and 3-years).
I don't expect earnings to grow that rapidly in the future, but it still might be reasonable to expect McDonald's to achieve 5% - 8% earnings growth over the next half-decade. When you combine the extremely low costs of capital with higher-than-average growth, we should expect McDonald's to get a high multiple.
The chart below looks at the valuation of McDonald's based on earnings multiples ranging from 15x - 22.5x. I'd estimate that McDonald's deserves about a 20x multiple. The market is currently valuing it at around 22x.
Based on all of this, McDonald's looks a bit aggressively valued to me, but less so than many of its peers. Given McDonald's strong growth, and the fact that it should be less vulnerable to the ACA than competitors, I think it deserves a premium valuation compared to other fast-food chains. Still on an absolute basis, it looks slightly overvalued, selling at about a 9% premium to my "best guess" $92 valuation.
McDonald's is less vulnerable to the negative impacts of the Affordable Care Act than most other fast-food chains due to its higher volume of sales. McDonald's grew significantly after the minimum wage hikes of 2007 - 2009, while other fast-food chains floundered. While menu changes and management choices certainly deserve some credit, McDonald's does appear more immune to regulatory changes than competitors. The ACA could have a similar or greater impact and allow McDonald's competitive advantage to grow.
For income investors afraid of potential macro impacts, McDonald's might conceivably be a reasonable buy here. It's much less likely to get hit by big issues than other fast-food chains, so downside might be more limited. Unfortunately, at $100, it's looking slightly overvalued. While MCD could theoretically gain market share and help justify that valuation, I believe there are better options for income out there on a risk / reward basis. A 5.4% earnings yield looks quite dismal, even in a yield-starved environment.
McDonald's may work better in long / short pair trades. I analyzed Sonic in a previous article, and I believe it's significantly overvalued. Many other chains appear to have a relative overvaluation versus McDonald's and macro headwinds are less likely to harm McDonald's than competitors. While I have not initiated a position in McDonald's, I am still considering it as a potential hedge on my current restaurant shorts.
Overall, I'm neutral on McDonald's at $100. If it were to dip back down to the $80 - $85 range, it would certainly become more interesting as an outright buy, but at the current price, I see as a potential hedge and not much more.