McDonald's (NYSE:MCD), together with the entire restaurant industry, has been receiving negative publicity amid growing concerns about income inequality. As an increase in minimum wage moves closer to a congressional vote, there is some apprehension among investors, due to concerns about reduced profitability. This article examines McDonald's business model and valuation, and goes on to quantify the effect of an increase in the Federal minimum wage, if enacted.
The Business Model
Approximately 80% of the company's units are operated by franchisees, who pay 4% of revenue, as well as rent. The company generally owns both land and building. The result is a stable flow of revenue, with the franchisees bearing a substantial part of the risk.
The benefits of this model can be seen by examining the company's results around the time of the financial crisis. The revenue stream from franchisees continued to increase, as did EPS and dividends. That's an important consideration for income oriented investors, some of whom are holding the stock as a substitute for fixed income investments.
It should be noted that the company identifies and develops the locations, polices quality, and develops new products. Operations are large scale and efficient.
I develop normalized earnings by applying an average margin to current revenues. McDonald's has increased net income as a percentage of revenue from 8.58% to 19.97% over the past ten years. A large portion of that can be attributed to a decrease in company-operated stores, as a percentage of the total. Remember, revenue from franchisees is a fixed percentage of their sales. When averaging, I weighted current margins more heavily than historical.
I arrive at normalized earnings of $5.06, to which I apply a multiple of 20, typical of high quality, and arrive at a price target of $101 as of today, with shares trading in the $96 area.
EPS growth came in at 3.3% for 2013, of which 1.9% was increased revenue and 1.3% decreased share count. Going forward, I'm looking for EPS to increase at a rate of 6% per year, driven by a 4% increase in revenue and 2% from share buybacks.
Capex proceeds at a rate approximately two times depreciation. As such, McDonald's continues to invest in growth, while paying a dividend and buying back shares. This demonstrates that it has the resources to drive growth by investing in new property, plant and equipment.
Of course McDonald's management is utterly clueless about what living on minimum wage entails. Most recently, they gave advice to employees on the topic of tipping, to include au pairs, swimming pool cleaners, etc.
Many counter service outlets have tip jars lately, in recognition of the fact that those who serve you can't live on what they're paid. Not McDonald's: it lets you dump your chump change into a charity of its choice.
I don't believe the public relations damage will be that great, for the fact that other employers of minimum wage earners have been equally obtuse. Let's concentrate on the likely effects of an increase in the minimum wage.
Doing the Math on Minimum Wage
There is an extensive literature on the economic effects of minimum wage increases, to include the restaurant industry. The most credible document I could locate suggests that 70% of the increased cost is passed on to consumers.
The entire industry would be affected by a minimum wage, and with the playing field leveled by law, passing it through is the natural outcome. Wendy's (NASDAQ:WEN), Burger King (NYSE:BKW) and Yum Brands (NYSE:YUM) would all do likewise.
Labor contributes 25% to 30% of cost in the fast food industry. Managers make substantially more than front line employees, and employees with additional responsibilities earn in excess of the minimum. Estimating that two-thirds of payroll cost goes to minimum wage earners, 25% X 67% = 16.75% of the cost goes to them. An increase from $8 to $10.10 would be 26.25%. Applying that to the 16.75% of the total cost of the hamburger that goes to the minimum wage earners, the price of the hamburger would go up 4.3%, if all of the extra cost were passed through.
What does that mean to McDonald's? For company-operated stores, it would reduce profit by 1%, assuming 70% is passed through. For franchised revenues, it amounts to a 3% increase, which will flow to the bottom line. For 2013, revenues from franchisees were $9,231 million. 3% of that is $277 million. After tax at 32%, it's $188 million, or 19 cents per share. Now the 1% reduction of profit on company operated stores works out to $188 million, or 13 cents per share after tax. A net gain to shareholders of 6 cents per share.
Yes, the customer can pay for it. A wage earner whose pay just went up from $8 to $10.10 has just received a 25% increase. He can afford another 3% on his hamburger. And yes, the economy can stand it. We could use some inflation. Remember, the Fed is terrified of deflation. Restaurants and retail don't constitute the entire economy, and the effect on the economy as a whole would be well less than 3% inflation.
Effect on Franchisees
All else equal, franchisees would see an approximate 1% reduction in margin. Very possibly they will sell more hamburgers, since minimum wage earners will have increased spending power. I think that's the most likely outcome. And bear in mind, the increase will be phased in over a period of years. Bumper crops of corn will eventually reduce beef costs, and it may be possible to avoid passing the savings along to consumers.
If not, the solution is simple enough: at $10.10 per hour, average motivation will increase. Those who can't or won't come to work on time and do what they're told can be let go. The bottom 5% is all it would take.
Closing Thoughts on Risk and Valuation
Looking forward two years, and assuming 6% annualized increase in EPS, my target price would be $114 by the end of 2015. If shares reach that level, capital appreciation will be 9.4% annualized. Adding the dividend, total returns would be 12.5%.
Based on this set of assumptions, I believe the stock is suitable for buy, hold and monitor. Buying at today's share prices, an investor has a reasonable expectation of receiving an increased flow of dividend income and eventual share price appreciation.