McDonald's (NYSE:MCD) is a unique company. They are known across the world for their food, and everything that goes with that reputation. However, McDonald's is so much more than hamburgers. Nearly a third of their annual revenue comes from franchised restaurants. The franchised restaurants are the real backbone of the McDonald's business. Despite their focus on franchising, McDonald's has been named as a joint employer. This status for McDonald's comes as a shock to many analysts that believed the franchise model would nullify attempts at unionization.
There's no use in shareholder's bemoaning what has already happened. As investors, we need to understand what this means for the company. To get a better feel for how the company is operating, take a look at McDonald's Operating Results. This image is reproduced directly from their 10-K on file with the SEC.
The first thing that should pop out when looking at that picture is how high company-operated expenses are relative to the sales. The margin on company-operated restaurants is dramatically worse than the margin overall. It is the revenues from franchised restaurants that make McDonald's so appealing to shareholders. Imagine McDonald's as two companies that are tied together. One operates restaurants, and the other collects fees from franchisees. The restaurant's best case scenario would be to assume that all selling, general, and administrative costs come from the franchise side. In that scenario, this is the gross margin for operating the restaurants:
Following that same scenario, this is the gross margin for the portion that controls the franchisees:
It should be very clear from this analysis that collecting the franchise fee is much more attractive than operating the restaurant. Since the companies are tied together, that might seem trivial. The companies financial statements are phenomenally consistent. What does it matter where the money comes from?
The company-operated restaurants make it much easier to tell how the business runs for a franchisee.
Those franchising fees require actual locations. McDonald's has two kinds of customers. The people that buy hamburgers, and the people that buy restaurants. While customers for burgers may not read the nutritional information, customers looking to buy a franchise are very concerned with reading the numbers. We're looking at gross profits, before interest expenses. Put yourself in the shoes of a person contemplating opening a McDonald's franchise location. Those margins are already pretty slim when you factor in the costs of royalties and interest.
There is no such thing as a franchise without an interest expense. Even if the hypothetical investor had millions of dollars available, they would still have to absorb the opportunity cost of not investing it interest bearing securities. They may not have to pay a top level manager if they put in those hours, but again there is an opportunity cost. The business of owning the franchise has become less attractive over the last few years. That is a problem for McDonald's, because the franchise operator is their most valuable customer.
McDonald's CEO Don Thompson has seen the writing on the wall, in regards to wages. He understands what is happening and preemptively got behind minimum wage increases. Ultimately, McDonald's wasn't going to be able to determine if the minimum wage was increased or not. He may not actually want the minimum wage increase, but at least these damage control measures may improve public perception of the corporation.
The actual situation for the franchise owners may not be as dire as it appears.
While the higher hourly wages will increase compensation costs, it may reduce some of the other general costs. Employee turnover may be reduced if McDonald's is seen as a preferred employee. Higher wages will also bring in more qualified applicants. The decrease in costs of background checks, new hire paperwork, and training may offset the increase in wages. McDonald's still operates in countries with higher minimum wage laws. In Denmark, young employees make at least $15/hour and employees over 18 years old make at least $21/hour. There are several factors that make it a different market, but an increase in wages will have some positive effects to offset the negative ones. It would be misleading to simply increase the "compensation" line item by a certain percent. Unfortunately, many potential franchise owners may do exactly that.
For now, the perception may be more important than the reality. If the perception is that compensation will increase by a set percent, then the projected margins will have to be decreased. That may prevent investors from opening new franchise locations. Even if the increase in compensation was 100% covered by increases in productivity and decreases in turnover costs, the perception of lower profitability for franchise owners could slow the growth of new locations.
There are two ways to watch McDonald's financial statements:
The wrong way
Watching McDonald's gross margins as one complete business would be a failure of analysis. The gross margins for McDonald's as a corporation will lag way behind the gross margins of franchise owners. Looking at McDonald's from that perspective creates information that is out-dated before it is published.
The right way
Treat McDonald's as two businesses. The attractiveness of the brick and mortar stores, or moreover the perception of their attractiveness, drives the growth in the franchise fees. The franchise fees drive the profits of the McDonald's Corporation. The higher the profit margin for the brick and mortar stores, the higher I would project the franchise fees to be in future years.
McDonald's financial statements will not show the full effect of these negotiations for several years. Even if McDonald's wins the case and minimum wage is unchanged, the uncertainty surrounding these costs may decrease the number of small investors that choose to open franchise locations. Effectively, small investors may be boycotting McDonald's most profitable business segment. If you're staying long in McDonald's, watch the financial statements for a change in the number of new franchises opening each quarter and a change in the margin between store revenues and store costs. The 1.66% drop in share price since the announcement, from $95.89 to $94.30, is insufficient to cover any meaningful reduction in the growth rate of franchise locations.
I am bearish on the stock, but not because their business model is wrong. Their model is great. I am not bearish because of the impact increased wages will actually have. I am bearish because I believe that potential franchise owners will overestimate the increase in costs and then decline to join in the program. I do not believe that those potential investors will wait for years to see the actual impact; therefore, I believe the temporary setback in growth will not be recovered in subsequent years.
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.
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