California's Minimum Wage Deal And McDonald's: New Era Begins

| About: McDonald's Corporation (MCD)

Summary

California passed a deal between the legislators and unions to raise the minimum wage to $15 by 2022.

McDonald's has been at the center of this minimum wage movement and investors are worried if this would erode the company’s profitability.

The firm’s business model is as strong as ever and it should be able to bring labor efficiencies to limit wage burden.

Short term earnings dip should be expected but over a longer term, minimum wage increase might end up benefiting the company.

California's minimum wage will get a boost to $15 per hour according to the deal reached by legislators and labor unions. Currently the statewide minimum wage is $10 an hour. As per the deal, the minimum wage will rise to $10.50 an hour on 1st Jan 2017, $11 an hour on 1st Jan 2018 and then it will see a $1 per hour increase every year till 2022 to reach the figure of $15 per hour. Future minimum wage increase will be linked to inflation, although the governor will have the powers to block an increase during economic downturns.

This deal averts the possibility of a showdown in November 2016 through a ballot. For the past several years the "Fight for $15" campaign was gathering steam. There were heated arguments on both sides. People in favor of the increase pointed to the fact that it would reduce income inequality and would also reduce government payouts in terms of benefits for minimum wage earners. Those against it mentioned the job loss it will cause in the local economy and lower investment by bigger companies.

McDonald's Corporation (NYSE: MCD) was at the center of this debate as a majority of its workers end up receiving near minimum wage. Also the entire fast food industry is generally viewed as the main battleground by advocates in favor of a minimum increase. Investors have worried that such a massive increase would reduce the growth possibilities of the company and would hurt the profitability due to higher wage bills.

We need to first look at the numbers behind this debate and not get entangled in the rhetoric of either side to find the exact pros and cons for the company. Currently the minimum wage in California is $10 an hour. According to the deal reached the percent increase in wage per year will be: 2017 - 5.00%, 2018- 4.76%, 2019- 9.09%, 2020- 8.33%, 2021- 7.69%, 2022 -7.14%. The compounded annual growth rate for the wages comes to 6.99% for the entire six year period. We can visualize the increase from the following chart.

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Fig: Minimum wage increase and percentage increase from 2016 to 2022 in California

On the other hand the inflation rate in US and California has been much lower for the past 2 decades.

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Fig: US and California's CPI inflation has been between 2-4% for major part of the past two decades.

The current statewide minimum wage hike is certainly much higher than the general inflation rate seen. It would also most certainly push other states to adopt a similar level of pay hike, although it might be adopted over a longer term.

McDonald's receives $8.56 Billion or 32% of its global revenue and close to 40% of its consolidated operating income from US. Of the $16.48 billion sales made in company operated restaurants globally, payroll & employee benefits cost was $4.4 billion. Hence payroll accounts for 26.7% of the total sales on an average. A sudden increase in the wage bill will surely put the earnings under strain for a couple of quarters. The firm will eventually have to increase the menu prices which will negatively impact the sales.

Over a longer term, McDonald's might end up benefiting from this minimum wage hike due to higher purchasing power among lower and average income earners. Food still makes up the largest expense for McDonald's. For 2015, the firm spent $5.55 billion on food within company-operated restaurants. This made up 33.6% of the total cost. Over the past few years food cost have risen considerably, which can be seen in the following chart.

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Fig: Rapid increase in major food constituents like beef, fish and poultry has led to a greater pressure on menu prices.

As the minimum wage increases throughout the state, it should leave more money for discretionary spending in the pockets of wage earners. Currently 42% of entire US population earns less than $15 per hour. A bump in minimum wage should also lead to a boost in the pay scale of other wage earners who are earning less than the average wage. We should see higher percentage spending by this group in MCD, as their income levels rise with the minimum wage increase.

Conclusion

McDonald's has been at the forefront of the minimum wage debate for the past few years. The current deal passed by California's legislators and unions will increase the minimum wage for the state to $15 per hour by 2022. This is 6.99% increase per year on a compounded basis and is much higher than the past inflation trends. The firm will surely see the impact on earnings for the next few quarters as other states also rollout their minimum wage laws. However investors should not get anxious over this minor setback as the firm should end up benefiting in the long run due to a higher purchasing power and greater discretionary income among lower to average income earners.

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I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.