McDonald's And Franchisees: Part 3 Of 3 Ways To Tell When The Worst Is Over

| About: McDonald's Corporation (MCD)
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MCD's share price and earnings have underperformed relative to the S&P and restaurant peers over the last 12 months.

A large part of MCD's problems in the US stems from growing tensions between corporate headquarters and MCD franchisees.

Strategically, MCD's franchisee problems link to both menu complexity (part 1 of this series) and food integrity issues (part 2 of this series).

Until MCD sorts out its problems with its franchisees, its share price will underperform peers and up-and-coming rivals.

While McDonald's (NYSE:MCD) share price has improved somewhat since I began this series in mid-April, relative to its peers MCD continues to languish. As of this week, it is up about 6% for the year, while the S&P is up triple that (18%). The same goes for an ETF tracking the QSR sector worldwide, the S&P International Consumer Discretionary ETF (NYSEARCA:IPD), which is also up some 18% for the year.

Source: Google Finance 6/5/2014

This underperformance is no surprise: last quarter, McDonald's same restaurant sales in America decreased by 1.7 percent, and worldwide revenues increased by only 1 percent. Meanwhile, its operating income declined 1 percent from a year ago.

This article is the final installment in a series to help investors figure out when the worst will be over for McDonald's shareholders.

When (and How) will McDonald's Shares Rebound?

In the first part of this series, I linked McDonald's underperformance to menu complexity - too many items on the average restaurant's menu board.

In the second part, I also connected MCD's declining fortunes to consumers' ebbing faith in the integrity of McDonald's food: how the MCD's ingredients are grown, processed and delivered is out-of-sync with the public's affinity for food perceived as marginally more "natural," "simple" and "healthy."

In this final part, I connect these two ideas to the final factor that explains MCD's underperformance: McDonald's deteriorating relationship with its owner-operators, the franchisees who make the magic happen (or not) every day. This relationship has historically been at the center of MCD's success. Until investors see evidence that this core relationship is improving, expect the price to languish. Essentially, right now the solution to declining sales suggested by McDonald's Oak Brook executives (increased menu complexity and discounts), is not compelling to franchisees and is counterproductive operationally. Performance at the US store level is lagging.

Meanwhile, MCD headquarters is basically ducking the long term brand cancer that a declining perception of MCD's food integrity represents, and antagonizing owners by expanding the menu (among other things). Conversely, the franchisees will be more energized when the company provides a compelling vision on where they're taking the brand (back to Middle America, but the one of today) and then work to get it supported by franchisees.

If the franchisee relationship remains a mess (and apparently it is), expect sub-optimal MCD share performance in the medium to long term.

Who Controls What?

Before we go any further, a rough sketch of the relationship between MCD's headquarters and its nominally independent franchisees is in order. After all, some 80% of MCD restaurants worldwide are owned and operated by franchisees. In the US, with some 14,100 locations, that figure is closer to 90%.

So who controls what? As the grantor of a franchise, Oak Brook literally writes the rule book, or operating agreement, for MCD franchisees. Essentially, this means that they call the shots concerning:

1) The Menu that each restaurant must offer

2) The Brand - Oak Brook sets the national and local advertising agenda; it proposes campaigns, and then franchisee cooperatives spend the funds to execute the advertising and market plan

3) The Real Estate - McDonald's manages all the site evaluation, acquires the property, and constructs the building; they then charge rent (right now, in the franchisees' view, too much!)

4) The Quality Standards for both food and service (both suffering)

5) The Training - for which franchisees pay a fee, and which takes employee time

6) The Supply Chain - there are franchisee buying cooperatives, but overall MCD is in charge

7) New Product and Equipment Standards - MCD sets these, though it is the franchisee who is required to make the investment to meet these standards

What do the Franchisees control? Some lines are fuzzy, but basically McDonald's restaurant owner-operator controls:

1) The Prices of most menu items (but with important exceptions like the "Dollar Menu" - currently a sore point)

2) The Labor - owners hire, set wages and schedule shifts; obviously, they have to balance Oak Brook standards of both service and cleanliness with both local conditions and their desire to make a return

3) The Purchasing and Maintenance of Equipment - again, these decisions are driven by Oak Brook standards but the franchisee has some say about timing and type

4) The Purchasing of Supplies - franchisees purchase their supplies independently, but through buying cooperatives from approved suppliers

5) The Local Advertising - each restaurant is required to spend a minimum of 4% of gross sales annually for advertising and promoting the business; they also vote on regional and national ad campaigns

6) In the future, Health Care - Under Obamacare, after 2015 franchisees will have to pay for employee health care if they have more than 50 employees

How the Money (and Tension) Flows

The final piece of the MCD/franchisee puzzle is how the money flows. Not surprisingly, this is where the tension is building.

Generally, MCD requires a minimum investment of $750,000 of "non-borrowed personal resources" to grant a franchise. After that initial investment, franchisees pay MCD anywhere from a low 8% to as much as 12% of store sales in rent to Oak Brook. In addition, all owner-operators pay headquarters a 4% service fee (for things like training and software), plus they contribute a mandatory 4% of sales to the McDonald's marketing fund, which is split between local and national advertising. Both of these 4% fees are, like rent, calculated on gross sales at the store level. Finally, the franchisee also bears the costs of equipment upgrades and restaurant refurbishments, which in many cases are mandated by MCD.

The Rising Alienation of McDonald's Owners-Operators

Given the structure outlined above, it is easy to imagine that when restaurant level cash flow is declining, franchisees are unhappy. They feel the pinch. They especially feel alienated - and perhaps even downright angry - when, as has happened lately, MCD Corporate:

  • Won't budge on rent when renewing leases, which many owners say have departed too far from the historic average of 8%
  • Require franchisees to run promotions like free coffee for several weeks to fight off competition in breakfast
  • Expand the "Dollar Menu & More," and then spend funds advertising it: this drives gross sales, but hurts owners' margins because people then don't buy as many more expensive sandwiches
  • Require upgrades to equipment like new prep tables that both cost money (estimated at some $15,000 or higher), plus downtime; these new prep tables are largely to accommodate Oak Brook's new menu customization scheme
  • Mandate physical restaurant "reimaging," which many owners feel are is both insufficiently flexible, and is being driven on timetable dictated from Oak Brook - to be completed by the end of 2016 - that owners feel is too fast
  • Crack the whip on service quality and friendliness, which for owners drive up staffing and training costs

In short, there is a culture problem between MCD and its owner operators brewing. One franchisee recently told Bloomberg: "What I see going wrong is the corporation itself is forgetting that its fiscal strength rides on the fiscal strength and the creativity of the operators, and it's just going for such centralized control." A survey conducted by McDonald's itself in March resulted in franchisees ranking their relationship with Oak Brook as a 1.73 on a scale of 1 to 5 (with 1 being poor, and 5 being excellent). At the end of 2013, the same survey had produced the lowest result ever, with franchisee satisfaction dipping to 1.7.

Can Investors Smell A Spoiling Culture?

As an investor, you can find evidence of growing animosity between MCD corporate and franchise owners in two ways. As I argued in the first piece in this series, the plural of anecdote is not evidence, but there is value in store visits when operational consistency is the name of the game. Evidence for a fraying rapport between franchisees and MCD corporate may be no further away than your local McDonald's. There, you might see or experience things backed up in wider surveys (your second source of evidence):

  • Increasing waiting times in store - According to the WSJ, in a recent webcast to franchisees, one slide said that complaints about speed of service "have increased significantly over the past six months." Another slide said that customers find service "chaotic." Another boldly stated "Service is broken."
  • Increasing waiting times at the drive through - A survey by QSR Magazine/Insula Research recently observed that McDonald's recorded its slowest drive-through time in 15 years. In their annual Drive-Thru Study, QSR Magazine's comparison of customer service at fast-food chains, average service time at McDonald's drive-through was 188.83 seconds, compared with 129.75 for Wendy's (NYSE:WEN), the industry leader.
  • Less friendly staff - In another recent survey, Chick-fil-A had the top friendliness ratings among QSRs. Of the seven major chains considered, McDonald's was second to last in the "very friendly" ranking, just above Burger King (BKW). According Bloomberg, in a recent Oak Brook-Owner webcast, 20% of customer complaints concerned staff friendliness (or lack thereof).

In short, McDonald's is running out of the special sauce needed to make the brand work in the long run - a culture of quality service. A big reason this is happening is because MCD is spoiling relationship with its franchisees.

The Actual Sources of Tension?

From a tactical perspective, it's easy to say the source of these problems is declining cash flows at the restaurant level. When they head back up, owner operators will smile again. Here, however, I would argue that investors need to think more strategically. The relationship problems are rooted in the two issues that I have already raised in this series.

First consider Menu Complexity: the sheer range of items McDonald's currently offers impacts efficiency at the store level in numerous ways. It affects day to day operational efficiency in everything from speed of service to order accuracy. It impacts the amount of staff training required, and it also impacts turnover - unhappy customers tend to create unhappy staff, which increases turnover, which leads to a vicious cycle of less satisfied customers and irritating, unfriendly and unhelpful staff. It adds to the amount of labor required to deliver any one dollar of food, and it also diminishes economies of scale at the supply chain level. In other words, menu complexity drives costs, and most of these costs are borne by the owners of the franchise.

The link between a broken franchisee relationship and menu complexity was illustrated clearly in a recent survey of 27 McDonald's owners by Janney Capital Markets. Collectively, these franchisees operate over 200 restaurants around the country. Among the anonymous comments offered were, "Free coffee, yeah, that'll do it!" Another said, "Our menu has gotten too big. We are trying to do too many things and our service and quality suffer. Look at In-N-Out Burger, Chick-fil-A, Five Guys. Their menus haven't changed in years and they do not offer discounts on a regular basis." One owner explicitly called the McWrap "an operational nightmare." Another respondent made the link between menu complexity, service problems and cultural problems even more clear, stating, "The menu items introduced during the last year - McWraps, Quarter Toppers, and Dollar Menu & More sandwiches - have killed our service and totally upset our kitchens." Another operator said, "Slow kitchen turnaround times; more new products that do not sell." Yet another said "Upper management and supporting departments are out of touch. We're spending like crazy on new equipment. Very little return. We keep adding more products and expecting different results on service times. We are 8-10 seconds slower than last year."

Next, investors should think about food integrity, the idea that MCD is no longer the go-to place for many American soccer moms. Here, the strategic link with long-term franchisee satisfaction is equally clear. Day to day, declining perceptions of MCD's food quality impact owners' ability to raise prices - one of the few key decisions under their direct control. Right now, restaurant owners are having to do the opposite, with one respondent to the Janney survey writing that MCD is "couponing like there is no tomorrow," and another complaining that, "every quarter we sell a smaller percentage of our menu at full (and profitable) price." Specifically on the issue of discounting to drive volume, a franchisee stated that in the long run it, "Won't help. No matter what. There is no way to make all those $1 or $2 sandwiches fast. We could do it when it was just the McDouble and the McChicken. But now with 25 total items, no. If you add crew it doesn't cover the cost to make all the Dollar Menu crap. Haven't sold a wrap in so long. No one remembers how to make one." In the short run, of course, profitless volume keeps Oak Brook happy because they make their money on each restaurants' gross, not net, sales.

But MCD's food integrity problem also hits franchisees in the long run. It does so by reducing the total addressable market size for each location. As more and more of the US middle class decides that MCD's ingredients are not grown, processed and delivered in a healthy enough manner for their families to eat regularly, the value of each franchise declines. As greater numbers of Americans switch to restaurants perceived as more "natural," "simple" and "healthy," (i.e., concepts like Chipotle (NYSE:CMG), which is built on this trend), McDonald's franchisees lose out. This will be a slow process, but because franchisee satisfaction is driven so largely by cash flow, it is a critical strategic challenge that initiatives like menu customization ignore.

The Way Forward

In other words, the way for Oak Brook to fix the culture of dissatisfaction among owners (which will help customer satisfaction and operational efficiency) is for them to focus on menu simplification and food integrity. Instead of nibbling away at the margins of these issues, trying to be all things to all people, and announcing share buybacks for a short-term boost, MCD needs to take drastic action on these core strategic issues.

For investors, the key to the long-term performance of MCD shares is these three linked "meat and potato" operational issues: menu complexity, food integrity, and franchisee tension. Until Oak Brook comes up with a plan that jointly addresses these, expect MCD's share price to languish.

Disclosure: The author is long MCD. 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.