Investor’s Business Daily – Can McDonald’s And Other Quick-Serve Franchises Digest $15 Minimum Wage?

McDonald’s (MCD) won few plaudits a year ago when, under fire from the Fight for $15 movement, it hiked the starting wage in its company-owned stores to $1 over the minimum.

Union organizers were far from satisfied. The hike upped the company’s average hourly wage to just above $10 an hour, and it only applied to workers at the roughly 1,500 company-operated restaurants in the U.S. — only about 10% of the total chain.

But no one was more upset than McDonald’s 3,000 franchise operators, who run the other 13,000 U.S. restaurants and who — as CEO Steve Easterbrook explained in an op-ed announcing the move — “make their own decisions about how they run their business and pay their employees.”

Being put on the spot to match the wage hike — by their hourly workers, if not exactly by Easterbrook — was, to say the least, awkward. The group has more to lose from minimum-wage hikes than non-franchise restaurants in the fast-food industry.

Quick-service franchises often operate on very thin profit margins. A big wage hike would squeeze them in multiple ways.

First, their labor costs go up, which puts pressure on them to raise prices. Higher prices could translate to lost sales.

Second, assuming that higher prices generate enough extra revenue to pay for the higher labor costs, franchisees have an added burden: The fees they pay to the companies behind franchises like McDonald’s and Burger King (owned by Restaurant Brands International (QSR)) are a fixed percentage of sales — a 10% price hike means a 10% hike in franchise fees.

For quick-service chains with few company-operated stores, a much higher minimum wage won’t have much of a direct effect, but a deterioration in the financial health of their franchisees — even if fees from the franchises were increased — would bode ill for the company’s future.

Slow vs. Quick Wage Rate Hikes

Chains such as McDonald’s and Burger King charge franchisees a royalty of around 4%-5% of sales and a similar-sized marketing fee. On top of that, a number of chains, including McDonald’s, Burger King, Tim Horton’s, Wendy’s (WEN) and Jack In the Box (JACK), generally lease out their restaurant locations to franchisees for an additional percentage of sales, said John Gordon, founder of Pacific Management Consulting Group, which provides restaurant industry analysis to investors and franchisees. At McDonald’s, rent can reach 14% of sales or more, Gordon said.

Some simple math illustrates the challenge for a McDonald’s franchisee under a long-term contract to pay out 20% of revenue to the fast-food giant. Assuming a franchisee earns a 2% profit margin, then a 10% price hike that’s just enough to cover extra labor costs would, all else equal, erase its profitability. (See table.)

Historically, “shareholders have benefited” from slow, modest increases in the minimum wage, as prices were pushed higher by wage inflation, said Richard Adams, founder of Franchise Equity Group and a former McDonald’s franchising executive. “The problem is if you accelerate the minimum wage too quickly.”

That looks to be the case in California and New York, where the minimum wage is set to rise to $15 an hour by 2022 and July 2021, respectively. While New York’s statewide minimum wage is only set to rise to $12.50 outside of New York City and surrounding counties, quick-service chains will have to pay $15 statewide under a separate fast-food wage, unless courts strike down the unequal treatment.

A survey conducted for the Employment Policies Institute found that franchise businesses would be more likely than non-franchise businesses to cut jobs (65% vs. 51%) and turn to automation (54% vs. 37%) in response to a $15 wage. While the group advocates against minimum-wage hikes, the notion that franchisees would be less able to manage higher labor costs jibes with analyst comments that labor costs passed through as price increases would also raise the cost of royalties, marketing and rent.

Flawed Franchise Model?

To the extent that advocates of a $15 wage have acknowledged the pressure it would put on franchisees, they have said that disrupting the franchise model is a feature of their strategy, rather than a bug.

The industry’s legal challenge against Seattle’s faster phase-in of its $15 minimum wage for franchisees, which would otherwise be given the same slower timetable as small businesses, prompted Mayor Ed Murray to argue that the franchise business model is exploitative.

“I don’t believe that the economic strain comes from a fairly slow phase-in of a higher minimum wage, but on a business model that really does — in many cases — harm franchise owners,” Murray said.

Industry experts see little chance that financial stress for franchisees exacerbated by minimum-wage hikes will lead to broad change in the model which ties franchise fees to a fixed percentage of revenue. This is, in part, because the franchising contracts tend to be 20 years in length. Still, Gordon of Pacific Management Consulting Group sees potential for revamped deals on a case-by-case basis if franchise locations encounter financial trouble and have to sell.

“The franchisor generally wants to keep the lights on,” Gordon said. By way of encouraging a larger franchise operator to buy out small “mom and pop” operators in financial distress, the company “might think about reducing royalty rates,” he said.

Gordon notes that most companies provide little transparency about the financial status of their franchisees — Popeye’s (PLKI) and Domino’s (DPZ) being exceptions — and Gordon argues that such franchisee metrics are critical.

“Profitable franchises produce an environment for franchise expansion,” Gordon wrote.

Because franchisors are paid based on revenue — not profit — it’s possible for the financial performance of franchisor and franchisee to diverge for a time. Minimum wage hikes that lead to price hikes might cause such a divergence, as might a discounting strategy that boosts sales but doesn’t help the bottom line.

Corporate Cash Flows At An All-Time High

Adams of Franchise Equity Group says the ongoing shift by big fast-food chains away from company-owned stores “is a reflection of the increasing risk and decreasing margins” quick-service restaurant operators face.

He notes that franchising contracts generally require franchisees to invest a few hundred thousand dollars in the restaurants over time to update technology and remodel. McDonald’s, for example, has been previewing its restaurant of the future recently, including “Create Your Taste” kiosks that let people custom-order their burgers.

If franchisees are under stress because of a higher minimum wage, they won’t have the cash flow needed to reinvest, Adams says.

McDonald’s executives on Friday said the company’s own wage hike shrank profit margins at company-owned U.S. restaurants in the latest quarter, but neither Easterbrook nor analysts brought up the $15 wage coming in California and New York.

For now, with commodity costs low and business getting a lift from all-day breakfast, Easterbrook said that franchisees’ cashflows are at an all-time high in many major markets.

Publicly-traded Carrols Restaurant Group (TAST), which operates 705 Burger Kings, says that restaurants remodeled in line with the BKC 20/20 restaurant image at a cost of $400,000 or more have seen a 10% to 12% boost in average sales.

Carrols, which has 133 restaurants in New York after closing three in the state last year, warned of the shift to a $15 minimum wage in its annual 10-K filing: “We typically attempt to offset the effects of wage inflation, at least in part, through periodic menu price increases. However, no assurance can be given that we will be able to offset these wage increases in the future.”

Dunkin’ Brands (DNKN) CEO Nigel Travis told analysts in an earnings call last October that the company has been instructing its franchisees that it’s best not to hike prices in response to minimum-wage hikes.

“We demonstrated by case studies, and I’m thinking of one particular where because of the minimum wage change in one town, they increased prices twice in a short period, and the (sales) in those stores went progressively negative,” Travis said.

Industry trends suggest the goal of quick-service chains that compete on price will be to get customers to spend more by building loyalty programs; offering custom orders and a wider range of quality options; and streamlining their staffing needs. But the challenge is huge, and poor execution could imperil their franchisees in high-minimum-wage areas.

One clue to how difficult it will be for franchise vs. non-franchise models: On February’s earnings call, Morgan Stanley analyst John Glass told management: “I’ve observed in Boston, for example, Dunkin’s pricing about $0.10 above Starbucks for a regular coffee” in response to the $10-an-hour Massachusetts minimum wage.

Dunkin Brands and Restaurant Brands International both plan to report quarterly results on Thursday.