There’s no denying it. McDonald’s Corporation (NYSE:MCD) is still the king of the fast food restaurants. Its network of nearly 37,000 locales all over the world is second only to Subway’s 44,600, but in terms of revenue, MCD stock is trailing-twelve month sales of $23.5 billion is second to none.
The sight of those familiar golden arches is daunting to other restaurateurs. And yet, owners of MCD stock that think the company is infallible may want to think again. While the quarterly reports, past and projected, may look fine, there’s a lurking philosophical, existential threat to the company it would be unwise to ignore.
Biggest Threat to MCD Stock
Most people know McDonald’s offers entrepreneurs a chance to open a franchise (at the entrepreneur’s expense) using the McDonald’s name. While the licensed use of the company’s moniker and access to its supply network are of clear benefit, such a relationship can be a fragile one.
The parent company calls the shots, dictating pricing, and effectively requiring franchisees to participate in the purchase of local advertising efforts. Financially pushed too hard, franchisees have pushed back in the past.
McDonald’s may once again be pushing too hard.
It’s hardly the first time it’s happened. This outcry first surfaced in earnest in 2015. That’s when, feeling the headwind of declining sales, then-CEO Don Thompson stepped down and was replaced by Steve Easterbrook.
While Thompson made the menu complicated to the point of being unserviceable and ignored the growing wave of a healthier-eating mindset, Easterbrook’s experience was limited to marketing rather than front-line operations, so restaurant owners doubted things would improve.
Franchisees were literally and figuratively paying the price for all the ill-advised changes the parent company was dictating.
A survey taken of franchisees at the time spurred comments like “There is no leadership, no plan, no respect for operators or their investment bottom line,” and “Relations between McDonald’s corporations and operators are the worst I have even seen.”
There’s no veiled, nuanced message there, and MCD stock paid the price.
Since then the tension has been somewhat relieved, though perhaps only due to the passage of time and a lack of options for store owners.
(Tacitly) underscoring the advantage of being a franchiser and the burden of being a franchisee, last year McDonald’s began selling company-owned stores to franchisees as a means of improving profitability for owners of MCD stock.
Though such divestitures lower revenue, they increase earnings simply because margins on franchise fees are stronger than the margins created by operating a restaurant.
The “it’s just business” argument applies, and it’s unlikely any of its franchisees, most of whom were in Hong Kong and China, were outright forced to buy one or more of the company-owned restaurants that were put up for sale.
They may have felt pressure to do so all the same though, just to maintain a good relationship with company headquarters.
Fast forward to this month. Once again, restaurant owners/franchisees are upset about changes that serve the corporation’s bottom line but may ultimately crimp each store’s profitability.
One of those initiatives is the rollout of the new value menu, which features items costing only $1, $2 and $3. They will certainly improve traffic, but they will almost certainly decease the average ticket price per customer. The cost of that food to the franchisee, however, doesn’t change.
Bolstering franchisees’ frustration are the expensive remodels that have been, in some cases, required by the parent organization. In an environment where gross margins on food are shrinking and labor costs are growing, there’s very little profit left to fund in-store improvements that ultimately come out of a franchisee’s pocket.
One disgruntled franchisee responded to a Nomura-Instinet survey:
“Large numbers of operators will be put in financial trouble with the amounts of money they will be spending. Operators are not happy with the company direction but they will not say anything fearful of retaliation. The company [wants] little or no input from Operators. The company looks at Operators as the problem instead of the solution.”
Another said “Our CEO will be great for shareholders but long-term franchisees will suffer and so will the system.”
In other words, the franchisee problem hasn’t actually been solved. It matters, because new franchises are the company’s lifeblood. If the reputation for difficult and sharp dealings is allowed to fester, McDonald’s may find fewer and fewer people want to bother opening one.
They could just as easily opt for a Yum! Brands, Inc. (NYSE:YUM) operation (Pizza Hut, Taco Bell or KFC) or a Wendys Co (NASDAQ:WEN). Those organizations treat their franchisees with a little more flexibility.
MCD Stock Earnings Preview
It’s a subjective idea that won’t readily show up on the company’s books. Indeed, earnings have been growing as the company shifts away from company-owned units and towards a franchisee/franchiser-focused business model.
That trend’s not likely to have changed last quarter either, though we’ll know for sure on Tuesday morning, Jan. 30. Analysts expect sales of $5.23 billion to turn into earnings of $1.59 per share of MCD stock.
That top line would be down 13.3% from last year’s $6.03 billion, though the bottom line would be a marked improvement on the year-ago earnings figure of $1.43 per share. The disparate direction of the two numbers reflects the greater profitability of franchising, rather than owning.
Just bear in mind those improved profits are ultimately coming at the expense of the actual restaurant owners.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities. You can follow him on Twitter, at @jbrumley.