Will Labor Uprisings Deter New Restaurant Franchises or Hurt Sales?

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The pressure for higher wages in low-cost labor has been front and center in the fast-food and casual dining industry. A recent ruling from the National Labor Relations Board (NLRB) went against McDonald’s Corp. (NYSE: MCD), ruling that franchisees and the much larger employers were effectively considered joint employers in certain circumstances. This has added more uncertainty for franchises, but a new report from Fitch Ratings signals that the NLRB ruling will not deter franchising by U.S. restaurants.

Fitch believes this new development will not have a direct impact on the credit quality of franchisors. While the ruling is significant — franchisors would become liable for the business and pay practices of their franchisees — they also noted that the decision has not held yet and that McDonald’s plans to contest the ruling.

Fitch went on to say that franchising is an extremely profitable business model (with EBITDA margins of 40% to 60%) for U.S. chains that franchise the vast majority of their units, such as Burger King, DineEquity and Dunkin’ Brands. Fitch said, “Operating earnings and cash flow quality are stronger with franchising because the franchisor has limited direct exposure to food, labor and other restaurant expenses and lower capital requirements.”

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Where the effort potentially matters is in companies still shifting towards franchising. Wendy’s Co. (NASDAQ: WEN) was singled out here. Fitch showed that Wendy’s completed efforts to sell some 415 company-operated units to franchisees during the first quarter of 2014. This now puts its 6,500+ system wide units up to 85% franchised from 82% at the end of 2013.

Fitch pointed out:

Joint-employer treatment for employee claims will not change the economics of franchising as franchisors are likely to adjust terms, including ongoing royalty rates and franchise fees, of future franchise agreements to accommodate higher business risk from the sharing of potential employee-related liabilities.

The NLRB ruling, along with employer mandates under the 2010 Affordable Care Act (ACA) and broad-based minimum wage pressures, all point to shifting momentum towards low-wage workers. Worker uprisings, continued negative press around worker pay and benefits, and potential unionization will continue to drive up labor costs, which represent about a third of the cost structure for US restaurants.

The big warning is that these headwinds could ultimately pressure sales due if consumer sentiment moves to seeing these brands being unfair to workers.

In its ruling, the NLRB investigated charges that alleged McDonald’s franchisees and McDonald’s itself (as franchisor) violated the rights of employees as a result of activities surrounding employee protests. It should be noted that the NLRB General Counsel found merit in some of the charges, but it also found no merit in other charges. In the July 29 NLRB ruling, the NLRB said:

The National Labor Relations Board Office of the General Counsel has had 181 cases involving McDonald’s filed since November 2012. Of those cases, 68 were found to have no merit. 64 cases are currently pending investigation and 43 cases have been found to have merit. In the 43 cases where complaint has been authorized, McDonald’s franchisees and/or McDonald’s, USA, LLC will be named as a respondent if parties are unable to reach settlement.

McDonald’s stock has slid since the NLRB ruling from $96 to less than $94, but some of that slide has been due to a weak stock market. The real issue is that McDonald’s is now just within 2% of hitting a 52-week low. The stock is also down close to 10% from its 52-week high.

Fitch may not be concerned about the ratings around the NLRB issues, but the market is worried that the pressures against these companies is nowhere close to being over.

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