Bad News For McDonald's: Your Franchisees Are Angry

McDonald's franchisee woes could be more problematic than Burger Kings 2010 spat.

Jul 21, 2014 at 4:00PM

McDonald's (NYSE:MCD) has received its share of bad news lately. First a consumer report showed that customers ranked McDonald's lowest in several categories; now, a new report is shows that McDonald's franchisees aren't too impressed either. While some of the franchisee complaints are similar to a dispute Burger King (NYSE:BKW) had with its franchisees years back, McDonald's faces unique challenges today. 

Not bullish on the future
The Franchisee Survey was conducted by Janney Capital Markets, reported in The Nations Restaurant News, and was released last week. A group of 27 Franchise Owners reported anonymously; they provided both their opinions and their outlook for the business. The outlook was shockingly bad, the franchisees reported a 2.6% decline in same-store sales in June, which led Janney to lower its same-store sales estimates by 3.8% for July. 

Mark Kalinowski, of Janney, confirmed that sentiment was the worst result to date: "Indeed, this result becomes the worst ever in our decade plus of conducting this survey, even lower than the previous low score of 1.89 from six months ago."  What may surprise you is that the franchisees place the majority of the blame at the feet of management, not their competitors.

Mc'Huge Menu Problems
McDonald's franchisees direct an overwhelming amount of their frustration toward management for two reasons. The first is a common criticism of McDonald's, its menu is too large. The menu expanded, in the first place, to stem off new competition from healthier restaurant chains. While that may have been a well intentioned idea, it appears it has backfired in the form of higher costs.

Expansive menu's are bad ideas in restaurants for a couple of reasons:

1. Having too many menu items that don't use similar ingredients (such as a yogurt parfaits and frappe's), raises inventory costs dramatically. 

2. When sales don't meet estimates, restaurants with crowded menu's suffer losses because their un-used inventory spoils. Restaurant inventory is perishable, so it makes better business sense to have items that "rhyme" and use similar ingredients. 

The expansive menu requires more labor costs for preparation. One franchisee stated: "Our competitors with simpler menus are doing just fine and run with far less labor." To this individuals point we can see in the chart below that Burger King runs on much higher operating margins than McDonald's. This metric measures profitability after most operating costs (labor, etc.) are factored in, but before interest and taxes are accounted for.

MCD Operating Margin (TTM) Chart

MCD Operating Margin (TTM) data by YCharts

The second complaint that franchisees have reminds me of a dispute that Burger King had with its franchisees in 2010. McDonald's owners are frustrated with the average spend of orders, and they attribute some of the pain to McDonald's $1 any size drinks. While the Burger King dispute was over the margins on its dollar menu item, these complaints are similar. What's different for McDonald's, this time, is how many battles it's fighting. McDonald's is trying to offer low priced options, pay employee's more, and make franchisees happy, all while fighting off fast casual competition. That's not an easy task, but it won't stop naysayers from pointing fingers at CEO Don Thompson and his team. 

Foolish takeaway
To put it simply, people matter. Ordinarily I would be inclined to feel that McDonald's recent worries are all part of a short term slump, and that things will turn around. But when you add up the terrible consumer report, with the negative view of franchisees, it's harder to write these concerns off. 

Over 80% of McDonald's are franchises, and the company prides itself on having great relationships with these folks. The people that matter most to McDonald's, its customers and its franchise owners, aren't happy right now. The problem is that there are no easy answers. Given the plethora of competitive forces ganging up on McDonald's, management will earn its money fighting its way through these troubles. Investors would be best served sitting on the sideline until things stabilize a bit. 

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Adem Tahiri has no position in any stocks mentioned. The Motley Fool recommends Burger King Worldwide and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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