Did California just kill the fast-food industry in the state? Governor Gavin Newsom signed a bill that creates a new board to oversee and set wages and working conditions in quick-serve restaurants, and the minimum wage in California could soar as high as $22 an hour beginning next year.
Starbucks (SBUX 0.29%) is one of the largest chains in California with over 3,000 locations representing nearly one-fifth of all of the coffee shops it operates in the U.S. Because the new law only applies to fast-food restaurants, and only those with at least 100 restaurants around the country, Starbucks could feel the impact of exorbitant labor expenses more than others.
The coffee shop is already struggling to manage inflation and rising labor costs, which caused operating margins to contract 350 basis points last quarter. Now faced with the potential for a monumental increase in those expenses, investors are right to question whether Starbucks stock is a buy.
Image source: Getty Images.
Labor costs set to explode
California's Fast Food Accountability and Standards Recovery Act, or Fast Act, creates a government panel with members appointed by the governor and legislature and will include equal numbers of worker, union, and business representatives. It is charged with managing workplace conditions for hours worked, health, and safety, and will also set the minimum wage for the restaurant industry next year.
Under the law, the board can increase the rate to a maximum of $22 per hour on Jan. 1, and then it will rise every year thereafter by the lesser of either the national inflation rate or 3.5%. California's minimum wage is currently $15 per hour and was set to rise by $0.50 per hour next year, so the new law means fast-food restaurants could see their labor costs surge 47% in January.
Because California represents approximately 14% of total U.S. restaurant sales and is often viewed as a leading indicator for the industry, the fear among restaurants is that other states might follow suit.
McDonald's (MCD -0.43%) has condemned the bill saying it "should raise alarm bells across the country." President Joe Erlinger said it creates an uneven playing field that "imposes higher costs on one type of restaurant, while sparing another."
For many of these restaurants, their locations are actually small entrepreneurial franchisees who own just one or two locations. Starbucks owns all of its stores.
|
Restaurant |
Locations in California |
% of Total U.S. Locations |
|---|---|---|
|
Burger King |
555 |
7% |
|
Chipotle Mexican Grill |
444 |
14% |
|
In-N-Out Burgers |
262 |
88% |
|
Jack in the Box |
942 |
42% |
|
KFC |
475 |
10% |
|
McDonald's |
1,165 |
8% |
|
Pizza Hut |
560 |
8% |
|
Starbucks |
3,005 |
19% |
Data source: ScrapeHero.com. Table by author.
The high cost of doing business
Starbucks was already raising workers' starting wage. Amid a widening national labor shortage, the coffee chain had raised its minimum pay to $15 per hour earlier this year, and then beginning Aug. 1, increased it again to $17 per hour.
While the corporate businesses of franchised chains like McDonald's won't be nearly as affected by the law since the franchisees will be carrying the burden, Starbucks will face the full cost itself.
It was able to partially offset some of its higher expenses by passing on the cost to consumers in the form of higher prices, but there is a limit to how much a business can raise prices before sales start taking a hit. And inflation is already weighing on Starbucks.
Although its North American revenue rose 13% in the fiscal third quarter, driven by a 9% rise in comparable store sales, only one percentage point of the increase was related to more transactions; the balance was driven by increases in the average ticket amount, or the amount customers are paying for their order.
Starbucks may have to eat a lot more of the wage hikes that are coming, which will hurt its bottom line even more, and net earnings already plummeted 23% last quarter.
Too hot to handle
Because California represents such a large portion of Starbucks' business, and since it won't be able to share costs with franchisees or fully pass them along to customers, investors should expect the coffee shop to be meaningfully impacted by the law.
Even though Starbucks stock is down 25% in 2022, at 25 times trailing earnings, 26 times next year's estimates, and at 129 times the free cash flow it produces, the coffee stock already looked to be premium priced in a weak market. California's Fast Act makes quick work in suggesting Starbucks is not a buy at these prices.
