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Are McDonald's Corp.'s Franchisees Its Real Problem?

By Rich Duprey – Jan 27, 2016 at 1:00PM

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They've been a value resource for the burger chain, but they may also hinder its recovery.

McDonald's says that simple changes such as using real butter instead of margarine in breakfast items helped win back customers, but franchisees are still not happy. Photo source: Flickr/kazamatsuri.

McDonald's (MCD 1.07%) franchisees were hoping to build on the momentum the fast-food chain generated last quarter, when it reported its first sales increase in two years, and it looks like the burger giant came through. Where a survey of the chain's franchisees conducted by Nomura analyst Mark Kalinowski indicated they expected expecting around a 4% increase in comparable-store sales for the fourth quarter, U.S. comps actually jumped 5.7%, the chain's best performance since 2012.

Ever since the fast-food joint reintroduced its all-day breakfast menu, investors have bid McDonald's stock higher, believing the long-awaited turnaround in its fortunes was imminent. When the restaurant reported sales had jumped 5% globally and were up almost 1% in the U.S., the market cheered. Over the past year, the S&P 500 has lost 6% of its value while McDonald's stock has gained more than 37%. Considering how sickly the burger business has been, it's a remarkable achievement reflecting just how patient investors have been waiting for the recovery to materialize.

Now that franchisees are once again upbeat, should investors be equally sanguine? No. The franchisees may be the biggest problem when it comes to the company's recovery.

Size matters
First, the survey of their outlook is based on a very small sample. Where McDonald's has 14,000 restaurants run by 3,000 operators, Nomura surveys just 26 operators representing a little over 200 restaurants. It may not be a representative sample, a point the chain has made note of in the past when the franchisees' views weren't as positive about sales and they were cranky about actions headquarters was taking. In fact, they're still a pretty restive bunch even though they expect sales to be better, and that may ultimately be what keeps McDonald's from making a full recovery.

According to Nomura, many of the latest changes McDonald's implemented that analysts have cheered, such as the all-day breakfast and the new McPick 2 menu, are the things the franchisees are largely panning. They see the value end of the menu as death to them, an assault on their profitability that's already on shaky grounds.

Some of the anonymous quotes from franchisees the survey picked up are telling:

  • "McDonald's has long left the franchisees behind. They have unattainable reinvestment requirements, while forcing the system to continue a price war with our competitors. This erodes margin and post-debt cash flow."
  • "We are discounting heavily, against my will, so sales should be up and profits down."
  • "The regional marketing teams are adding numerous other discounts to the McPick 2, primarily breakfast items. They are encouraging, quite literally, everything being on sale. This is a very hard cultural adjustment for me."

Loss leaders are just losses
McDonald's franchisees have never been enamored of the chain's dollar menus, feeling they cut too deeply into their profits. And they're not alone. When Restaurant Brand International's (QSR 2.09%) Burger King chain introduced a double cheeseburger for $1 a few years ago, its franchisees sued it because of the losses they incurred from the promotion.

While such discounts help drive traffic to the restaurants, they don't increase the operators' profits, because customers aren't purchasing more premium items. That's why I thought McDonald's had packaged its McPick 2 menu better than either Burger King or Wendy's (WEN 1.74%) did with their bundled offers. Where the latter two gave a set meal including fries and drink for one low price, McDonald's gave its customers choices but also required they buy the higher-margin fries and drinks separately. It seemed like the best of both worlds, but apparently the franchisees see it differently.

McDonald's new McPick 2 value bundle has upset franchisees because customers are buying the discounted items and not the premium, higher-margin sandwiches. Image source: McDonald's.

Strength in numbers
Because of their sheer number, which far outweigh those running either Burger King or Wendy's restaurants. even though those two chains have almost completely refranchised their operations, franchisees are creating headaches for McDonald's, which may find it difficult to serve two masters: the franchisees running its restaurants and the customers visiting them. Both have different agendas that don't seem to meet.

There are definite benefits to the franchise model, including the following:

  • A company can expand more quickly by franchising.
  • The franchisee, not the parent, bears many of the costs associated with running a business.
  • Lucrative rents and royalties are collected from franchisees -- McDonald's collected $9.3 billion in franchise revenues in 2014, 33% of its total $27.4 billion generated that year.

Because they can be a fractious group, franchisees can be problematic, too. Starbucks (SBUX 3.59%) and Chipotle Mexican Grill (CMG 4.78%), for example, are wholly company-owned operations, and when business falters, they can quickly respond by closing down stores in a market. During the recession, Starbucks shuttered 600 stores and laid off 12,000 employees because conditions deteriorated. Chipotle is temporarily closing all of its stores on Feb. 8 to update all of its employees on the ongoing foodborne-illness crisis. Those kinds of actions are not feasible when your restaurants are run by a franchisee.

Company-owned chains can also uniformly roll out ideas or promotions across all of its restaurants; with franchisees, they often have the right to opt out, such as when McDonald's raised employee minimum wages last year, a move that angered franchisees because it covered only company-owned restaurants and franchisees felt pressured to follow suit even though they weren't generating the profits to support the increase.

Buying out all of its franchisees to become a company-owned business again, or even a majority of them, would be prohibitively expensive and maybe not even desirable. But the schizophrenic nature of the push and pull that exists between its owners and management, and the desire of franchisees for premium menu items butting up against their customers who want less profitable, even loss-leading, value meals, means McDonald's may never have a smooth ride.

Rich Duprey has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Chipotle Mexican Grill and Starbucks. 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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Stocks Mentioned

McDonald's Stock Quote
McDonald's
MCD
$272.79 (1.07%) $2.90
Chipotle Mexican Grill Stock Quote
Chipotle Mexican Grill
CMG
$1,626.96 (4.78%) $74.24
Starbucks Stock Quote
Starbucks
SBUX
$102.20 (3.59%) $3.54
The Wendy's Company Stock Quote
The Wendy's Company
WEN
$22.56 (1.74%) $0.39
Restaurant Brands International Stock Quote
Restaurant Brands International
QSR
$66.35 (2.09%) $1.36

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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