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This Is McDonald’s Biggest Risk

By Jamal Carnette, CFA - Mar 18, 2016 at 2:00PM

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Would you like a lawsuit with that?

Are employees inside McDonald's employees of McDonald's? The NLRB says maybe; McDonald's says no. 

McDonald's (MCD 2.26%) appears to be in the midst of a turnaround. Shares of the company are up 27% versus the S&P 500's loss of nearly 2% over the past year. This return nearly coincides with the tenure of new CEO Steve Easterbrook, who replaced outgoing CEO Don Thompson, who left in March 2015.

The stock market has reacted favorably to Easterbrook's prescripts, which include cutting more costs and jobs, franchising more company-owned restaurants, and a business reorganization. For consumers, however, the most-visible change for McDonald's was the introduction of all-day breakfast items. The prior CEO dismissed calls to introduce all-day breakfast, citing the operational challenges associated, which put further strain on franchisees and employees.

According to a new survey from Nomura Securities (by way of Business Insider), those concerns were well founded. Nomura said McDonald's franchisees are reporting "[increased] management turnover, and crew turnover out of frustration. Employee morale is down because of it." Currently, Easterbrook and his management team are not incentivized to care about crew turnover, so it's likely these concerns will fall on deaf ears.

However, a ruling from the National Labor Relations Board may force McDonald's to care -- and it could be the biggest risk to the company's stock.

Whose employees are these?
According to a report from QSR Magazine, that's a question up for debate. Traditionally, crew members in a franchised store are considered employees of the franchisee, and not of the franchisor. This is a key issue when it comes to pay and employee benefits. This disparate group of employers has been quite effective at controlling labor costs (more on this later), and rebuffing attempts by labor unions to hold collective bargaining votes.

Last year, the National Labor Relations Board changed the definition of a franchisor to a "joint-employer," meaning unions could negotiate with the parent company instead of the franchisee. Additionally, the rule change opens up the parent company to liability for violations like wage theft and employee discrimination for participating in union activities. Last week, the NLRB opened its case to classify McDonald's as a joint-employer in court.

Let's not forget about how the death of Supreme Court Justice Antonin Scalia hangs over this case. The Roberts court has been defined as extremely business friendly when conservative justices had a five-to-four majority. Now, with an even split, the company's chances are more uncertain due to the fact that a tie would mean that the lower court's decision would stand. Earlier this year, Dow Chemical agreed to settle an antitrust case for $835 million, due, in part, to Scalia's death, which reduced the court's chances of overturning an earlier award, reports Bloomberg.

A stakeholder issue
As a CEO, Easterbrook's first responsibility is to McDonald's' shareholders. Additionally, McDonald's is arguing that franchisee crew members (store-level employees) aren't even McDonald's employees, but rather labor suppliers to its franchisees. As such, the responsibility owed to these workers, including working with franchisees to ensure wage increases, is low to nil on the list of stakeholder demands. An NLRB win could quickly change its relationship with crew members.

McDonald's recently agreed to give a wage increase to crew members working at company-owned restaurants, but this will affect few employees due to the fact that the company plans to have 95% of its restaurants franchised. The biggest risk to McDonald's is wage pressure affecting the organization itself, or its delicate franchisees either through an NLRB diktat, or via a more-competitive job market. In another survey from Nomura, one franchisee estimated "30% of operators [franchisees] are insolvent."

Regardless of the case, wages will probably increase
That's because McDonald's' tremendous growth has been built upon low, possibly illegal, wages. During the last two decades, the restaurant industry has benefited from the influx of both legal and undocumented immigrants, with Pew Research finding that nearly 20% of cooks, and 30% of dishwashers, do not have legal status. This increase in the labor force has allowed the entire industry, McDonald's included, to keep wages low. As a result, it appears the company allowed franchisees to overbuild under the guise that these favorable labor rates would continue in perpetuity.

There's a reason to think higher wages will occur, even if the NLRB loses its case. More recently, the number of people coming into the U.S. from our largest immigration partner, Mexico, has slowed, with Pew Research (subscription required) finding a negative immigration rate (read: more Mexican citizens left than arrived) from 2009-2014. Additionally, with low-wage competitors like Wal-Mart and Target raising pay, McDonald's franchisees will most likely be forced to raise pay to retain employees.

If instituting all-day breakfast is causing consternation among franchisees, how are they going to respond to a more-competitive job market?

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