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It's Not The End Of McDonald's Tug-O-War With U.S. Franchisees

Summary

  • The overall pie needs to grow or both sides will need to fight for the scraps.

  • Turnaround plan is Corporate's answer, but it still looks pretty tactical thus far.

  • The next downturn could intensify pressure on franchisee relationships.


(Seeking Alpha) Recall that back in Oct 2018 when many franchisees in U.S. voted for the first time in McDonald’s history to form an independent association – the National Owner’s Association (NOA). The NOA drew about 75% of the chain’s 1,700 U.S. franchisees to its meeting in Dec 2018, to gain leverage in expressing frustrations about being unfairly subjected to the cost of CEO Steve Easterbrook’s “expensive and somewhat unnecessary” remodel costs, and unfair financial arrangements. The relationship between corporate and its U.S. franchisees have been fraught for a long time, with relationship scores (on a scale of 1 to 5) hovering between range of 1 to 2 for years. However, this time around, things might have reached an inflection point with what could be a major shift in franchise relations. Even as CEO Steve Easterbrook alluded to calming tensions from a rebound in franchisee cashflow that is of a magnitude larger than its decline in 2018, the core issue driving a wedge between corporate and franchisees still remains.


The structural problem treated with a tactical solution


The core issue is structurally lower ROI. As McDonalds reach the end of the re-franchising drive, profit growth needed to satisfy the stock’s expected rate of return would almost be entirely coming from growing receipts from franchisees (e.g. royalties, rent), while reducing capex and opex contributions, aside from increasing store count. This means that store comps need to come in higher than percentage rise in costs invested, where the overall revenue pie would grow at a rate that allows both corporate and franchisees to feel satisfied with their ROI trends. This is going to get tougher going forward. Key problems are 1) continued decline in guest counts, and 2) sustainability of increased check.


Firstly, McDonald’s has had a problem with negative guest counts for a long time. Management mainly attributes this to increasing competition in the QSR field, which has been well documented over time. Even with the latest turnaround capex splurge, CEO Steve Easterbrook has mentioned that “..we were losing traffic before we started EOTF.. So, the traffic piece is beyond EOFT. As we’ve gotten better and done more of those EOTF projects.. that in and of itself won’t resolve all the traffic issues.”. The point here is that McDonald’s still does not have a solution to drive increased customer visits, and delivery is not looking like the solution that was touted. While specifics of increased check size compensating for cannibalized store visits remain cloudy due to lack of breakdown, an eye test at headline comps level certainly does not suggest any big growth driver here. For fear of sounding like a broken record, I will leave you with this quote from CEO Steve Easterbrook from Q4 2018 earnings call: “..QSR market share is incredibly muted.. frankly, we’re not expecting any tailwinds from broader growth in either IEO or QSR.. so our share gains will be someone else’s pain.”. Definitely sounds like an immovable scenario given how long they have been attempting to “gain share”.


Secondly, investors have long questioned how sustainable is the increase in check. While analysts and practitioners have been skeptical for a long time, McDonald’s has continually proved them wrong, and I am not going to preach like I know any better here. Perhaps check still has a long runway to go, but I will point out a few things here. McDonald’s is competing in the value-for-money segment, or fast food segment rather than fast casual segment. The business proposition regarding price, cooking methods, quality of good, speed/convenience and dining experience revolves around that. That is also why I agree that delivery and self-service kiosks are probably in the right direction and complement their core value proposition. But trying to get customers to continually trade up to boost check is going against this very proposition. Its business model is definitely to sell higher volume at cheaper prices, and it definitely needs to drive traffic to do that, which is not happening due to competition.


Fast Food prices are in the <$5 per head range, while Fast Casual prices are in the $7-$12 range (comps used here is Shake Shack). While its sandwich competitors are eating away luring away customers at the fast food segment with price and value, going into the fast casual segment with Signature Crafted Recipes platform was also not the answer either, as it misses out on several of the fast casual qualifying factors, e.g. table service, better dining atmosphere, and operationally-wise did not complement its fast food model. McDonalds also tried to be everything to everyone to drive traffic by accommodating a wider range of customer preferences with increased variety, but this did not work too and the chain scaled back its all-day breakfast menu, and signature crafted menu. The point here is that there McDonald’s is sandwiched at both ends of the spectrum, and it has been treading in the middle of nowhere for a long time, with what I call “tactical moves” to boost comps, e.g. product-mix changes, trade-ups, obscure price hikes, improving speed, drive-thru, etc.

The so-called “turnaround plan” looks pretty tactical in my opinion, rather than introducing new strategic or fundamental revenue drivers to sustain growth.


A receding tide exposes the balance of risks


And the sun is setting soon, plausibly. On the macro level, consumer confidence is starting to take a hit, as evidenced by recent UoM and Conference Board indicators, where consumer sentiment took a hit from tariff-related and Fed rate-cut concerns. At the same time, while employment remained strong, non-farm payrolls have been trending downwards, suggesting softer momentum in job creation. The next wave of tariffs will also hit consumer purchasing power, effectively representing a tax to U.S. consumers, just when the boost from tax cuts have run its course.


Financial maneuvers by CEO Steve Easterbrook to drive profit growth at McDonald’s, and a lack of credible growth from tactical strategies used will come haunting again, in a weaker economic backdrop. But this time, it could be a bigger problem. After guiding customers to trade up via new product-mix offerings, a wave of trade downs back to its core value offerings could be in line as disposable income growth declines. This will likely dent franchisee ROI even further, exposing the degree of “ripping-off” franchisees from previous financial maneuvers to juice corporate profits.


Remember that its financial maneuvers also included a major re-franchising, where McDonald’s consolidated more restaurants in hands of larger owners, giving them more leverage against corporate decisions. So here comes the risk associated with franchising – lesser control over their cash cows and ultimately the control of the brand. The short and long-term concern over increasing franchisee power is that they can influence or, to some extent, dictate the ROI split between corporate and franchisees going forward. Profit engineering where franchisees shoulder more growth risks and capex burden while McDonald’s continue to take a slice from top-line will likely come to an end, if it is repeatedly shown that expensive growth strategies suggested by corporate are not working.


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