Prediction: These 2 Challenges Will Become Full-Blown Problems for McDonald's
There's no denying McDonald's (NYSE: MCD) is king of the fast-food industry. Not only has the company clearly mastered the art and science of quick-service restaurants, but with more than 42,000 stores each doing on the order of $3 million in sales per year, it's also the biggest name in the business. It's made for a rewarding long-term investment as well.
No great company is guaranteed to thrive forever, however. Indeed, it's possible the very things that once made a company great will eventually turn into liabilities.
That's arguably where McDonald's is now. For decades it pulled ahead of its competition by being the premier name in restaurant franchises. Now, though, its once-fruitful relationships with franchisees are strained to the point of becoming problematic. Two specific tensions serve as evidence of the company's deeper-seeded challenges even if their risk isn't readily evident.
McDonald's stock could be tough to own until these hurdles are plainly cleared.
McDonald's franchisees are growing increasingly frustrated
McDonald's doesn't actually own the majority of its stores. As of June 95% were owned and operated by franchisees that not only pay an upfront fee for the right to run a store, but pay the parent ongoing royalties from their restaurants' revenue. The franchisor (that's McDonald's) also requires its franchisees to purchase their supplies from the company itself, and contribute to certain marketing efforts. Perhaps most notably, McDonald's differs from other franchises by virtue of owning the real estate where its franchisees operate, collecting ever-rising market-based rent payments for the right to use its building and land.
Whatever the arrangement, the restaurant business is becoming increasingly competitive. This puts more and more pressure on several facets of McDonald's operation, in turn creating tension between franchisees and franchisors... each of which just wants to maximize their bottom lines. Stories of franchisees becoming frustrated with unexpected costs and heavy-handed requirements are nothing unusual these days.
Indeed, they're now common enough that the U.S. Federal Trade Commission is getting involved. Just last month the FTC issued an official warning to U.S. franchisors reminding them that the "use of contract provisions, including non-disparagement clauses that prohibit franchisees' communications with the government, violate the law." The regulator also reminded them that "franchisors cannot lawfully impose and collect fees from franchisees that were not previously disclosed."
The Commission didn't explicitly name McDonald's as a violator of these standards (nor any other fast-food chain, for that matter). These messages are in the same vein as many of the heated complaints McDonald's franchisees have voiced in recent years, however. The fact that the FTC felt compelled to issue a public statement on the matter at all is a sign that McDonald's increasingly strained relationships with its franchisees may be at or near an impasse that could impede future growth. Franchisees aren't going to take on above-average risk for below-average returns on their investment, after all.
And the second stumbling block? Inflation (although once again the complicated franchisee/franchisor arrangement plays a role in this headache).
Anyone reading this is certainly aware that higher prices are taking a big bite out of your buying power of late. McDonald's restaurants and its customers aren't immune to this challenge. Just a few months ago the price of a Big Mac meal was nearing $20 in some markets. Other combos were seeing similar price increases, forcing some consumers to forego visits to the fast-food chain.
Then in late June the company finally countered, by introducing several combo meals that could be purchased for only $5. And it worked. Customers returned. It worked so well, in fact, that the restaurant chain extended what was supposed to be a short-lived promotion all the way into this month at most locations.
But it's not as if the generous offering isn't taking a toll. Several franchisees have voiced frustrations that the cost of making and selling these $5 meals is simply too high without assistance from the corporation itself... which doesn't appear to be coming. In that many of the chain's pricing and menu decisions are compulsory though (effectively, if not literally), relief may not be on the horizon if these $5 value meals are extended again, or made permanent.
Again it's more of a symptom rather than the problem itself. Nevertheless, it's another potential source of tension stemming from a business arrangement that offloads much of the cost burden -- and therefore much of the risk -- onto franchisees.
Too much potential risk to simply ignore
These are obviously philosophical problems at least as much as they're operational problems, making them more challenging to fix. But, they can be fixed. And even if they're not, it's not as if McDonald's doesn't enjoy the sort of stature that inspires franchisees to swallow their frustrations and continue toeing the line well into the future.
These seemingly small philosophical challenges, however, can also slowly chip away at a business without anyone noticing until it's too late. Think back to once-great companies like General Electric, IBM, or Blockbuster (which at one point had an opportunity to acquire Netflix for next to nothing). These companies weren't suddenly and unexpectedly upended. They simply suffered a slow demise by ignoring the little things eating way at their top and bottom lines until they became very big things.
McDonald's isn't likely to suffer the same fate as Blockbuster, or even GE or IBM, and its attractive dividend isn't in any immediate jeopardy either.
Red flags are waving though, and increasingly so. The way it handles franchisees -- and the way it requires franchisees to handle customers -- is evolving into a tangible liability for investors. Shareholders will want to keep an eye on this aspect of the business. The stock may not be your very best bet right now.
Should you invest $1,000 in McDonald's right now?
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James Brumley has no position in any of the stocks mentioned. The Motley Fool has positions in and recommends Netflix. The Motley Fool recommends International Business Machines. The Motley Fool has a disclosure policy.
