McDonald’s Has A Looming Franchisee Rebellion

Summary:

• McDonald’s franchisees face challenges from the company’s unilateral dictats, with some describing the relationship with the company as “toxic”.
• MCD’s Operation PACE inspection program and its pursuit of greater diversity among franchisees has discomforted incumbent franchisees, causing fear of losing franchise renewal agreements or opportunities for growth.
• The Biden Administration’s appointment of Lina Khan as FTC Chair has brought increased focus on the franchise model, potentially impacting McDonald’s restaurant operations and labor relations.
• Government is likely to empower franchisees over franchisors, and that will likely affect MCD corporate profits.

NEW YORK (June 7) – McDonald’s (NYSE:MCD), as those of us who saw “The Founder” all know, isn’t a restaurant company; it’s a real estate company – more precisely, a landlord – that has its franchisees sell hamburgers to pay it rent. And the company gets its rent, no matter what.

But it also gets a piece of those hamburger sales, too. As writer James Brumbley put it so succinctly:

…royalties are typically paid as a fixed percentage of a restaurant’s sales. Rising inflation inherently drives these payments higher, and these payments must be made regardless of how much or how little profit margin a franchisee/operator produces. (Emphasis is mine.)

One McDonald’s financial executive characterized the relationship to Time Magazine in 1973 this way: “We’re just like the Mafia; we skim it right off the top.”

The Looming Franchisee Conflict

That type of Big Corporate McDonald’s franchise dictate has caused some troubles down among the serfs, McDonald’s franchisees; the owner-operators who oversee the chain’s individual restaurants, who take all the risks, do all the work, and pay the vig, no matter what, to Big McDonald’s.

Restaurant Business, a respected industry website, reports that franchisees suffered an average unit cash flow decline of $100,000 per restaurant last year because of food price inflation and the revenue and margins lost by the “specials” that are offered through the MCD app. It also reported some franchisees saying their relationship with MCD is “toxic”. McDonald’s restaurateurs complain that franchisee inspections are more frequent, more detailed, and more confrontational.

Operation PACE, Big MCD’s acronym for “Performance and Customer Excellence”, instituted earlier this year, imposes an additional 6 to ten visits by inspectors and company officials per year per restaurant venue. That puts considerable stress on restaurant managers and staff at a time when staffing levels are still stressed. One franchisee reportedly said their managers are spending one-third of their time preparing for inspections. The National Owners Association, a group of about a thousand McDonald’s franchisees, reportedly found that only 3% of franchisees felt Operations PACE’s standards accurately reflected operations. In practice, the PACE inspections seem absurdly frivolous. For example, one franchisee complained that minor staff mistakes (i.e., mandated three shakes of salt over fresh french fries) was corrected on the spot, but still “written up” by inspectors.

Mc-DEI?

The underlying fear of PACE with some franchisees is that they will lose their franchise renewal agreement, that they will not be able to obtain agreements for additional restaurants, and that they will not be able to pass on their franchise to their spouses or heirs. The fears seem well-founded.

Scores of Black plaintiffs have brought lawsuits alleging a form of McDonald’s franchise “redlining“, a concept adopted from discriminatory residential housing, that is characterized by the “systematic denial of services such as mortgages, insurance loans, and other financial services to residents of certain areas, based on their race or ethnicity.”

A Black franchisee of multiple McDonald’s venues in Ohio, the largest Black franchisee in the nation, settled a lawsuit alleging such “redlining” with Big McDonald’s for $33.5 million, albeit structured as a sale of the plaintiff’s McDonald’s franchises to the company. But while McDonald’s denied the plaintiff’s allegations, it had just days prior to settling the lawsuit (reported on December 16, 2021), announced, on December 8, 2021, a “global effort to increase demographic representation of [the – Ed.] franchisee base”. And although McDonald’s couched the plan as part of “its global diversity, equity and inclusion [DEI] commitments”, the principal financial investment was a

“$250 million in the U.S. over five years to provide alternatives to traditional financing, to help candidates – who may face socio-economic barriers – join the McDonald’s System.” [Emphasis is mine.]

The nexus between the lawsuit settlement and the DEI initiative – principally targeting the USA – to add more diverse franchisees speaks for itself, not withstanding McDonald’s denials. Several dozen plaintiffs who had alleged racial discrimination toward the Golden Arches franchisor had their suit dismissed.

Just six months after the aforementioned settlement, the president of McDonald’s USA Joe Erlinger issued a “New Term” edict:

Moving forward, we will adopt (the phrase-Ed.) “New Term” across the U.S. market to describe the process of awarding another 20-year franchise agreement based on performance history. This change is in keeping with the principle that receiving a new franchise term is earned, not given.

We will separate the New Term process from the assessment of qualification to buy additional restaurants. When growth discussions are separate and distinct from New Term, owner/operators have a clearer, more transparent path forward.

For Next Gen, Spouse or RA [i.e., Restaurant Associate – Ed.] candidates, we will adopt a single approach for the evaluation of any potential new owner/operator – regardless of pathway. This will provide a consistent process based on equally applied criteria. For all approved candidates, we will provide a comprehensive onboarding and training program to best position them for the process. (Emphasis and clarification is mine-Ed.)

It seems clear that incumbent franchisees could be at risk of losing their franchises under the new paradigm. Moreover, the new rules seems to make MCD more palatable to Environmental, Social, and Governance [ESG] investors. At the time PACE and “New Term” were adopted, two of McDonald’s largest shareholders, Vanguard and BlackRock, were fulsome advocates of ESG investing. (Vanguard, seeing the growing political blowback against ESG, recanted its support in January of this year.)

Franchisees Express Their Fears

Restaurant Business, the industry news site, reported that at a Houston convention attended by 600 franchisees,

“The most recurring comments shared were fear,” NOA wrote in a message to its members over the weekend, seen by Restaurant Business. “Fear about individual’s financial health. Fear about being deemed not qualified to buy or eligible for new term. Fear of intimidation and retaliation for attending owner/franchisee-only meetings. Fear for speaking their minds” at various company meetings.

Fear that the future of a McDonald’s franchisee will not be as bright and positive as it once was,” the association wrote.

Franchisees worry that the new operating standards, coupled with new ownership standards, could force them out of their stores once their franchise agreements come for renewal. [Emphasis is mine.]

Enter the Heavy Hand of “Uncle Sam”…

The Biden Administration’s Chair of the Federal Trade Commission (FTC), Lina Khan, Esq., has brought increased focus on the FTC Franchise Rule and other aspects of the franchise model, including the National Labor Relations Board (NLRB) “Joint Employer” Standards.

…in restaurant operations…

As if reading some of the recent litigation alleging racial bias, the FTC solicited a Request for Information [RFI], saying,

“It’s clear that, at least in some instances, the promise of franchise agreements as engines of economic mobility and gainful employment is not being fully realized…This RFI will begin to unravel how the unequal bargaining power inherent in these contracts is impacting franchisees, workers, and consumers.”

Reading the litigation, one could easily infer that the FTC believes “the promise of franchise agreements as engines of economic mobility” was disproportionately denied to minority franchisees.

The RFI lists a whole array of topics, including a request for information about any retaliation that franchisees may suffer from franchisors joining franchisee associations that are not sanctioned by the franchisor.

Also disconcerting to McDonald’s is, perhaps, the FTC’s focus on unilateral changes to the franchise agreement by the franchisor and prohibitions against disparagement of franchisees by franchisors. Allowing franchisees to negotiate changes to the franchise contract will doubtlessly impair MCD’s share of restaurant-level revenues.

…and in labor relations.

The National Labor Relations Board proposed regulations in 2022 to reinstate the decision in Browning-Ferris Industries of California, Inc., 362 NRLB 1599 (2015) (“BFI”), which held that “two entities were deemed joint employers based on the mere existence of reserved joint control, indirect control, or control that was limited and routine.”

That ruling was overturned in 2020, but is now being proposed again and with apparent support from the FTC. According to Littler Mendelson PC, a labor and employment law firm, “A joint employer may be required to bargain with a union representing jointly employed workers; may be subject to joint and several liability for unfair labor practices committed by the other employer; and may be subject to labor picketing that would otherwise be unlawful.”

What We Will Likely See

We infer that what we have seen with “New Term”, PACE, and the $250,000,000 diversity initiative is a brush back of some of McDonald’s alleged “red-lining” practices, with incumbent franchisees likely to be denied renewals and/or expansions so that they can be transferred to new, more diverse, franchisees.

Moreover, with the FTC’s involvement, some of MCDs more imperious franchise practices., like imposing unilateral and non-negotiable standards, and particularly the FTC’s RFI about franchisor retaliation against franchisees joining non-sanctioned franchisee organizations, will greatly restrain MCD’s power over its restaurant operators.

That will likely allow franchisees to balk at MCD dictates, to organize among themselves, and to be in a better position to collectively negotiate different terms, including the share of the costs of new capital additions franchisees have to bear; the ability to reject the pressure of staffing and supplying all-day breakfast, if the franchisee doesn’t want it; and to limit other menu options if franchisees so demand. All the specials available on the MCD app might have to come with a caveat that they are “available only at participating locations,” thereby throwing MCD advertising into chaos. But all those changes will better empower franchisees, diverse or otherwise, likely at cost to MCD’s share of the restaurant revenue pie.

Additionally, the pending reinstatement of the Browning-Ferris decision will likely impose additional costs on franchisees (and hence MCD), and might even ultimately lead to MCD restaurants being organized by labor unions. We recommend holding MCD if you have it, but stop accreting shares until these other issues are sorted. We think MCD’s share of reliable, steady, unchallenged, stream of restaurant profits are at some risk. There are better plays in the QSR/casual dining consumer discretionary sector where restaurants are not franchised.

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