NEW YORK--(BUSINESS WIRE)--A National Labor Relations Board (NLRB) ruling adds to mounting labor issues for the restaurant industry but is unlikely to deter the continued shift toward franchising in the US restaurant industry, according to Fitch Ratings. We believe the development will not have a direct impact on the credit quality of franchisors.
The NLRB on July 29 ruled that McDonald's Corp. (IDR: 'A/Stable') could be treated as a joint employer in certain complaints by employees of franchised restaurants. The ruling is significant given that franchisors would become liable for the business/pay practices of their franchisees if the decision holds. McDonald's views the decision as wrong and plans to contest the ruling.
Franchising is an extremely profitable business model, resulting in EBITDA margins ranging from 40% to 60% plus for US restaurants that franchise the vast majority of their units, such as Burger King Worldwide, Inc. (IDR: 'B+/Stable'), DineEquity, Inc. (IDR: 'B/Stable'), and Dunkin' Brands Group, Inc. (Private Rating). Operating earnings and cash flow quality are stronger with franchising because the franchisor has limited direct exposure to food, labor and other restaurant expenses and lower capital requirements. Examples of companies still continuing to shift towards franchising in the U.S. include The Wendy's Co. (Wendy's; Private Rating). Wendy's completed efforts to sell 415 company-operated units to franchisees during the first quarter of 2014, increasing the percentage of the brand's over 6,500 system-wide units to about 85% franchised from 82% at the end of 2013.
Joint-employer treatment for employee claims will not change the economics of franchising as franchisors are likely to adjust terms, including ongoing royalty rates and franchise fees, of future franchise agreements to accommodate higher business risk from the sharing of potential employee-related liabilities.
The NLRB ruling, along with employer mandates under the 2010 Affordable Care Act (ACA) and broad-based minimum wage pressures, all point to shifting momentum towards low-wage workers. Worker uprisings, continued negative press around worker pay and benefits, and potential unionization will continue to drive up labor costs, which represent about a third of the cost structure for US restaurants.
These headwinds could also ultimately pressure sales due to declining consumer sentiment towards brands perceived as being unfair to workers. Darden Restaurants, Inc. (IDR: 'BBB-/Stable'), which does not franchise its restaurants, in late 2012 admitted that negative publicity from a test relating to shifting to more part-time workers in certain test markets in response to ACA had a temporary negative impact on sales trends.
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