Wage Demands Could Hurt This Restaurant Industry Leader

Reuben is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Employees of fast food companies, including McDonald's (NYSE: MCD) and Burger King (NYSE: BKW) are striking in demand of higher wages. If these demands lead to increased pay, these companies won't take a direct hit. Darden Restaurants (NYSE: DRI), however, won't be so lucky.

Franchising

The fast food industry is built on the franchise model. The franchisee takes on the operating risk and has to pay most of the costs of running the business. The franchiser, meanwhile, normally gets paid a percentage of revenues in exchange for the use of the company's name, access to its business model, and national advertising.

The Golden Arches

McDonald's franchisees invest a portion of the capital to start a new restaurant, funding the costs of such things as the food equipment and decor. McDonald's, meanwhile, owns most of the land and buildings that house its restaurants. McDonald's earns its keep from rent/lease payments and from its cut of sales.

If employees demand higher wages, McDonald's revenue stream doesn't take a direct hit. It's revenues come from the top-line at its franchised locations, not profits. And rent is a set expense independent of employee wages. The longer-term problem that McDonald's faces is the relations with its franchisees.

Friction between the company and these important business partners could force McDonald's to adjust its franchise agreements. That's where McDonald's risk comes from. If there's no change here, there's little risk for McDonald's.

After running up early in the year, McDonald's shares have pulled back some on weakness in the company's same store sales. The shares recently yielded a generous 3.1% or so and have a price to earnings ratio of about 18. That's a little higher than its five year average.

The shares are probably fairly valued. Growth and income investors should take a look. That said, investors should strongly consider buying shares if wage demands lead to a sell-off because the impact on McDonald's will likely be muted.

Greater Franchise Risks

Burger King, meanwhile, hadn't historically purchased the property and buildings in its franchisee network. However, in an effort to spur growth, it has been franchising company-owned restaurants. So, only about a quarter of its franchisees pay rent in addition to a percentage of sales for the right to run a Burger King. With a greater dependence on food sales, Burger King could feel a bigger pinch if franchisees demand concessions.

Like McDonald's, though, Burger King's revenues are well insulated right now from any wage demands. The shares yield around 1.2%, so income investors won't be interested.

With a trailing PE of about 46 and a forward PE of around 21, investors appear to be anticipating a successful turnaround at this perennial also ran. McDonald's is probably a better option right now. That said, any sell-off on salary concerns could bring the shares back into a reasonable range for those seeking a turnaround play.

A Direct Hit

Darden Restaurants, on the other hand, owns virtually all of its over 2,000 restaurants. According to Bloomberg, the average restaurant worker wage is about $9 an hour. Wage demands from the strikers are for $15. That would represent a 66% increase in pay, a huge cost increase to handle.

The company's fiscal 2013 sales were $8.55 billion. Restaurant "labor" amounted to 31.5% of sales, or about $2.7 billion. That's a big line item. However, if the company has to increase that by 66%, it's looking at an additional $1.8 billion. That would take labor costs up to $4.5 billion, or over half of the company's sales.

That would be a notable problem for Darden and likely push earnings into the red. Luckily for the company this isn't in the cards just yet. However, it is a risk that investors should watch closely.

Darden shares are currently struggling under the weight of poor comparable store results at its Olive Garden restaurants. That presents an opportunity for income seekers, with the shares yielding around 4.4%. Investors are being paid well to wait for a turnaround. And Wall Street appears to be overlooking the fact that Darden is moving into international markets, which should spur growth.

That said, if wages become an issue, investors should consider heading for the exits.

There are Big Problems and BIG Problems

The franchise model actually protects McDonald's and Burger King from material direct financial exposure to rising wages. That could make both worthwhile investments if salary issues lead to a sell-off. Of the two, McDonald's appears more reasonably priced today. Value priced Darden, however, could see a big hit if employee wages move materially higher since it owns and operates its own restaurants.

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Reuben Brewer has no position in any stocks mentioned. The Motley Fool recommends Burger King Worldwide and McDonald's. The Motley Fool owns shares of Darden Restaurants and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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