McDonald’s Corp. officials pushed back against reports of mutiny among owner-operators last month after public comments from franchisees revealed ongoing discussions with the franchisor over rent structure, value strategy and remodeling programs.
An Aug. 6 article on Bloomberg.com  said two groups of California franchisees were “going rogue” by having meetings, listing grievances and suggesting negotiations with McDonald’s to Lee Heriaud, a Phoenix-area franchisee who chairs the National Leadership Council for all domestic McDonald’s owner-operators. The report also speculated that McDonald’s franchisees would be less likely to open new restaurants or remodel existing ones.
A copy of a memorandum obtained by Nation’s Restaurant News, which operators in the Pacific Sierra region drafted after a June 6 meeting in Stockton, Calif., lists several points of contention the franchisee group has with McDonald’s. The memo is addressed to Heriaud and Kevin Hern, an Oklahoma-based franchisee who chairs the franchisee-franchisor joint System Economic Team, both of whom attended the meeting.
“Over the past several years, our owners have expressed their concerns in various forums,” the memo said. “However, many operators have expressed that they don’t feel that their concerns are being heard by top management and that they are not responding fast enough to our concerns.”
The Pacific Sierra operators listed four main concerns: diminishing owner cash flow, rent terms for new agreements on leased sites, the major remodeling initiative and McDonald’s “value evolution” strategy.
McDonald’s officials refuted the implication that a franchisee uprising was underway. Spokeswoman Heather Oldani said that the franchisee groups’ meetings are not unusual and did not constitute a “brewing franchisee revolt,” as suggested in the Bloomberg story.
“To characterize this as a revolt is the wrong picture,” she said.
Tensions between franchisees and franchisors are nothing new to the restaurant industry, and they tend to escalate when sales slow and commitments dictated by the franchise agreement don’t. But the severity of dissension is best gauged by the number of franchisees that exit the system, according to Dennis Lombardi, executive vice president of Columbus, Ohio-based WD Partners.
“There is always some percentage of operators that is unhappy,” he said. “But if you look at how many franchisees have said, ‘Here are the keys; I’m out,’ I bet that’s a low number.”
The number of exits is low, said Jim Johannesen, executive vice president and chief operating officer of McDonald’s USA. While the latest give-and-take between McDonald’s and its franchisees over value-heavy marketing, remodeling mandates and rent inflation has caused tension, “we’re at some historic lows relative to people exiting,” he said.
Heriaud, who owns 16 McDonald’s units, agreed that the owner-operators and McDonald’s remain committed to working through these disagreements together.
“Whether you run a business or a family, we see increased costs over time,” he said. “My sense is that the number of operators leaving the system isn’t significant. There’s no lack of appetite for new opportunities.”
Wrangling over rent
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The franchisee group listed rent inflation among its major concerns in its memo to Heriaud, saying franchisees and McDonald’s are no longer aligned on the issue.
“The higher the landlord raises the rent at the 20-year renewal, the higher the disproportionate profit for McDonald’s through percentage rent,” the letter stated. “Win-win for the landlord and McDonald’s, lose for the owner.”
In addition to rent, every McDonald’s owner-operator pays a 4-percent service fee and contributes 4 percent of sales to McDonald’s marketing fund, which is split between local co-ops and the Operator’s National Advertising Fund, or OPNAD, Johannesen said.
Rents are cost based, meaning the base rent percentage can vary in higher-cost markets, and rates can also rise gradually as operators make certain revenue levels, he said.
In the memo, the Sierra Pacific operators charged that the “rent chart is broken” and “no longer provides a fair and equitable return to the owner based on current costs, profits and risk-reward between company and owner.”
The memo noted that rents on new buildings in the region have reached as high as 16 percent to 18 percent of annual unit volumes.
“This is too high, and at rewrite in 20 years, these sites will see rents over 20 percent,” the memo said. “This is a ‘next-gen’ business. We have to think of the next generation of owners that will be assuming this increase. How can they survive?”
The systemwide average rent paid by franchisees is approximately 10 percent, including base rent and any escalated rents that kick in after certain revenue thresholds, Johannesen said.
John Gordon, principal of San Diego-based Pacific Management Consulting Group, agreed that McDonald’s rent escalations on higher-volume stores can cut into operators’ profit margin percentage and suggested that the corporation has room to make concessions on rent.
“McDonald’s has a capability via rent relief to provide a pressure valve on over-discounting, if they would find some costs elsewhere in the corporate G&A structure to decrease,” Gordon said.
The franchisor does provide rent relief in cases where warranted, Johannesen said.
“If one location has a higher rent and the sales aren’t there, we would address that,” he noted.
Heriaud added that the System Economic Team works with McDonald’s to negotiate issues such as rent agreements when leases come up for renewal, often in higher-cost environments.
Cash flow concerns
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Franchise consultant Gordon added that, in addition to rent eating up incremental sales dollars at franchisees’ restaurants, a “witch’s brew” of the other grievances listed in the Pacific Sierra operators’ memo put pressure on their cash flow. Namely, a marketing strategy heavy on value strains profits, making investments in McDonald’s reimaging program harder to afford, he said.
The Pacific Sierra operators explicitly stated in their memo that they do not share the sentiments of chief financial officer Pete Bensen in McDonald’s first-quarter earnings call, who said the chain would sacrifice margins to gain market share in an anemic economy.
“Owner cash flow is already eroding, … and heavy discounting is also shrinking the bottom line,” they wrote.
Heriaud responded that franchisees would continue to work with McDonald’s and exert their influence on the value marketing strategy through OPNAD.
“It’s the owner-operators who decide that through a national voting process,” he said. “The company can’t determine value when, at the end of the day, the OPNAD vote comes from the operator community.”
At the end of 2012, for example, OPNAD approved new $1 items, such as the Grilled Onion Cheddar Burger, but rejected a move to sell hamburgers and cheeseburgers for 69 cents and 89 cents, respectively.
Operators also wrote that the pace of reimaging stores mandated by McDonald’s — calling for all remodels to be complete by the end of 2016 — was too fast and that the franchisees did not have enough flexibility in how they remodeled their stores. The Pacific Sierra memo suggested that McDonald’s slow the pace of remodels and decrease the decor mandate to a minimum standard that franchisees could “plus up” however much they wanted.
Johannesen responded that, as with the negotiating process for rent agreements, franchisees work with the System Economic Team “to make sure we’re looking at the same numbers and understanding how the economic pie between the company and owner-operators is looking.”
Heriaud added that flexibility around the initiative was discussed at the last meeting of the National Leadership Council in June.
“We had dialogue around flexibility of timing for each operator, as well as sequencing,” he said. “Maybe they can bite off different pieces at a time, like maybe the dual drive-thru opportunity before addressing the rest of the building.
“I think we’re arriving at a good spot,” he added.
McDonald’s has more than 2,500 owner-operators that run about 90 percent of the chain’s more than 14,000 U.S. restaurants.