The minimum wage is rising across the US, and fast-food companies are feeling the pinch. In our view, watching how companies cope reinforces the importance of a selective approach to stockpicking.
This week, New York’s Department of Labor has proposed raising the minimum wage for workers in the fast-food industry. According to the plan, staggered wage increases will boost the minimum wage to $15 per hour by 2018 in New York City and by 2021 outside the city—a 71% increase from $8.75 today. These wages would apply to all national chains with at least 30 locations across the country. It’s not a done deal, as the legality of wage hikes in a single industry may be challenged. Still, the proposals could prompt changes that reverberate through the fast-food system, the US labor pool and company earnings.
There aren’t any clear historical parallels. The magnitude of this proposed wage increase is much larger than anything we’ve seen in at least 50 years. That said, two major cities—Seattle and San Francisco—have already approved wage increases to $15 over the past year. To frame the challenge, we can take a closer look at how one major restaurant company is dealing with the wage pressures.
Chipotle’s San Francisco Response
Chipotle, the Mexican restaurant chain with at least 12 locations in San Francisco and dozens more in the Bay Area, is a great case study. Based on its most recent financial reports, Chipotle’s direct labor costs are around 22% of revenues. While some of this represents salaried management personnel, we estimate that about 15% is direct store labor that could be affected by the minimum wage legislation.
Even though Chipotle currently pays more than minimum wage, the upward move will likely force it to pay more. In fact, the company’s management team mentioned wage and benefit pressures nationally on its most recent earnings call on July 21. So, looking at San Francisco specifically, the jump (over time) from $10.74 to $15 represents a 39% increase. If Chipotle’s wage increases are similar, this would represent a roughly 6% increase in wages relative to revenues (15% labor times 39% increase).
How does a company offset this kind of wage pressure? One way would be to make labor more productive with new technology. For example, online ordering and payment, which Chipotle has introduced, is certainly a strong help to controlling costs. But in San Francisco, that hasn’t been enough; given other cost pressures, the company has chosen to raise menu prices by 10% because total store costs in the city are 30% above system averages. Its ability to raise prices without driving away business will determine whether it can absorb the higher costs without sacrificing margins.
Burritos, Inflation and Interest Rates
There are several takeaways here for investors, both macro and micro. On the macro side, we believe this story highlights that higher minimum wages will be inflationary. With 41% of US employees earning less than $15 per hour (Display), according to data from the Bureau of Labor Statistics, many companies and industries will grapple with wage pressure over the next few years. So while many investors are anxious about the Fed potentially raising rates when there’s little sign of inflation on the horizon, we think it’s only a matter of time before prices start to rise.
It’s also worth considering how broader wages may be affected by minimum-wage trends. In New York, state hourly wages averaged $28.42 in June. So with the minimum wage at $8.75, the lowest wage was roughly 31% of the average. If minimum wages move to $15—or approximately 53% of the overall average—it could generate upward pressures on overall wages. For example, a worker in New Jersey paid the current $8.38 minimum would have a big incentive to jump on a commuter train to get a 79% pay hike for the same job in Manhattan. This type of effect could cascade across markets throughout the country. However it plays out, higher wages mean more disposable income, which should be good for the economy, as approximately two-thirds of US GDP comes from consumer spending.
The micro takeaway is that pricing power is likely to become increasingly important. Companies with pricing power, such as Chipotle, will likely maintain operating margins. Companies with more limited pricing power could be squeezed on earnings and margins.
Since pricing power depends on many factors, from industry dynamics to brand presence, investors will need to watch closely. And the potential impact of wage hikes extends far beyond the fast-food industry. As a result, we expect pricing power to become a larger factor in the success of individual US companies. Knowing the difference between those that have it and those that don’t requires a keen understanding of company fundamentals and a selective investment approach.