Fast Food At Papa John's, McDonald's, KFC, And Others May Soon Come With An Obamacare Surcharge

 @moranzhang
on August 31 2012 4:18 PM

David Barr, who owns 23 KFC and Taco Bell outlets in Alabama and Georgia, started with two KFCs in 1998 and expanded the number of outlets in his franchise portfolio every single year until details of the proposed federal health care insurance plan began to emerge early after President Barack Obama's inauguration. Since then, Barr hasn't added any restaurants.

"I have zero desire to expand until the uncertainty goes away," Barr said, adding that he's even thinking about downsizing.

Signed into law in 2010 and recently upheld by the Supreme Court, the Patient Protection and Affordable Care Act, or ACA, requires that employers with 50 or more full-time or "full-time equivalent" employees provide health insurance to full-time employees by 2014 or pay a penalty. For each block of 30 weekly hours of part-time work by one or more employees, a business is deemed to have one full-time-equivalent employee.

Currently, Barr provides health insurance for only 30 managers or office personnel. But under the ACA's rules, starting in 2014, he will have to extend insurance coverage to an additional 134 full-time employees among his 424 workers. "By any definition, the law applies to us." Barr said. "If we fully implement the law, we'll have to just file for bankruptcy."

As Barr figures it, with health care coverage running about $5,000 per year, he would have to lay out about a half-million dollars annually to cover his employees, even if he sets their share of the premium at the maximum allowed for their wage scales under the new law.

"This business, believe it or not, does not cash flow more than half a million dollars a year," Barr argued. "After I pay all my expenses, pay debt service, pay required upgrades and other capital expenditures required to run the business, we don't have half a million dollars a year. And I really believe that's the case for many low-wage service industries."

'A Lose-Lose Situation'

If Barr is correct, the Affordable Care Act could stifle the growth of franchise businesses at a time when many argue they are critical to economic revival in the U.S.

The franchise industry is responsible for nearly 18 million jobs in the U.S., one out of every eight private-sector positions, according to Matthew Haller, vice president of public affairs for the International Franchise Association, or IFA. Many of these jobs are targeted for entry-level, low-skilled workers, a group with some of the highest unemployment rates.

Adults without high school diplomas faced an unemployment rate of 9.1 percent in July, almost twice as high as college graduates and well above the national average of 8.3 percent, according to the Labor Department. The unemployment rate for teens, another low-skill group, was 25.6 percent.

As many as 38 percent of employers -- not all of them franchises, but quite a few -- would be at risk of violating the coverage provision in the ACA, according to a study by Mercer, a human resources consulting firm.

In a recent study, the Hudson Institute, a conservative think tank, found that many franchise businesses would be motivated to reduce the number of locations and move workers from full-time to part-time status when the employer mandate phases in, in an effort to stay below the 50 full-time employee mark. The study estimated that more than 3.2 million jobs at franchise businesses would be affected.

With higher paying jobs, employers can offer the required benefits and pay for them by adjusting wages downward. But low-wage jobs in many sectors, such as restaurant and retail businesses, leave little room for such trims. (Restaurants represent 50 percent of franchise employment.)

"You are starting to see how much of a job killer this piece of legislation is," the IFA's Haller said.

"It's bad for franchisees, and it's bad for consumers, because employers are left with a clear choice: either to eliminate jobs or raise prices. It's a lose-lose situation."

Indeed, Papa John's International Inc. (Nasdaq: PZZA) said that the health care reform will cost the company an additional 11 cents to 14 cents per pizza, which the company vowed that its many franchisees would have to ultimately ask consumers to pay for.

"We're not supportive of Obamacare like most businesses in our industry," Papa John's CEO John Schnatter said in a call to analysts. "But our business model and unit economics are about as ideal as you can get for a food company to absorb Obamacare. We will find tactics to shallow out any Obamacare costs and core strategies to pass that cost onto consumers in order to protect our shareholders' best interests."

Papa John's is hardly alone in expressing these concerns about ACA. McDonald's Corporation's (NYSE: MCD) Chief Financial Officer Peter Bensen told analysts recently that the law will add between $10,000 and $30,000 in annual costs to each of the 14,000 McDonald's restaurants in the U.S., 89 percent of which are franchisee-owned.

"Many of our franchisees will struggle with how to reconcile the financial implications ... and will likely take other measures to reduce costs," Steven Wiborg, Burger King Worldwide Inc.'s (NYSE: BKW) North American president, said. 

Local Rivals Will Gain An Advantage

In the U.S., more than half of all franchise outlets are operated by franchisees that own multiple locations. They argue that they will be especially penalized by the new healthcare law and be placed at a disadvantage relative to local, nonfranchise competitors.

If a multi-unit franchisee owns four establishments with 15 full-time employees in each one, under the ACA, this store owner will be treated as a single firm with 60 full-time employees. However, if these four outlets were owned and operated separately, they would be exempt from providing health care benefits, because they would have too few workers.

In fact, if they chose to offer health insurance, they would in many cases be entitled to a tax credit. Under the ACA, if an employer has fewer than 25 employees and they earn less than $50,000 on average, a tax credit is available to defray 35 percent of the cost of providing health insurance to the workers.

While raising prices to cover health care costs is certainly an option that some franchise companies will take, in the current operating environment, it's not a very palatable one.

Standard & Poor's Capital IQ analysts said in a June 7 note that "very little pricing power exists" among restaurant owners and hiking the cost of meals will only reduce the number of customers served.

To keep up with the rising cost of commodities, most restaurant companies already raised their prices between 1 percent and 4 percent in 2011. While this is in line with core inflation, it is below the rate of food inflation, which is estimated to be running about 2 percent to 5 percent, according to Capital IQ.

And commodities prices are still going up. Market Vision, a restaurant commodities consulting firm, said the price of wheat in 2012 is expected to rise 26.32 percent, corn 19.69 percent, dry whey 16.43 percent, choice grade beef 8.08 percent, broiler chickens 5.06 percent and soybeans 3.54 percent.

"The importance of price as a competitive factor is greater than at any time in the recent past, and we see no end to the trend," Capital IQ analysts said.

That's certainly the view of John Metz, who owns more than 40 Denny's and Dairy Queen stores in Florida, Georgia and Virginia. He said that when he raises prices, people just buy cheaper items. Instead of a steak, they ask for a burger or a sandwich.

"I've been in the restaurant business since the late 1970s, and I know if I raise my prices 10 percent across the board, my average check does not go up 10 percent," Metz said. "My average check might go up 2 percent to 3 percent, if I'm lucky."

Reduce Hours, Close Stores

When the employer mandates go into effect in two years, many franchisees will likely minimize the number of hours employees are working, turning full-time workers into part-time help without benefits. Indeed, KFC/Taco Bell franchisee Barr says that a majority of his 164 full-time employees will be placed into part-time positions.

"The unfortunate part is it doesn't help me, because I'm probably losing a good employee," Barr said. "And it doesn't help my employees, because they might end up taking two part-time jobs and they still won't have [employer-provided] insurance."

But that won't necessarily negate their ability to obtain medical insurance. Employees who are not offered coverage by their employers will still be able to buy insurance directly through health care exchanges, and people making less than about $43,000 per year could be eligible for tax credits to help pay for it.

Still, those who share Barr's perspective argue that the ACA will worsen the unemployment situation in the country. In July, 8.2 million people were working part-time because they couldn't find full-time jobs, according to data from the Labor Department. That's five percent of the labor force. But if the arrival of the employer mandate adds to this group significantly, overall unemployment rates are likely to rise as well. 

It's Cheaper To Pay The Penalty

Some restaurant franchisees that offer limited health benefit plans say they will drop coverage and pay penalties rather than provide the more expensive insurance required under the law. Although the details of the law are complex, simply put, for employers above the 50-employee threshold, the annual penalty per employee who is not offered medical coverage could run between $2,000 and $3,000. However, some employees will be excluded from this requirement. Metz employs about 1,200 people at his restaurants and currently provides insurance to close to 150 of them. That means, in his case, for about 1,000 uninsured full-time workers, he has to decide whether to provide insurance at a cost of about $6,000 to $8,000 per year each or pay the much lower penalty.

"I kind of did the math, and obviously I'll pay the penalty for those uninsured employees of mine," Metz said.

A View From The Other Side

To some health care experts, the franchise industry's rationale for its blanket rejection of the ACA is ill-considered and erroneous.

For one thing, the notion that the new law will burden the franchise industry with additional costs that can't be managed is misleading, they say; it fails to take into account that as with any change in economic and regulatory conditions -- any new rule or commodity price spike, for example -- companies will simply adjust workers' compensation over time to offset any added expenses. After the wage adjustments occur, it is not inconceivable that some prices will shift a bit, too.

"Relative prices change all the time in our market economy, and businesses cope with them, as they will if there are any changes in relative prices in response to the Affordable Care Act," said Henry Aaron, an economist and a longtime health policy analyst at the Brookings Institution and the Institute of Medicine. "The idea that people are going to stop eating hamburgers, buying groceries, wearing jeans and consuming the rest of the many products that franchise chains sell is silly."

The deeper issue at hand is if health insurance coverage is something that virtually everyone should have (a proposition that Aaron thinks most people, if not all, accept) and if Americans don't want to replace the entire structure of employment-based U.S. health insurance with a single-payer plan such as Medicare for all, then it is necessary to extend employment-based coverage to as many employed people as possible.

Charge A 5% Health Care Tax On Every Bill

Although most people in the franchise sector are dreading the day that the ACA mandate arrives, they are doing so while offering up some gallows humor, often in some of the more interesting ways that they can make the public pay for the added health care costs on their books.

Metz has come up with two of the most intriguing options. One possibility, he says, is to put a health care surcharge of 5 percent on every bill. He notes that since the Supreme Court ruled mandated health care legal by calling it a tax, why can't he actually apply the tax for his benefit?

His other idea, though, is a bit more practical. Metz may tell his cost-sensitive customers to tip their servers less, putting more of their tab toward their meals. Since any increase in the price of the dinner is the result of providing health care insurance for workers, waiters and the like are getting a higher percentage of the bill in benefits. Hence, customers can rightfully tip servers more frugally without feeling guilty, Metz says.

"I'm not opposed to a nationalized health care policy," Metz said. "I just think that having the employer bear 100 percent of the cost of that is, for lack of a better word, 'nuts.'" 

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