Prediction: These 2 challenges will become full blown problems for McDonald’s

It cannot be denied McDonald’s (MCD 0.11%) is the king of the fast food industry. Not only has the company clearly mastered the art and science of quick-service restaurants, but with more than 42,000 stores each doing $3 million in annual sales, it’s also the biggest name in the business. It also makes for a rewarding long-term investment.

However, no great company is guaranteed to thrive forever. Indeed, it is possible for the very things that once made a company great to eventually turn into liabilities.

That’s probably where McDonald’s is now. For decades, it has outlasted the competition by being the top name in restaurant franchises. Now, however, its once fruitful relationships with franchisees are strained to the point of becoming problematic. Two specific tensions serve as evidence of the company’s deeper challenges, even if their risk is not readily apparent.

McDonald’s stock could be hard to own until these hurdles are clearly cleared.

McDonald’s franchisees are increasingly frustrated

McDonald’s does not actually own most of its stores. As of June, 95 percent were owned and operated by franchisees who not only pay an upfront fee for the right to operate a store, but pay the parent royalties from their restaurants’ revenue. The franchisor (ie McDonald’s) also requires its franchisees to purchase supplies from the company itself and contribute to certain marketing efforts. Perhaps most notably, McDonald’s differs from other franchises in that it owns the real estate in which franchisees operate, collecting ever-increasing market-based rent payments for the right to use its building and land.

Regardless of the arrangement, the restaurant business is becoming increasingly competitive. This puts more and more pressure on many facets of the McDonald’s operation, in turn creating tension between franchisees and franchisors…each of whom only wants to maximize their profits. Stories of franchisees becoming frustrated by unexpected costs and onerous requirements are nothing unusual these days.

Indeed, they are now common enough that the US Federal Trade Commission is getting involved. Just last month, the FTC issued a formal warning to US franchisors, reminding them that “the use of contract provisions, including non-disparagement clauses that prohibit franchisees from communicating with the government, violates the law.” The regulator also reminded them that “franchisors cannot lawfully impose and collect fees from franchisees that have not been previously disclosed.”

The Commission did not explicitly name McDonald’s as a violator of these standards (nor any other fast food chain, for that matter). However, these messages are in the same vein as many of the heated complaints that McDonald’s franchisees have voiced in recent years. That the FTC felt compelled to issue a public statement on the matter is a sign that McDonald’s increasingly strained relationship with its franchisees may be at or near an impasse that could hinder future growth. After all, franchisees aren’t going to take above-average risk for below-average returns on their investment.

And the second stumbling block? Inflation (although once again the complex franchisee/franchisor arrangement plays a part in this headache).

Anyone reading this is surely aware that higher prices have been taking a big bite out of your purchasing power lately. McDonald’s restaurants and its customers are not immune to this challenge. Just a few months ago, the price of a Big Mac was approaching $20 in some markets. Other combinations have seen similar price increases, forcing some consumers to forego visits to the fast-food chain.

Then, in late June, the company finally countered by introducing several combo meals that could be purchased for just $5. And it worked. Customers are back. It worked so well, in fact, that the restaurant chain extended what was supposed to be a short-lived promotion through this month at most locations.

But it’s not as if the generous offer isn’t taking its toll. Several franchisees have expressed frustration that the cost of making and selling these $5 meals is simply too high without assistance from the corporation itself…which doesn’t seem to be coming. But since many of the chain’s pricing and menu decisions are binding (effectively, if not literally), relief may not be on the horizon if these $5 meals are extended again or become permanent.

Again, it’s a symptom rather than the problem itself. However, it is another potential source of tension that arises from a business arrangement that offloads much of the cost burden – and therefore much of the risk – onto franchisees.

Too much potential risk to simply ignore

These are obviously philosophical problems at least as much as operational problems, which makes them more difficult to solve. But, them maybe be fixed And even if they aren’t, it’s not as if McDonald’s doesn’t enjoy the kind of stature that inspires franchisees to swallow their frustrations and toe the line well into the future.

These seemingly small philosophical challenges, however, can also creep up on a business without anyone noticing until it’s too late. Think of once great companies such as General Electric, IBMor Blockbuster (which at some point had the opportunity to acquire it Netflix for next to nothing). These companies were not suddenly and unexpectedly overthrown. They simply suffered a slow extinction, ignoring the little things eating into their uplines and downlines, until they became very big things.

McDonald’s is not likely to suffer the same fate as Blockbuster, or even GE or IBM, nor is its attractive dividend in immediate danger.

Red flags i am still fluttering more and more. How they deal with franchisees – and how they require franchisees to deal with customers – is evolving into a tangible responsibility for investors. Shareholders will want to keep this aspect of the business in mind. The stock may not be your best bet right now.