California’s minimum wage could reach $22 next year. Is Starbucks still a buy?

Did California just kill off the fast food industry in the state? Governor Gavin Newsom has signed a bill that creates a new board to oversee and set wages and working conditions at quick-service restaurants, and California’s minimum wage could climb to $22 an hour from next year.

Starbucks (SBUX -0.86%) is one of California’s largest chains with more than 3,000 establishments representing nearly one-fifth of all the cafes it operates in the United States. Because the new law only applies to fast food restaurants, and only to those with at least 100 restaurants worldwide. countries, Starbucks may be feeling the impact of exorbitant labor expenses more than others.

Coffee is already struggling to manage inflation and rising labor costs, which caused operating margins to contract by 350 basis points last quarter. Now faced with the possibility of a monumental increase in such spending, investors are right to wonder if Starbucks stock is a buy.

Image source: Getty Images.

The cost of labor will explode

California’s Fast Food Accountability and Standards Recovery Act, or Fast Act, creates a government panel made up of members appointed by the governor and the legislature and will include an equal number of labor, union and business representatives. It is responsible for managing working conditions for hours worked, health and safety, and will also set the minimum wage for the restaurant industry next year.

By law, the board can increase the rate to a maximum of $22 per hour on January 1, then it will increase each year thereafter by the lesser of the national inflation rate or 3.5%. . California’s minimum wage is currently $15 an hour and is expected to increase by $0.50 an hour next year. The new law therefore means that fast food restaurants could see their labor costs increase by 47% in January.

Since California accounts for about 14% of total restaurant sales in the United States and is often considered a leading indicator of the industry, restaurants are concerned that other states may follow suit.

McDonald’s (MCD -0.21%) condemned the bill saying it “should sound alarm bells across the country”. Chairman Joe Erlinger said this creates an uneven playing field that “imposes higher costs on one type of restaurant, while sparing another.”

For many of these restaurants, their locations are actually small, entrepreneurial franchisees that only own one or two locations. Starbucks owns all of its stores.

Restaurant

Locations in California

% of total US locations

Burger King

555

seven%

Chipotle Mexican Grill

444

14%

In-N-Out Burgers

262

88%

jack in the box

942

42%

KFC

475

ten%

McDonald’s

1,165

8%

pizza hut

560

8%

Starbucks

3,005

19%

Data source: ScrapeHero.com. Table by author.

The high cost of doing business

Starbucks was already raising starting salaries for workers. Amid a growing national labor shortage, the coffee chain raised its minimum wage to $15 an hour earlier this year, then from August 1 raised it again to $17 an hour.

While businesses in franchise chains like McDonald’s won’t be as impacted by the law since franchisees will bear the burden, Starbucks will have to bear the full cost itself.

It was able to partially offset some of its higher expenses by passing the cost on to consumers in the form of higher prices, but there is a limit to how much a company can increase in price before sales hit. begin to suffer. And inflation is already weighing on Starbucks.

Although its North American revenue increased 13% in the third fiscal quarter, driven by a 9% increase in same-store sales, only a percentage point of the increase was related to more transactions. ; the balance was driven by increases in the average ticket amount, or the amount customers pay for their order.

Starbucks may have to eat a lot more of the upcoming pay raises, hurting its bottom line even more, and net profit has already fallen 23% last quarter.

Too hot to handle

Since California accounts for such a large portion of Starbucks’ business and it won’t be able to share costs with franchisees or pass them on entirely to customers, investors should expect coffee be significantly impacted by the law.

Even though Starbucks stock is down 25% in 2022, at 25 times earnings, 26 times next year’s estimates and 129 times the free cash flow it produces, coffee stock already looked at a high price in a weak market. The California Fast Act does a quick job of suggesting that Starbucks is not a buy at these prices.

Rich Duprey has no position in the stocks mentioned. The Motley Fool has positions in and recommends Chipotle Mexican Grill and Starbucks. The Motley Fool recommends the following options: Short Calls October 2022 at $85 on Starbucks. The Motley Fool has a disclosure policy.

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