How McDonald’s Makes Money: Franchising Fast Food
When the story of McDonald’s is told, it often begins with Ray Kroc, the native Chicago milkshake mixing machine salesman who had the vision to see what the business model deployed by one of his clients, Speedee Service System, could become. Speedee Service System, launched in 1948, was the brainchild of two brothers, Richard James (Dick) and Maurice James (Mac) McDonald, who successfully utilized the “drive-in” concept to food delivery and, ultimately, franchising opportunities. Impressed by what he saw, Ray Kroc became their franchise agent in 1954, opened up the first McDonald’s franchise in 1955 and, in 1961, bought out the McDonald brothers for the, then hefty, sum of $2.7 million. The rest is part of the entrepreneurial lore that is the hallmark of iconic businesses.
- McDonald’s makes money by leveraging its product, fast food, to franchisees who have to lease properties, often at large markups, that are owned by McDonald’s.
- Approximately 93% of total capacity are franchises.
- Franchisees are lured by the impressive margins that make McDonald’s franchises an almost guaranteed moneymaker.
- McDonald’s remains committed to growth, continuing its aggressive deployment of the three growth accelerators — EOTF, Delivery, and Digital — in 2019 and beyond.
Almost 80 years later, the enterprise has grown to about 38,000 restaurants globally that serve close to 68 million customers — roughly 1% of the world’s population — per day, all wanting a burger, fries, and/or chicken nuggets as quickly as possible. It has, effectively, morphed into the most popular family restaurant that appeals to children and adults alike and emerged as the dominant force in the “Quick Service Restaurant (QSR)” end of the market.
The QSR category contains a number of popular franchises, including McDonald’s Corp (MCD), KFC and Taco Bell (YUM), and Wendy’s (WEN). In 2019, McDonald’s emerged as the most valuable QSR (i.e., fast-food) chain with a brand value nearing 130.36 billion USD and total assets worth $53.8 billion USD at the end of 2021. McDonald’s has, consistently, led this market segment in terms of overall sales and number of restaurants worldwide, followed by Starbucks (SBUX) and Subway.
On the way to serving hundreds of billions of people, McDonald’s has blazed multiple corporate trails since its 1955 incorporation, such as franchising and institutionalized training. McDonald’s even had a mission statement long before mission statements were a thing. “Quality, Service, Cleanliness and Value” is self-explanatory, and McDonald’s has set standards for at least the first and fourth of those qualities. As legendary Michelin chef, Ferran Adria, once said of the Big Mac: “Ferran Adria and the 100 best chefs in the world cannot do better for the price.”
In 2019, McDonald’s emerged as the most valuable QSR chain with a brand value nearing 130.36 billion USD and total assets worth 53.8 billion USD in 2021.
Essentially, McDonald’s makes money by leveraging its product, fast food, to franchisees who have to lease properties, often at large markups, that are owned by McDonald’s. As reported in their 2019 10-K, 36,059 of the 38,695 restaurants were franchised with McDonald’s operating the remaining 2,636 restaurants. So, approximately 93% of total capacity are franchises.
The advantage of this model is that the revenue stream (rent and royalty income received from franchisees) is far more stable and, most importantly, predictable, while the operating costs are measurably lower, allowing for an easier path to profitability. McDonald’s, because it has control over the land and long-term leases, can leverage its market position to negotiate deals. As has been noted by analysts, this is akin to a subscription, where the subscriber (the franchisee) pays a fixed amount each month.
According to industry analysts, McDonald’s keeps about 82% of the revenue generated by franchisees, compared with only about 16% of the revenue from its company-operated locations, which is further trimmed by the costs incurred in operating these units.
Why Are McDonald’s Franchises in Demand?
McDonald’s has notoriously strict criteria for its franchisees (net worth, liquidity, etc.). Additionally, the franchisees are also responsible for paying salaries, ordering supplies, and paying rent/owning the premises. So, why become a franchisee? The lure is that McDonald’s provides them with an almost guaranteed moneymaker due, in large part, to the impressive margins.
The restaurant industry is infamous for its turnover, and as any restaurateur will tell you, one major reason for this is that the margins can be thinner than a slice of processed American cheese. Yet, McDonald’s operating margins are Double Quarter Pounder thick — north of 40%! How is that possible in a business whose very purpose is providing inexpensive food?
The answer lies in the fact that the food is even cheaper to prepare than one might think. Some menu items — coffee, for instance — sell for dozens of times their cost. Note to people who think nothing of paying $5 for an iced mocha — you’re drinking a few pennies worth of beans, boiled in water that’s too cheap to measure, and some chocolate syrup.
36,059 of the 38,695 restaurants in 2019 were franchised, with McDonald’s operating the remaining 2,636 restaurants.
Markets & Business Segments
As per their recent 10-K, effective May 14, 2020, McDonald’s is operating with the following global business segments: U.S., International Operated Markets, and International Developmental Licensed Markets and Corporate. Each sector accounts for 37.2%, 54%, and 8.7% of revenues, respectively, as of the company’s most recent annual report.
- U.S.: The largest segment, with revenues of $7.843 billion in 2019.
- International Operated Markets: Markets including Australia, Canada, France, Germany, Italy, the Netherlands, Russia, Spain, and the U.K. This segment had $11.398 billion in revenues in 2019.
- International Developmental Licensed Markets & Corporate: Comprised of developmental licensee and affiliate markets, plus corporate activities. This segment had $1.836 billion in revenues in 2019.
According to McDonald’s 10-K, 2019 free cash flow was $5.7 billion, a 36% increase over 2018, and global comparable sales increased 5.9% and global comparable guest counts increased 1%.
|McDonald’s Income Statement|
|2018 (Dec. 31)||2017 (Dec. 31)||2016 (Dec. 31)|
|Total Operating Costs||($12,202.60)||($13,267.70)||($16,877.40)|
|Interest & Taxes||($2,898.30)||($4,360.4))||($3,058)|
|Shares Outstanding (Basic)||$778.20||$807.40||$854.40|
|Shares Outstanding (Diluted)||$785.60||$815.50||$861.20|
|Dividends per Common Share||$4.19||$3.83||$3.61|
Total revenues decreased in 2018 but the percentage from franchised restaurants rose, which is reflective of the transition to a heavily franchised business model. Revenue from franchised restaurants (rents, royalties & initial fees) was $11.01 billion, which is over 50% of McDonald’s total revenues and a substantial increase over 2017. Operating income was lower than what was reported in 2017, which was skewed by gains from the sale of assets in China & Hong Kong. Excluding these, operating income rose by 2% in 2018. Operating margin increased, which would bode well for future franchisees.
|McDonald’s Balance Sheet|
|2018 (Dec. 31)||2017 (Dec. 31)|
|Total Current Assets||$4,053.20||$5,327.20|
|Total Other Assets||$5,915.30||$6,028.20|
|Net Property & Equipment||$22,842.70||$22,448.30|
|Liabilities & Shareholders’ Equity|
|Total Current Liabilities||$2,973.50||$2,890.60|
|Total Shareholders’ Equity||($6,258.40)||($3,268)|
|Total Liabilities & Shareholders’ Equity||$32,811.20||$33,803.70|
McDonald’s has a track record of paying dividends on its common stock for 43 consecutive years and, even more impressively, increasing the dividend amount every year. The 2018 full year dividend of $4.19 per share reflects the quarterly dividend paid for each of the first three quarters of $1.01 per share, with an increase to $1.16 per share paid in the fourth quarter. This increase in the fourth quarter dividend can be viewed as McDonald’s confidence in the ongoing strength and reliability of its cash flow, which is a validation of their business model.
|McDonald’s Statement of Cash Flows|
|2018 (Dec. 31)||2017 (Dec. 31)||2016 (Dec. 31)|
|Cash Provided by Operations||$6,966.70||$5,551.20||$6,059.60|
|Cash from (used for) Investing||($2,455.10)||$562||($981.60)|
|Cash Used for Financing||($5,949.60)||($5,310.80)||($11,262.40)|
|Effect of Exchange Rate Changes||($159.80)||$2,640||($103.70)|
|Change in Cash & Equivalents||($1,597.80)||$1,066.40||($6,288.10)|
In 2018, cash provided by operations increased by $1.4 billion or 25% compared with 2017, primarily due to lower tax payments. McDonald’s current ratio, which is a measure of liquidity, is 1.36 and confirms that the company is on sound financial footing.
According to the annual report, “Over the long-term, the Company expects to achieve the following average annual (constant currency) financial targets:
- System-wide sales growth of 3% to 5%
- Operating margin in the mid-40% range
- Earnings per share (EPS) growth in the high-single digits
- Return on incremental invested capital (ROIIC) in the mid-20% range”
McDonald’s Stock Chart – MCD(source: TradingView)
As noted in its latest annual report, “In 2018, the Company continued to evolve to a more heavily franchised business model, and is currently about 93% franchised, with a long-term goal of approximately 95%. The Company will continue to make progress toward this long-term goal in 2019 primarily by re-franchising restaurants to conventional licensees. As a result of the continued evolution of the Company’s business model, in September 2018, the Company announced several organizational changes to its global business structure. These changes are designed to continue the Company’s efforts toward efficiently driving growth as a better McDonald’s through the Velocity Growth Plan.”
The Velocity Growth Plan, introduced in 2017, is McDonald’s customer-centric strategy that focuses on the key drivers of the business, namely food, value, and customer experience.
- Retaining Existing Customers: Focusing on areas where it already has a strong foothold in the Informal Eating Out (IEO) category, including family occasions and food-led breakfast.
- Regaining Customers Who Visit Less Often: Recommitting to areas of historic strength, namely quality, taste, quality, and convenience of its product: food.
- Converting Casual to Committed Customers: Building stronger relationships with customers so they visit more often, by elevating and leveraging the McCafé coffee brand and enhancing snack and treat offerings.
McDonald’s remains committed to continuing its aggressive deployment of the three growth accelerators (also identified in 2017) in 2019 and beyond. The growth accelerators are:
- Experience of the Future (“EOTF”): Restaurant modernization and technological upgrades to transform the restaurant service experience and enhance customer’s perception of the brand.
- Digital: By evolving the technology platform, McDonald’s is expanding choices for how customers order, pay and are served through additional functionality on its global mobile app, self-order kiosks, and technologies that enable conveniences such as table service and curb-side pick-up.
- Delivery: In 2018, McDonald’s expanded the number of restaurants offering delivery and it is now available in over half of the global system. McDonald’s has been, and intends to be, quite proactive in keeping up with the current trends when it comes to expanding its brand and business. In 2017, McDonald’s announced it would partner with Uber Eats for home delivery for the first time in the U.S and followed that up by adding Doordash and GrubHub this year (2019). These partnerships are part of a strategy to keep up with the newer generations who prefer home delivery over pickup.
McDonald’s has managed to stay comfortable ahead of its main competitors, like Burger King, Wendy’s, Kentucky Fried Chicken, etc., in the fast food arena, but its key challenge might just be a consumer who demands healthier, organic menu choices coupled with fast-food convenience.
Over the past few years, another restaurant model, one that offers consumers freshly-prepared, higher-quality food in an informal setting and with efficient counter service, has been making a bid to garner the attention of the consumer, or more appropriately, their palates. Dubbed as fast-casual restaurants, these entities — Chipotle (CMG), Shake Shack (SHAK), among others — have been making inroads into the space long dominated by QSR’s like McDonald’s.
Fast-casual differs from fast food in that their aim is to provide consumers healthier selections with fast food convenience at a slightly higher price point that consumers would be willing to pay. The growing consumption trends for food that is healthy, economical, and available with minimal wait times has begun to eat into the market share of leading QSRs. McDonald’s recently reported a 6.47% decline year-over-year sales for the 12 months that ended March 31, 2019.
This didn’t go unnoticed by McDonald’s. In late 2018, it announced that it was removing all preservatives, fake colors, and other artificial ingredients from seven of its burger selections. Its menu now features a Southwest Grilled Chicken Salad, and you can get apple slices with a kid’s Happy Meal.
The Bottom Line
Fast food should be as stable an industry as any. People need to eat and they want their food fresh and fast without having to spend unnecessarily. That said, the industry does face challenges relating to a shift in demand towards healthy eating. A restaurant chain that sells familiarity and consistency needs to recognize that those qualities themselves are enormous assets. Even when McDonald’s has an under-performing year, it’s still profitable. When operating at its peak, it’s a must-have stock in any comprehensive portfolio, especially since it has similarities with REITs as well.