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🍟 McDonald's: The Franchise OG
The burger giant plans to increase its US royalty fees by 25%
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In the mid-1950s, Ray Kroc stumbled upon the McDonald brothers' local diner and was captivated by its efficiency and potential. While the brothers had previously dabbled in franchising, it was Kroc's belief in a nationwide model, combined with his aggressive pursuit of this vision, that truly unleashed the power of franchising in the fast-food industry.
McDonald’s is the 5th most valuable brand globally, only behind the leading tech industry brands, according to Kantar BrandZ.
The franchise model still sits at the heart of the company’s success today. Franchised restaurants represent 95% of McDonald’s 41,000 locations worldwide.
Recently, the company announced a 25% hike in its US and Canadian royalty fees for new restaurants, raising it for the first time in nearly 30 years from 4% to 5% of sales, bringing it in line with other global markets.
As we unpack the implications of this change, let’s dive into the legacy of McDonald's franchising system and understand the ripple effects on its growth strategy.
Today at a glance:
How the franchise model works.
McDonald’s Q2 FY23.
Recent business highlights.
What to watch looking forward.
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1. How the franchise model works
McDonald's has been instrumental in shaping the franchising landscape as we know it. Today, chains like KFC, Burger King, and Wendy’s follow the same approach.
Ray Kroc’s emphasis on uniformity, standardization, and the replicable "system" paved the way for the global fast-food industry's growth.
So how does it all work?
McDonald’s has two types of restaurants:
Company-owned restaurants: These are owned and operated directly by McDonald’s Corporation. The corporation takes on all expenses and responsibilities and, in turn, collects all the revenues.
Franchised restaurants: These are owned and operated by individual business owners (franchisees) who have entered into a franchise agreement with McDonald's. Franchisees pay various fees to McDonald’s, including:
Rent if the property is owned by McDonald’s.
Royalty as a percentage of their sales (4% to 5%).
The company often refers to its "Systemwide sales,” the combined sales generated by company-operated and franchised restaurants. It encompasses all restaurants under the McDonald's brand, regardless of ownership status. This metric gives a comprehensive view of the brand's overall performance and footprint, and it often showcases the strength and appeal of the brand across different regions and markets.
There are several perks to the franchise model:
Revenue is highly predictable, comparable to a subscription business.
A very high-margin business (84% gross margin in the latest quarter).
The franchisees handle the rent, workforce, and ordering supplies.
The franchisor (McDonald’s) handles training, marketing and IT support, franchisee recruitment, R&D (new products), and property management. Many of these costs don’t necessarily scale with each additional franchisee, hence the attractive scalable appeal of this formula.
The initial investment to open a McDonald’s franchise can add up fast:
Initial Franchise Fee: $45,000.
Total Initial Investment: Ranges from $1 million to $2.3 million, including equipment, inventory, and licenses.
Financial Requirements: Potential franchisees should possess a minimum of $500,000 in non-borrowed personal resources.
By asking for stringent capital requirements, McDonald’s stacks the deck in its favor and limits the potential for bad debt.
So why is this an attractive business for franchisees?
For one thing, McDonald’s has a 16% gross margin from its operated restaurant. That gives us a ballpark of what most franchisees can achieve.
What does a franchisee's P&L look like?
💵 Revenue: Sales of food and beverage.
Major costs include:
🍟 Food and Paper: Ingredients, packaging (30% to 40%).
👩🍳 Labor Costs: Salaries, benefits, training (20% to 30%).
🏪 Rent: Lease from the franchisor (8% to 15%).
👑 Royalties: Typically 4% to 5% of sales.
📺 Advertising: Local fund contributions (4% to 5%).
🔌 Other: Utilities, daily expenses.
📈 Operating Profit: Typically falls in the ~5% to 10% range. It can vary based on location.
Remember, while the franchisor (McDonald's corporate) enjoys high royalty and rental income margins due to its relatively low variable costs, franchisees operate on a more traditional restaurant business model with the associated costs and challenges.
Franchisees choose McDonald’s for many reasons:
Training and support.
Tried-and-true business model.
Resale value (the franchise often retains substantial resale value, allowing for an exit strategy and return on investment).
In addition, the company has a unique model wherein they secure prime real estate locations and then lease them to franchisees, giving access to locations that might otherwise be out of reach.
Challenges & Franchise Turnaround Plan
McDonald’s has seen rising competition from fast-casual chains (like Chipotle, Five Guys, and Shake Shack), positioned as higher quality for a slightly higher price. There is also a growing trend toward healthier eating and skepticism of processed foods.
In 2015, McDonald’s announced a refranchising initiative. The chain would increase the share of franchised locations from 81% to over 90%.
Why? Higher margin, capital efficiency (with expenditure handled by franchisees), local adaptability, cash flow predictability, and a focus on core strengths (advertising, promotions, digital transition, and more).
Instead of recording the entire store's sales as revenue, McDonald's would only record the rent and royalty fees as revenue, a fraction of a store's total sales. As a result, in the second half of the 2010s, McDonald’s saw a decline in revenue but improved profitability.
2. McDonald’s Q2 FY23
McDonald’s key restaurant metrics as of June 2023:
Total restaurants grew +3% year-over-year to 41K.
95% of restaurants are franchised.
32% are in the US.
Global comparable sales grew +12% year-over-year.
Digital sales represented 40% of Systemwide sales in the top 6 markets.
Here is a bird’s-eye view of the income statement.
Revenue has two main components:
Company-owned restaurants (38% of overall revenue).
Sales of food & beverage.
Franchised restaurants (61% of overall revenue).
Rents — 39%.
Royalties — 22%.
Initial fees — 0.2%
Revenue grew +14% Y/Y to $86.5 billion, a $210 million beat.
Sales from company-owned restaurants grew +18% Y/Y to $2.5 billion.
Revenue from franchised restaurants grew +12% Y/Y to $3.9 billion.
Gross margin was 57% (flat Y/Y).
Company-owned restaurants had a 16% gross margin.
Conversely, franchised restaurants delivered an 84% gross margin
As a result, franchised restaurants drive 89% of the gross profit.
Operating margin was 48% (+21pp Y/Y).
Non-GAAP EPS $3.17 ($0.38 beat).
Operating cash flow in the trailing 12 months was $8.7 billion (36% margin).
Cash and cash equivalent and marketable securities: $1.6 billion.
Long-term debt: $48.6 billion.
So what to make of all this?
A substantial part of revenue (39%) comes from rent. The company is a real estate giant with $42 billion in property and equipment (at cost).
Management expects top-line growth to moderate in the second half as inflation begins to normalize. This is in line with industry trends after COVID tailwinds in the past few years.
Operating leverage is expected to continue moving forward with further margin expansion as the company scales its number of franchised restaurants.
The massive jump in operating margin was primarily due to a $1.2 billion charge related to the sale of the company business in Russia in the first half of 2022.
As you can see, royalties are only 22% of overall revenue, and the 25% royalty hike in North America will only affect new restaurants, so the impact will be limited. However, it will be 100% accretive to the operating margin.
Is the business sustainable?
McDonald's carries significant debt on its balance sheet primarily due to its strategy of owning the land and buildings of a substantial portion of its locations. McDonald's secures a consistent revenue stream by leasing these properties to franchisees at a marked-up rate. This real estate strategy, combined with share buybacks and other investments, leads to higher leverage but also provides consistent returns.
The net debt of $47 billion could probably be paid over the next four or five years based on the company's cash flow, so it’s not a major concern.
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3. Recent business highlights
President & CEO Chris Kempzinski started the latest earnings call by discussing the popularity of Grimace—a McDonald’s mascot who likes to steal people’s milkshakes. This purple character celebrated its 52nd birthday this summer, reaching 3 billion views on TikTok in the process.
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“This viral phenomenon is yet another proof point of the power of marketing at McDonald's today.”
The post below garnered millions of views and is another recent illustration of McDonald’s social media team capturing the zeitgeist.
“In June, McDonald's earned an impressive 18 lions across 10 markets at the Cannes Lions International Festival of Creativity.”
The company continues its digital transition. About 90% of McDonald’s business currently comes through digital channels in China.
Progress on the digital front comes from improvements within the direct-to-consumer McDonald’s app, notably in the US:
“Last quarter, we introduced an enhanced ordering process through our app in the US with the goal of delivering a faster and more enjoyable experience for the customer. While we're still learning from this deployment, early results have been extremely positive with elevated sales initiated through the app, increased customer satisfaction and improved service times.”
The success of digital sales is intertwined with the company’s loyalty program, which now includes over 52 million 90-day active members. For context, Starbucks had 31 million US Active Rewards Members in its latest quarter.
Notably, management sees a roughly 15% increase in frequency when someone signs up for the loyalty program.
Tailwinds and headwinds
The global pandemic boosted drive-thru and digital orders, inflation is cooling down, and the macro environment remains uncertain. As a result, growth is expected to moderate in the coming quarters.
However, management is focused on market share and recently highlighted gains in most top markets.
The leadership is less concerned by macro conditions and more focused on outperforming the competition, a better reflection of the momentum. Among other things, they want to lead on affordability and value for money, which requires constant attention to pricing, even in an inflationary environment.
4. What to watch looking forward
McDonald’s is focused on three pillars of growth that are critical to watch under its strategic plan called “Accelerating the Arches.”
McDonald’s seeks to leverage its global brand power to appeal to a broader audience. This involves smart investments in digital marketing and leveraging its international celebrity partnerships (like the Travis Scott and BTS meals) to resonate with customers.
The aim is to strengthen brand loyalty and attract new demographics.
Commit to the Core:
McDonald’s focuses on its core menu items that customers love, such as the Big Mac, Quarter Pounder, Chicken McNuggets, and fries.
By consistently enhancing these core items – through new flavors, ingredients, or promotional strategies – the company intends to drive sales and boost customer loyalty.
Double Down on the 4 D’s:
Digital: Expand the use of the McDonald’s app for ordering, promotions, and loyalty rewards. They see tremendous growth potential in further digitizing the customer experience through mobile ordering, payments, delivery, rewards, or deals. Digital should represent a growing portion of Systemwide sales over time.
Delivery: Expand delivery services through their app and third-party partners to meet the growing demand for convenience.
Drive-Thru: Invest in faster and more efficient drive-thru experiences, especially given its increased importance in a post-COVID environment.
Development: In the US and some international markets, the number of restaurants hasn’t grown in the past decade, so management wants to accelerate the pace of new restaurant openings and explore new formats, including smaller restaurants—primarily relying on digital and delivery—with a unique opportunity from a real estate angle.
These growth accelerators represent McDonald’s strategy to keep evolving with customer preferences, leverage its brand strength, and capitalize on convenience and digital engagement trends. For investors, these pillars indicate the company's proactive approach to sustain and accelerate growth in the coming years.
Alright! After writing all this, I’m hungry now. Parapapapa.
That’s it for today!
Stay healthy and invest on!
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Author’s Note (Bertrand here 👋🏼): The views and opinions expressed in this newsletter are solely my own and should not be considered financial advice or any other organization’s views.