The McDonald’s Franchisee Business Model

McDonald’s earns insane profit margins for a company that operates in the fast food industry. Wendy’s executives, who are fairly bragging about the improved sales results stemming from their 4-for-$4 summer deal, have been able to improve the profit margins at Wendy’s from an all-time low of 1.8% in 2010 to 7.9% now. They deserve credit and praise for their accomplishments in a highly competitive area.

However, consider this: McDonald’s is going to make almost 20% profit margins this year, and it has never had profit margins below 13% in the past quarter-century. Most years, profit margins fall in the 16% to 20% range. It is worth posing the question: why is it that McDonald’s has delivered 16% annual returns for almost half-a-century, turning $1,500 invested in the IPO into over $1.3 million today? How come it has a record of paying out a higher and higher dividend each year for the past three decades while the rest of the industry shares that “rise and fall of empires” characteristic that is typical of retail?

The answer is a combination of four factors: (1) a reputation, often borne out in fact, of being the low-cost producer; (2) franchising agreements that turn locations into large streams of passive income compared to the amount invested; (3) shrewd management that bought locations in attractive areas and continues to hold nearly all of the real estate; and (4) obscene economies of scale that permit it to become the low-cost producer mentioned in Factor #1.

There are 36,400 McDonald’s locations in the world. McDonald’s the parent company owns 6,500 of them, and the rest are independently owned by small, medium, and large businesses that give up some of their profits and autonomy in exchange for their right to leverage the McDonald’s brand.

McDonald’s stock, therefore, is more like a giant landlord and revenue collector than an actual operator of fast-food restaurants (though it does operate 6,500 of its own locations). Primarily, it makes money by collecting an override on the sale of supplies, directly selling some supplies, collect rent from the tenant-franchisees, and collect a high single digit percentage of sales at each location. Its primary expenses are related to advertising, overseeing quality control, buying supplies and ingredients as necessary (though it prefers to outsource both of those activities when possible), insurance, and making tax payments related to the real estate (and this varies substantially depending on when the agreement was executed and in what country).

In exchange for permitting the use of its brand, and offering a turnkey fast-food solution to those looking to operate in the industry, McDonald’s is able to earn returns of nearly $0.20 on each dollar that it deploys. This is far superior to what McDonald’s earns by running its own restaurants; at the restaurants owned by McDonald’s itself, the net profit margins are between 11% and 12%. Some of this is the result of the fact that licensing is more lucrative than operating, but some of this is also the result of the specific locations owned by McDonald’s. The ones that McDonald’s runs are the locations it is “stuck with”; locations that don’t generate enough to interest independent franchisees but are still too lucrative to tear down. Don’t cry too much for McDonald’s; there are worse hardships in life than earning $120,000 in profits per location while being surrounded by peers making $200,000.

All of this is a lead-in to the news that McDonald’s is planning to create franchises for 3,000+ locations in China and Hong Kong as part of a 20-year master franchise agreement that seeks about $3 billion for the franchising rights. For some reason, a lot of people commenting on McDonald’s have been giving this news bad press or “the pursuit of short-term profits.”

While that second statement isn’t inherently false–McDonald’s will get an injection of $3 billion that will improve short-term results–usually the phrase “the pursuit of short-term profits” carries the implied second part “at the expense of long-term profits.” But I don’t see that here. McDonald’s is doing what it has always done–giving up operation rights for the ability to be a landlord and sales collector–so that it can boost its net profit percentage above the 20% market for only the second time in its history. The change that makes this possible is increasing the percentage of franchised locations to over 90% of all McDonald’s.

Although this is conjecture, I also suspect that the regulatory cost of business doing business will decrease for McDonald’s once it puts Chinese and Hong Kong businessmen in charge of operations at these storms. Businesses owned entirely as American multinationals tend to be ripe for picking by Chinese regulators–Beijing regulators fine McDonald’s 4 million yuan for water impurity levels–while issuing warnings to Chinese businesses that also engaged in water pollution (Beijing Simplot Food Processing said that McDonald’s deserved the fine due to the enormous size of its operations, which could be true, but could also be a colorable guise to take a crack at American business).

By making these locations franchisees, McDonald’s may remove the regulatory target on its backs. It is far easier to adopt harsh regulatory stances when you are punishing some remote, faceless, foreign-owned business rather than one of your fellow countrymen that is a member of your community hustling to lead an upper middle class lifestyle. Perhaps my suspicion of bad faith is unwarranted, or perhaps Chinese regulators will find ways to punish the parent community while letting the franchisee off the hook, but I would classify it as “probable” that McDonald’s cost of doing business in China will decrease post-franchising compared to when it was both American owned and operated.

The advantage of franchising is that the passive revenue streams permit you to do things like repurchase gigantic blocks of stock to boost ownership earnings, which is a nice source of growth when the business itself is stagnating. Three years ago, McDonald’s made around $5.55 per share. It is on pace to earn the same thing this year. And yet, profits are down from $5.5 billion to $4.8 billion.

The pie got smaller, but each share represents a larger percentage of the pie so the amount you get is just the same. It has retired 150 million shares in the past three years. It is retiring about 3-4 million shares per month. This keeps shareholder returns advancing forward even when the business itself stagnates, and is one of top benefits of creating a synthetic equity business model that generates so much free cash flow that investors can do well even when the amount of free cash flow isn’t growing quickly.