Why McDonald’s Stockholders Got So Rich

From 1981 through 2017, McDonald’s (MCD) stock returned approximately 14% annually. Someone who witnessed Ray Kroc’s visionary leadership in rolling locations across the country and chose to reinvest $100,000 in the enterprise that was already by that time the largest fast food empire in the United States would have ended up with a present day value of over $20,000,000 generating in the neighborhood of $500,000 in annual dividends.

There are no other fast food businesses that generated returns anywhere within hailing distance of that. Heck, there are only three or four publicly traded fast food businesses that have a record of making profits that stretches back more than thirty years.

This raises an important question for investors: What is it that Ray Kroc was able to do that was so superior to what every other fast food competitor was able to accomplish? Most people, in answering this question, focus on speed and cost. McDonald’s was the first restaurant to deliver food within a few minutes of ordering, and the ten cent burgers were hard to compete with.

Those factors explain why McDonald’s investors were able to, say, reap high single digit returns and build a lasting moat. But it doesn’t explain what took McDonald’s returns from, say, a legacy of 8% returns to 14% returns. And less you think that difference is indistinguishable—keep in mind that our hypothetical investor would have turned his $100,000 into just $1.7 million instead of $20 million had he earned the former rather than the latter returns.

The first reason why McDonald’s succeeded is that it chose to earn profits from real estate rather than hamburgers alone.

The most important quote from the Ray Kroc bio The Founder is the following passage:  

“You’re not in the burger business. You’re in the real estate business. You don’t build an empire off a 1.4% cut of a 15 cent hamburger. You build it by owning the land upon which that burger is cooked. What you ought to be doing is buying up plots of land and then turning around leasing said plots to franchisees, who as a condition of their deal, should be permitted to lease from you and you alone.”

Most people think that Ray Kroc’s biggest legacy was transitioning from milkshake salesman to burger man, but really, it was the second step from burger man to real estate man that put him on the path to make life-changing moves like the purchase of the San Diego Padres.

Ray Kroc would purchase the land, and sometimes the building, near highway exits so that McDonald’s would be the first thing that you would see if you wanted something to eat. Recognizing that people would respond to proximity, and that a competitive advantage exists even if you’re just a tenth of a mile closer to a highway exist, was a uniquely Kroc-ian insight that cemented McDonald’s place in the fast food market.

Once a franchisee entered into a contract with McDonald’s to operate a location, Kroc would collect rental income in addition to the royalty fees that resulted from the sales of burgers, fries, nuggets, and ice cream. At that time, the industry norm was for a franchisor to make peace with a small percent of sales or profits.

In a nutshell, Kroc bought the real estate at cheap prices because it was not clear at the time that real estate near highways would be quite so lucrative, and then he created a bit of a closed economy in that prospective McDonald’s franchisees were not able to shop around for the best real estate rates—they had to go through Kroc. No need to shed tears for McDonald’s franchisees, as survey data shows as of 2016 only 2% of McDonald’s locations generate less than $100,000 in profits per year. For wealthy individuals, the approval rate for McDonald’s loans is essentially 100% because it would take self-destruction to make a McDonald’s franchise fail.

The second distinguishing characteristic of the McDonald’s model is that it limited the purchase of franchise rights to one location at a time. This pivot was anathema to the way American business worked—if you were selling franchise rights for $50,000 each, and someone shows up with $500,000, you give him $500,000. It is difficult to say no to someone who is trying to give you money, and it is even more difficult to say no to someone who is giving you exactly the amount of money that you’re asking for on a scalable basis.

But what Kroc understood, even earlier than a point at which he could truly take advantage of the insight, is that letting a franchisee acquire a significant amount of locations transfers a significant amount of power to the franchisee in the event of contract disputes. Specifically, Wal-Mart worked under twenty-year master contracts that served as the operating agreement between franchisee and the franchisor.

If there were, say, 1,000 McDonald’s locations and two franchisees controlled over 300 of them, any dissent on their part could upset the system and what the people generally regards as the brand. Also, they would have significant control over the bargaining process. If two entities control a third of the business, they are going to negotiate that 8% royalty rate down, or whatever it may be.

That risk to the McDonald’s corporate entity does not exist when locations are sold one at a time. Assuming 1,000 locations outstanding at the time, someone in the community might accumulate a dozen McDonald’s franchises over a lifetime. If the relationship becomes fractious, there is not really the possibility of delivering a body-blow to McDonald’s corporate.  It can be absorbed.

Also, it ensures that the parent entity maintains the upper hand in contract negotiations. If you don’t want to pay the rent and royalty agreements that McDonald’s demand, or participate in the national sales campaign, you can forfeit your franchise and move on. You’ll be replaceable.

The upside of this strategy for McDonald’s is even more exaggerated because the locations were not built all at the same time. Let’s say you did manage to accumulate a dozen locations over a lifetime. Maybe one was acquired in 1977. Another in 1980. And then another one in 1982. Well, if your relationship as a franchisee with McDonald’s turns hostile, they now have advance notice about the other locations. If it is 1997 and you are negotiating the next iteration of that 1977 contract, and the negotiations indicate that the relationship can’t continue, you now have notice to expect trouble in 2000 and 2002 when you are negotiating the contracts on the other locations. This gives the parent company time to gradually fill in the locations.

The legacy of Ray Kroc is that wealth didn’t just get created by selling people cheap hamburgers quickly. The structure of a business is often more important than the part of the business that the customer sees. The reason why McDonald’s has been such an outperforming business is because McDonald’s owns the real estate and is able to charge its franchisees a non-competitive rent while also historically limiting any one franchisee from acquiring a meaningful collection of locations such that it could destabilize McDonald’s ability to negotiate terms. In a very real way, each McDonald’s dividend that shareholders collect today is the result of a strategy executed by Ray Kroc almost a half century ago.