Some brand logos are instantly identifiable at first glance. As the public sees massive golden arches, most believe they are looking at one of the world’s largest and fastest chains.
McDonald’s is an American fast-food restaurant chain founded in 1940 in San Bernardino, California, by Richard and Maurice McDonald.
However, McDonald’s is a real estate company disguised as a fast-food restaurant.
Furthermore, the McDonald’s franchising scheme serves as a buffer zone between the existing real estate empire and the overtly noticeable fast-food activity.
They renamed their business a hamburger stand and later converted it into a franchise, introducing the Golden Arches logo in 1953 at Phoenix, Arizona.
In 1955, businessman Ray Kroc entered the organization as a franchise agent and eventually acquired the chain from the McDonald brothers.
McDonald’s originally had its headquarters in Oak Brook, Illinois, but relocated to Chicago in early 2018.
To understand how McDonald’s makes money, we must first understand their franchising scheme.
The origins of McDonald’s: from the McDonald Brothers to Mr. Ray Kroc
According to the McDonald’s website, “Dick and Mac McDonald relocated to California in search of opportunities that they perceived were inaccessible in New England.”
They introduced the Speedee Service System In 1948, which offered hamburgers for 15-cent.
As the restaurants gained momentum, the brothers began franchising their idea, eventually reaching nine operating locations.
Ray Kroc, a native Chicagoan, was the sole distributor of the Multimixer milkshake mixing machine in 1939. In a nutshell, he was a salesperson.
In 1954, he met the McDonald brothers and was so taken with their business model that he became their franchise agent.
He opened the first McDonald’s restaurant before acquiring the McDonald’s rights from his brother’s business for $2.7 million in 1961.
Ray Kroc was passed away on January 1, 1984; the rest is a legend.
What is the Business Model of Mcdonald’s?
McDonald’s makes money primarily by licensing its commodity, fast food, to franchisees required to lease properties owned by McDonald’s at significant markups.
According to the company’s 2019 10-K filing, 36,059 of the 38,695 restaurants were franchised, with McDonald’s running the remaining 2,636.
Thus, franchises account for approximately 93 percent of total capacity, falling short of McDonald’s long-term target of 95 percent.
The benefit of this model is that the revenue stream (rent and royalty income earned from franchisees) is much more reliable and consistent. In contrast, operating costs are significantly lower, allowing for a more straightforward road to profitability.
McDonald’s will use its market advantage to win deals because it owns the property and has long-term leases.
As analysts have noted, this is similar to a subscription model, in which the subscriber (the franchisee) pays a fixed monthly fee.
According to industry experts, McDonald’s retains approximately 82 percent of the revenue generated by franchisees, compared to roughly 16 percent of the revenue generated by company-operated stores, which is further reduced by operational costs.
This will account for their acquisition of the 95% franchise mark.
Why Is McDonald’s Franchisee So Popular?
McDonald’s is well-known for its stringent franchisee requirements (net worth, liquidity, etc.).
Additionally, franchisees are accountable for paying employees’ wages, ordering materials, and paying rent/owning the property.
But why should you become a franchisee? The allure is that McDonald’s provides them with a near-guaranteed profit stream, owing in large part to the high margins.
The restaurant industry is notorious for its turnover. As any restaurateur can tell you, one of the primary reasons is that margins can be as slim as a slice of processed American cheese.
McDonald’s profit margins, on the other hand, are Double Quarter Pounder thick — north of 40%!
How is this even possible in a company whose sole aim is to provide affordable food?
The response is that the food is much more affordable to prepare than one would believe.
Certain menu items, such as coffee, sell for dozens of times their cost.
To those who think nothing of paying $5 for an iced mocha, keep in mind that you’re drinking a few pennies’ worths of beans boiled in water that’s too cheap to measure, along with some chocolate syrup.
What is the structure of McDonald’s Franchise System?
Rather than opening McDonald’s restaurants independently, the company licenses the menu, branding, and organizational infrastructure to those interested in operating a restaurant for them.
The catch is that McDonald’s earns the majority of its profits by purchasing and renting out outlet locations to franchisees rather than receiving hefty royalty fees.
According to an Industry Insider study, this is how McDonald’s business functions mathematically.
Franchisees invest their capital in the venture from the start.
McDonald’s franchisees are required to be:
- Paying $45,000 in franchise fees to get started.
- Charge a rental expense equal to 10.7 percent of the restaurant’s revenue on rental deals with a 20-year term.
- Monthly royalty fee equal to 4% of gross revenue.
These figures are unique to franchisees in the United States and can vary by market, but the underlying pricing structure remains relatively constant.
Franchisees gladly pay the amount mentioned above to acquire the rights to McDonald’s branding because it drives foot traffic.
Additionally, we should not ignore the fact that while McDonald’s earns money from sales and leases, it also saves money by offloading some of its obligations.
If the organization leases the place to a franchisee, the franchisee assumes responsibility for everything from payroll to food supplies.
Former Chief Financial Officer Harry J. Sonneborn once said that the hamburger was a simple communication method between tenants and the business. That they are simply “the most significant source of income from which our tenants will pay rent.”
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How does McDonald’s Franchise work?
As stated in its annual report, “under McDonald’s traditional franchise agreement, franchisees contribute a portion of the capital needed by initially investing in their restaurant’s facilities, signage, seating, and décor, and then reinvesting in the business over time.”
The Company typically owns the land and buildings on which its restaurants are located or secures long-term leases for both Company-operated and traditional franchised locations.
This ensures long-term occupancy privileges, assists in cost management, and facilitates collaboration with franchisees, resulting in restaurant success that is among the best in the industry.“
In a nutshell, the model is very astute. McDonald’s maintains ownership of land and/or long-term leases to exploit its market advantage while negotiating deals.
Simultaneously, this type of arrangement helps to balance the company’s interests with those of its franchisees.
Who are Key Partners of McDonald’s?
McDonald’s business model is built around three significant actors.
McDonald’s business model relies on franchisees, vendors, and workers.
- Franchisees are entrepreneurs who allow McDonald’s to overgrow while maintaining a global emphasis at the local level.
- Suppliers around the world ensure McDonald’s high capacity operation.
- McDonald’s can operate at maximum capacity due to the ongoing training of staff in over 36,000 restaurants worldwide.
What are McDonald’s segments?
On a qualitative basis, the segments can be classified as follows:
- The United States remains the largest market even in 2021.
- Fast Growth Markets include China, Korea, Italy, Poland, the Netherlands, Russia, Spain, and Switzerland.
- Australia, France, Germany, Canada, and the United Kingdom are all international lead markets.
- Foundational Markets & Corporate, the remainder of the McDonald’s system, the majority of which are franchised.
As of 2017, the United States, International Lead Markets, and High Growth Markets accounted for 35%, 32%, and 24%, respectively, of overall revenues.
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How many McDonald’s Franchisees are there?
According to McDonald’s website, more than 80% of restaurants globally and almost 90% in the United States are owned by franchisees, not McDonald’s.
Hence, only 20% of company-owned outlets globally and only 10% in the United States.
This is also how McDonald’s maintains such low food costs. Many people incorrectly believe that McDonald’s profits solely from the amount of food sold.
On the other hand, McDonald’s benefits from a smart real estate strategy and franchise sales, as well as a persistent market for affordable, fast food.
Additionally, it allows McDonald’s to experiment with their menus, recognizing that a fall in revenue would not be as detrimental as it would be to a self-operated business.
And if a new specialty burger or reintroduction dish fails, the locations must continue to pay rent and royalties.
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Markets & Business Segments of McDonald’s
McDonald’s operates through the following global business divisions, effective May 14, 2020: United States, International Operated Markets, International Developmental Licensed Markets, and Corporate.
As of the company’s most recent annual report, each sector accounted for 37.2 percent, 54 percent, and 8.7 percent sales, respectively.
- United States: The biggest segment, with $7.843 billion in sales in 2019.
- Markets Operated Internationally: Markets in Australia, Canada, France, Germany, Italy, the Netherlands, Russia, Spain, and the United Kingdom. This segment generated revenue of $11.398 billion in 2019.
- International Licensed Markets and Corporate: Consists of developmental licensee and partner markets and, as well as corporate operations. This segment produced revenue of $1.836 billion in 2019.
Financial Statements of McDonald’s
According to McDonald’s 10-K filing, free cash flow was $5.7 billion in 2019, up 36% from 2018, while comparable global revenues increased 45.9% and comparable guest counts increased 1%.
However, the sales of McDonald’s decreased by -10.9% in 2020 because of the COVID-19 Pandemic.
While total sales declined in 2018, the percentage of franchised restaurants increased, indicating the company’s shift to a heavily franchised business model.
Franchised restaurant revenue (rents, dividends, and initial fees) was $11.01 billion, representing more than 50% of McDonald’s overall revenue and a significant improvement over 2017.
Operating income was lower than in 2017, which was distorted by losses on the selling of properties in China and Hong Kong.
Except for these items, operating income increased by 2% in 2018. Operating margins improved, which bodes well for prospective franchisees.
Cash produced by operations rose by $1.4 billion, or 25%, in 2018, largely due to lower tax payments.
McDonald’s current ratio, a liquidity ratio, is 1.36, indicating that the business is financially stable.
As stated in the annual report, “Over the long term, the Company anticipates achieving the following average annual financial goals (in constant currency):
Systemwide revenue growth of 3% to 5%
Operating margins in the mid-to high-forties
Increases in earnings per share (EPS) in the high single digits
Return on incremental capital invested (ROCI) in the mid-twenties “spectrum.”
What are the Future Plans of McDonald’s?
As stated in the company’s most recent annual report, “In 2018, the Company continued to move into a more heavily franchised business model, reaching approximately 93% franchised at the end of the year, with a long-term target of approximately 95%.
The Company will progress against this long-term objective in 2019, mainly through franchising restaurants to traditional licensees.
As a part of the Company’s ongoing transformation of its business model, the Company announced multiple organizational improvements to its global business structure in September 2018.
These improvements are intended to support the Company’s efforts to expand more efficiently as a better McDonald’s in accordance with the Velocity Development Plan.”
McDonald’s Velocity Growth Plan, launched in 2017, is a customer-centric strategy that focuses on the company’s main factors, including food, value, and customer experience.
- Retaining Existing Customers: Concentrating on segments of the Informal Eating Out (IEO) group where it already has a good presence, such as family occasions and food-driven breakfast.
- Recognize and Retain Customers Who Visit Less Frequently: Recommitting historical strengths, specifically the consistency, taste, and convenience of its product: food.
- Converting Informal to Committed Customers: Strengthening customer relationships to encourage frequent visits by elevating and optimizing the McCafé coffee brand and expanding snack and treat offerings.
McDonald’s remains committed to deploying the three growth accelerators (also established in 2017) aggressively in 2019 and beyond. Accelerators of development include the following:
- The Experience of the Future (“EOTF”): The modernization and technological advancement of restaurants to change the dining experience and improve the brand image of McDonald’s to the customers.
- Digital: McDonald’s is expanding consumer options for ordering, paying, and service by improving the technology platform. This includes adding features to its global mobile app, self-order kiosks, and innovations that allow conveniences such as table service and curbside pick-up.
- Home Delivery: McDonald’s increased the number of restaurants providing delivery in 2018, and it is now available in more than half of the company’s global system. McDonald’s has been and will continue to be very aggressive in expanding its brand and market. McDonald’s announced a partnership with Uber Eats for home delivery in the United States in 2017, followed by the addition of Doordash and GrubHub this year (2019). These collaborations are part of a strategy to remain relevant to younger millennials who prefer home delivery over the pickup.
What are the Key Challenges for McDonald’s?
McDonald’s has maintained a comfortable lead over its primary rivals in the fast-food industry, such as Burger King, Wendy’s, and Kentucky Fried Chicken. Still, its primary obstacle could be a consumer appetite for healthy, organic menu options combined with fast-food convenience.
Over the last few years, another restaurant model has attempted to capture the consumer’s interest, or more precisely, their palates, by offering customers freshly made, higher-quality food in a casual environment and with efficient counter service.
Dubbed fast-casual restaurants, these businesses — like Chipotle (CMG) and Shake Shack (SHAK) — have been making inroads into a market long dominated by quick-service restaurants like McDonald’s.
Quick-casual restaurants are distinct from fast-food restaurants. They tend to provide customers with healthy options while maintaining fast-food value at a slightly higher price point than consumers are willing to pay.
Consumption trends toward food that is safe, affordable, and available quickly have started to erode the market share of leading QSRs.
McDonald’s recently announced a year-over-year sales decrease of 6.47 percent for the 12 months ended March 31, 2019.
McDonald’s took care. In late 2018, it revealed that seven of its burger options would be free of preservatives, artificial colors, and other artificial ingredients.
Its menu includes a Southwest Grilled Chicken Salad, and children’s Happy Meals now include apple slices.
Key Highlights of McDonald’s Business Model:
- McDonald’s operates mostly by franchises. As of 2018, the company franchised 93 percent of its restaurants.
- Its long-term goal is to own 95% of franchised restaurants globally.
- Although sales have declined since 2013, it is critical to recognize that this is a natural result of its shift to a heavily franchised business model.
- Indeed, according to McDonald’s financial reports from 2018, franchised margin dollars accounted for approximately 85% of total restaurant margins in 2018, 80% in 2017, and approximately 75% in 2016.
- As McDonald’s business model shifts primarily toward a heavily franchised model, this effect of reduced sales and improved margins can be anticipated.
- This is also a result of how revenues are recorded for each chapter.
- Although company-operated restaurants generate more revenue than franchised restaurants, their gross margins and net income are lower.
- It’s important to consider the critical distinction between the McDonald’s company-owned restaurant model and the McDonald’s franchised restaurant model.
- McDonald’s may be considered a restaurant business if the McDonald’s company-owned business division is considered a restaurant business.
- However, it can be called a colossal commercial real estate corporation on the franchising restaurant side of the market. Indeed, McDonald’s posted over $37 billion in property and equipment costs in 2018, making it one of the world’s largest commercial real estate firms.
So, How McDonald’s Make Money & What are McDonald’s Business Model Patterns?
McDonald’s earns money by franchising, product supply chain, self-service model, and the targeted customers’ design which boosts McDonald’s sales-generating revenue in billions.
Franchise Opportunities
How they do it: Individual entrepreneurs will open their own McDonald’s restaurants. They operate their own (or multiple) restaurants but must adhere to all corporate guidelines, including buying, product offering, and corporate identity.
Without Frills
How they do it: McDonald’s maintains a consistent and straightforward product, supply chain, and restaurant design, which enables efficient procurement, food preparation, and a high degree of standardization, as well as low prices across restaurants. In comparison to traditional restaurants, the consumer is responsible for serving and cleaning the table.
Self Service
How they do it: Rather than receiving table service, McDonald’s customers would order at a counter and bring their food to their table. This enables food to be sold at affordable rates by lowering labor costs in the restaurant’s service area.
Focus On The Poor
How they do it: McDonald’s maintains fair pricing, making its goods accessible to everyone. Due to the company’s high level of standardization and international market recognition, it can sell goods reasonably while maintaining a consistent level of quality.
User Designed
How they do it: McDonald’s often hosts competitions in which consumers can create their burgers. This is accomplished by the use of an online tool available on the McDonald’s website. Following that, visitors will vote for their favorite creation, with the most famous one being created and sold in restaurants. This allows them to engage with their customers and evaluate potential restaurant menu items.
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Final Thoughts on Revenue Model of McDonald’s
Fast food should be a stable business, just like any other. People need to eat, so they want it fresh and quickly without spending an excessive amount of money.
Having said that, the industry faces challenges due to a change in consumer preference for healthier eating. A restaurant chain that sells familiarity and quality must consider such attributes as tremendous assets in and of themselves.
McDonald’s is successful even though it has a poor year. When running at maximum capacity, it is a must-have stock for any comprehensive portfolio, all the more so given its similarities to REITs.
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