Under the Spotlight: McDonald's (MCD)

Two all-beef patties, special sauce, lettuce, cheese, pickles, onions, on a sesame seed bun. If you were a McDonald’s regular in the 1980s, you most likely read the recipe for the house’s flagship, the Big Mac, in the rhythm of its jingle. And we’re sorry Hungry Jacks (aka Burger King | $QSR), but the Big Mac is likely the world’s most famous burger. The burger is so famous that it has even become a measure of inflation and purchasing power parity. If you are ever hungry and want to do some economic analysis at the same time, check out The Economist’s Big Mac index.

The Founders

McDonald’s ($MCD) was founded in 1940 in California by brothers Maurice and Richard as a drive-in offering a wide selection of items. It wasn’t until 1948, that the brothers decided to revamp the business, with a newly envisioned restaurant bearing their name, that things took off.

The newly imagined McDonald’s was designed to produce huge quantities of food at low prices. With a limited menu – featuring hamburgers, chips (later renamed french fries), drinks, and a pie – and an efficient format coined the Speedee Service System, it also included a  self-service counter, removing the need for wait staff and empowered customers.

Fast-food wasn’t a new concept by any means, but all these innovations allowed the brothers to charge just 15 cents for a basic hamburger (approximately US$3.00 today) – about half the price of any competing restaurant. Popularity for McDonald’s began to grow but it wasn’t until Ray Kroc entered the game, that McDonald’s super-sized.

The Franchisee

There’s no denying that the McDonald brothers revolutionised the concept of the American diner. But much like Jobs to Wozniak, Ray Kroc saw greater potential in the humble burger shop.

Realising the great promise in their restaurant concept, Kroc became a franchise agent for the brothers. When he joined, the organisation operated more or less like a standard restaurant chain. It was Kroc’s unique insight that gave him the tools to transform the entire fast-food industry: enter McDonald’s the real estate company.

It was Kroc who realised that the real McDonald’s customer didn’t have to be hamburger eaters. Instead, the focus would be on the franchisee. Kroc would select and buy the land on which the restaurants would be built, establish guidelines for the construction of the stores and provide all the equipment and training necessary for the operation. This guidance guaranteed a high degree of consistency to the restaurant products and certain revenue predictability for the franchisee, who in practice had little control over the business.

In exchange for the guidance and support, franchisees paid a property rental fee to McDonald’s, in addition to royalties for using of the brand. While royalties fluctuate, the rental fee generates a stable revenue stream for the company. If a particular unit doesn’t prove to be profitable, McDonald’s can always try to pass it on to a new franchisee or even sell the land, often at a profit.

But it would be wrong to think of this model as ripping off the franchisee. The franchisee benefits from McDonald’s mastery of choosing the property, usually in places with large circulation of people, ideally with plenty of parking space and a drive-through. If possible, the land is even next to a traffic light, so drivers have more time to notice the restaurant’s presence and consider stopping by. The other benefit for the franchisee is by allowing McDonald’s to choose and purchase the land, it removes the most significant expense from the equation.

This makes the operation of a McDonald’s franchise widely considered to be less risky then  other fast-food franchises. Even without the cost of the land, opening a McDonald’s franchise is rather costly, so risk reduction is key from an investment standpoint. Subway for example, does not offer nearly as much guidance on the restaurant’s location as McDonald’s, although the cost to open one is generally less than $500,000 compared to McDonald’s $2m.

Living On Rent

Today, the McDonald’s network has just over 40,000 stores worldwide. Of these, around 37,300 (93%) are franchises, not managed directly by the company. In other words, McDonald’s largest asset is land and buildings, which at US$39b make up 71.4% of the company’s total 2021 assets. This makes the company’s operating costs extremely low (2021: US$13b) compared to its gross revenue (2021: US$23b). This brings McDonald’s net profit to US$7.6b in 2021.

Despite setbacks during COVID, by 2021 McDonald’s was already showing signs of a strong recovery, with revenue up 8% compared to pre-pandemic 2019. The company has also seen considerable efficiency gains, with earnings per share rising an average of 11.8% annually over the past five years. This has been a large driver of dividends paid by the company growing consistently over the past ten years.

If you’re still not convinced of the benefits of being a real estate company in the restaurant game, just look at the company’s net profit margin: 32.4%, against an average of 6.6% in the restaurant sector. Of the US$13b in expenses the company had in 2021, only US$2.3b were related to franchisees, with US$8b of expenses being generated by the approximately 3,000 stores the company directly operates.

In 2022, McDonald’s expects to open another 1,425 stores. And if inflation and recession are some of the scenarios most feared by companies around the world, this is no problem for McDonald’s: in times of crisis, its sales have historically increased, thanks to its consistently cheap food, despite a burger no longer costing 15 cents.

Considering this, what could be negative for McDonald’s? The risk lies not in any economic indicator, but in ever-changing tastes. Demand for healthier and sustainably sourced food continues to be the biggest threat to the fast-food chain. With a solid business model that is time-tested in different economic scenarios, Ray Kroc’s empire could be threatened by a generation that looks at its menu and no longer says “I’m lovin it”.

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This does not constitute financial advice nor a recommendation to invest in the securities listed. The information presented is intended to be of a factual nature only. Past performance is not a reliable indicator of future performance. As always, do your own research and consider seeking financial, legal and taxation advice before investing.