McDonald’s Sales Growth Comes at a Price to Franchisee Profit Margins

McDonald’s (NYSE:MCD) competes with Wendy’s (NYSE:WEN), Burger King  and Yum! Brands (NYSE:YUM) in the fast food market and is the market leader with about 19% share. The company also competes with Starbucks (NASDAQ:SBUX) in the specialty coffee market.

McDonald’s owns and franchises restaurants across the globe with over 32,000 restaurants in 117 countries as of 2009. Of these, roughly 80% were operated by franchisees, with the balance being company-owned. We estimate that franchisee rent & fees accounts for 63% of McDonald’s stock value with franchisee royalties generating an additional 30%. The remaining 7% comes from company-owned restaurants.

We maintain a price estimate for McDonald’s stock at $73.58, roughly in line with the current market value.

We’ve previously discussed the threat of rising input costs and their potential to pressure MCD profit margins (McDonald’s Profit Margins Could Suffer on Rising Agricultural Prices). However, the recent spike is primarily a short-term concern, and unlikely to impact the company’s long-term outlook.

A greater threat could come from what is quickly becoming a staple of McDonald’s strategy and one of the key reasons for its consistent sales growth – fluid adaptation of its menu and operations to match shifting consumer trends.

McDonald’s Has Benefited from Timely Adjustments to Meet Consumer Demands…

McDonald’s quarterly comparable store sales numbers have recorded 30 straight year-over-year increases dating back to 2003. The success is largely due to the company’s strategic adaptation of product offerings as well as operations. For example, the company has increased its healthy food offerings to attract health-conscious consumers and added on-the-go type meals for consumers eating at non-conventional hours, in addition to keeping many of its restaurants operating 24/7 to cater to these customers. ^[1]

… But There’s a Cost

Despite the sales upside, these initiatives are resulting in increasing operating costs. More McDonalds stores are being kept open 24 hours, many are now equipped with flat-screen TVs in addition to offering free Wi-Fi. More hours of operations and a greater selection of menu items necessitates a larger staff and, accordingly, higher labor costs.

Frozen drinks machines, being incorporated at some McDonald’s locations, cost $13,000 to install. New McCafe coffee stations cost $100,000 to install (and the corporation only covers $30,000 for franchisees). At many of the franchise restaurants the new products like the McCafe drinks are selling poorly, further pressuring profit margins. ^[1]

What’s the Tradeoff?

McDonalds’ propensity to diversify and adapt in order to drive sales improvement could indirectly hinder profit margins at many of its franchises, as franchisees often bear the brunt of expansion and upgrade costs resulting from the new initiatives.

Could this downside to profitability make potential owners think twice about opening new McDonald’s franchises? We currently project a 1.6% annual growth rate in the number of franchised and affiliated McDonald’s restaurants. Drag the trend line in the modifiable chart above to see how various trends in the number of franchised and affiliated restaurants could affect McDonald’s stock price.

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See our full analysis of McDonald’s here

1. The Wall Street Journal: On McDonald’s Menu: Variety, Caution, Dec 27 2010 [↩] [↩]