Developing Markets Offer McDonald’s Big Growth But Slimmer Profits

McDonald’s Corporation (NYSE:MCD) recently announced that it will expand into Eastern Russia by adding 150 new stores in the next three years. Russia is a big growth opportunity since the nation of 140 million only has 357 McDonald’s currently. ^[1] Similarly, it will also add 300 stores in China alone this year to take its tally to 2,000 by the year end. ^[2]

There is no doubt that McDonald’s has tremendous potential to grow in developing markets where its penetration is only a fraction of what it is in the U.S. As the economy grows, discretionary spending will rise and food is one area where consumers like to spend. Moreover, American fast food companies are considered a sign of quality and even novelty in some cases. Thus, there is already a pent up demand for American fast food chains in these markets.

Lower Average Sales Per Restaurant

Although McDonald’s has more than 34,000 restaurants globally and is present in 119 countries, its sales and margins differ from region to region. One important thing to highlight is that the average sales per restaurant in emerging markets trails that of its American and European counterparts. Take a look at the following table :

APMEA refers to Asia/Pacific, Middle East and Africa. As you can see APMEA has the lowest average sales per restaurant, which is not totally unexpected since people in Asian cities generally have lower incomes, especially when converted to dollars. The lower incomes result in cheaper menu prices. The Economist’s Big Mac Index validates this point. For example, a Big Mac, which costs around $4.20 in the U.S., costs only $2.44 in China but $6.80 in Switzerland. The local purchasing power can, to a great extent, dictate the upper limit of the average sales of a restaurant.

Also, since McDonald’s has been present in the United States for a long time, it understands its home market pretty well. A long history of presence in the country helps the company to optimize store sales. McDonald’s is still relatively new in many countries, so it might still take some before it can understand the local market dynamics and tweak its menu to local tastes in order to fully optimize store-level economics. Therefore, it might still take some time for the average sales in developing markets to rise to the levels that in the U.S. or Europe.

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Below is the comparison of company-operated margins in different regions:

Again, McDonald’s margins in APMEA trail those in the U.S. and Europe. One reason could be that that higher sales in developed markets result in fixed costs such as labor and occupancy that spread out over a bigger base, which in turn results in higher margins.

Another reason could be that a greater proportion of sales in developing markets comes from value meals since consumers here are more price-sensitive. Value meals, in general, have tighter margins. Other factors such as higher rentals (relative to sales) or paying a significant premium for trained (often English speaking) labor also bloat the expenses.

In short, although there is no doubt that developing markets present a huge growth opportunity for McDonald’s, it is important not to overestimate their contribution to profitability.

We have a $92.80 price estimate for McDonald’s, which is about 5% lower than the current market price.

Methodology:

a) Average Sales per Restaurant:

Total sales = Company-operated sales + Franchised sales

We have used the average of the number of year-end restaurants to calculate the figure. For example,

Average sales in 2012 =  (Total Sales in 2012)/(Number of restaurants at the end of 2012 + Number of restaurants at the end of 2011)/2

Note that franchised sales are different from franchised revenues. Franchised sales represent the sales generated by McDonald’s franchisees. Franchised revenues represent royalty and rental income, which are a percentage of franchised sales.

All the figures are picked up from McDonald’s 10-k filing.

b) Company-Operated Margins:

These figures are directly picked up from the company’s 10-k filing.

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1. McDonald’s boosts franchises to expand in Russia, February 21, 2013, chicagobusiness.com [↩]
2. MCD 10-k [↩]