Why Is McDonald’s Concentrating On Refranchising?

In 2015, McDonald’s (NYSE:MCD) came out with a turnaround plan to address its falling revenues and slowing comparable store sales growth. One of the key aspects of this turnaround plan was the decision to optimize the restaurant ownership mix through accelerated refranchising.

To take a step back and get a little bit of perspective, let’s explain how the franchisee model actually works and why it is increasingly being preferred by restaurants such as McDonald’s and Dunkin’ Brands.  A franchisee pays the franchisor, in this case McDonald’s, an initial franchise fee in return for the rights to operate a business under the franchise trademark. Further, the franchisee is obliged to pay a percentage of the revenue it earns, annually, in royalty or rent payment to the franchisor. However, one major demerit of the franchisee model is that it results in the franchisor, like McDonald’s, to lose control over its operations. Since franchisees independently take care of their business and day to day operations, revenues realized by McDonald’s are dependent on a franchisee’s ability to grow its business. There could also be a lack of willingness or ability on the part of franchisees to align with major initiatives being undertaken by the franchisor, McDonald’s, tarnishing its brand name. On the positive side, since the franchisor isn’t involved in the day to day running of the business, it doesn’t incur costs on salary, administration, and other general expenses. The model also allows the franchisor to outsource its risk, while maintaining profitability. As a result, franchisor’s margins from a franchised restaurant are much higher than company operated restaurants.

Coming back to McDonald’s, in 2015 its management announced a plan to change the company’s ownership mix in favor of franchisees. The possible rationales behind this are:

• Higher Margins: As discussed above, franchised restaurants have much higher margins, almost five times that of company operated restaurants, due to negligible operating expenses. In a bid to stay profitable, while refraining from investing its own capital in the new growth areas which are likely perceived as high risk, McDonald’s is making efforts at becoming 95% franchised. Although, the shift in the revenue mix towards franchisees would decrease the company’s top line, it would help bolster margins. Consequently, we can expect the company’s total operating margins to increase going forward.

*All figures as of December 2015

• Geographical Expansion: The U.S. market in its current state is quite concentrated. The way forward for behemoths like McDonald’s is geographical expansion. The company expects the majority of the refranchising to take place in the High Growth and Foundational markets, which mostly cover countries in Asia, Africa, and the Middle East. The aforementioned geographical segments have very low penetration currently. As a part of this plan, McDonald’s will be refranchising about 4,000 restaurants through 2018 in these areas, furthering its outreach and growing its brands in areas with low penetration.

Have more questions on McDonald’s? See the links below.

• McDonald’s Versus Burger King: Whose Franchisees Perform Better?
• McDonald’s Slows Down In Q2’16, Despite Growth In Comparable Store Sales
• McDonald’s Q2 FY 2016 Earnings Preview: Investment In Quality, All Day Breakfast To Drive Revenues
• McDonald’s 2016 Revenues To Decline YoY Despite Improvement; To Pick Up Pace Thereafter
• What’s McDonald’s Fundamental Value Based On Expected 2016 Results? (Updated After Q1 2016)
• By What Percentage Have McDonald’s Revenues And EBITDA Grown Over The Last Five Years?
• What Is McDonald’s Revenue & EBITDA Breakdown? (Updated After Q1 2016)
• How Has McDonald’s Revenue And EBITDA Composition Changed Over 2011-2015?
• McDonald’s Q1 FY 2016 Earnings Preview: All Day Breakfast To Drive Comp Sales In The US
• Where Will McDonald’s Revenue And EBITDA Growth Come From Over The Next Three Years? (Updated After Q1 2016)

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