McDonald’s has been in the news recently because of a health scare in China related to their meat suppliers. They have warned investors that this negative press may cause near term pressure on sales volume and revenue. Investors following the story, or any story involving McDonald’s for that matter, will repeatedly run into reporters that call McDonald’s the “world’s largest hamburger business,” or something to that effect. This is in fact a misleading description. While it is true that McDonald’s sells more burgers than any company in the world, its primary revenue source comes from being a franchise operator and land owner.
McDonald’s counts 35,429 restaurants worldwide. Of those, 6,738 are owned by McDonald’s, the rest are owned by franchisees. Restaurants operated “in-house” have profit margins of approximately 18 percent on just over $2.5 million in annual sales. The franchises, however, are the true gold mine.
McDonald’s operating margin for franchised restaurants is an industry leading 83 percent, and is not expected to drop any time soon. Because McDonald’s is able to drive more volume and more profit into the pockets of franchisees than any other global fast-food chain, they retain the bargaining power in negotiations with franchisees. Franchises bring McDonald’s profit from two sources: franchise fees and rental income.
McDonald’s franchisees pay McDonald’s corporate a fee for the right to operate their restaurant. The “right” does not cost McDonald’s much in terms of cost of goods sold, but it pays incredibly well. McDonald’s has already done all of the work required to figure out how to optimize restaurant profitability, and while it will likely keep on getting better at what it does, improvements are mostly incremental and do not cost much in the way of R&D. Further, it has a well-honed marketing machine that has nurtured one of the most recognized and valuable brands in the world. This means that the majority of the income it takes in “franchise fees” goes straight to the bottom line.
Further proof that McDonald’s is not simply in the burger business is its $6 billion portfolio of some of the most valuable real estate in the world. By buying the real estate and then leasing it to its franchises, McDonald’s gets exposure to rising real estate values, and it creates one of the most reliable annuitized revenue streams any corporation has ever produced. The perfect “renter” for a landlord is someone that the landlord knows well. The more information the landlord has about a potential renter, the less he is afraid of a missed payment, or worse, needing to evict because of non-payment. McDonald’s has a better idea than anyone regarding the profitability of its franchises, and is constantly receiving an invaluable “information stream” relating to their business situation. It is perfectly situated to help ensure that they do not go out of business, and remain loyal franchise fee and rental customers.
The recent meat scare coupled with a weak earnings report have sent McDonald’s shares to within two percent of their 52 week low. It is currently paying a dividend of around 3.3 percent, and has achieved Standard and Poor’s highly coveted Dividend Aristocrats designation – a list comprised of companies that have increased their dividends for at least 25 consecutive years. Industry leading profit margins, a great dividend that can be expected to rise, and the most attractive annuitized revenue stream in the world combine to turn McDonald’s from a “burger business,” into an ideal investment.
Opinion by Benjamin A. Buchanan