McDonald’s a Brilliant Business

  • Mr. ACE 
McDonald's Store

The recent Corona Virus outbreak had sunk many businesses and those which are surviving are barely afloat. During recessions and such economic downturns, consumer behavior tends to change in fairly predictable ways. The hardest-hit businesses are, of course, the most unnecessary like travel and tourism, leisure and hospitality and manufacturing but some other businesses like fast food stand to benefit. Stomachs don’t respond to economic downturns, but smaller bank accounts do and therefore people opt for cheaper alternatives.

Fast-food chains like Burger King, Wendy’s, etc often perform better than average during recessions. From 2008 to 2010, for example, while other businesses closed or downsized, Subway, added nearly 6,000 new locations. KFC added around 300 in roughly the same period. One company which stands out as the clear fast food winner of 2008: McDonald’s. That year, it continued its 55-month long streak of same-store sales increases with even better performance than before the recession, while opening 600 new locations, and with an impressive 29% Return on Equity. Some of this is for obvious reasons: During that time, consumers were simply eating cheaper food.

True Business Model

Many people think they know what McDonald’s is, it is a fast-food company that has many locations and servers food at affordable rates but the reality is very different. McDonald’s is what some analysts call “Recession-Proof” and the reason for that is it first and foremost is a real estate company and then a company that is involved in the fast-food business.

Asset Size of McDonald's (Polymatter)

Glancing at its 2019 balance sheet, one number, in particular, should grab your attention: $39 billion. That’s the current value of all its property and equipment before it charging depreciation. That would technically make it the fifth-largest real estate holder in the world, measured by total assets. Without the name McDonald’s and it might look like the financial statement of any other boring big-name real estate developer.

Fast food companies like Burger King and Subway were able to grow so fast and reach so many countries around the world through franchising. McDonald’s has the same philosophy and almost 85% of its restaurants are owned by someone who essentially ‘leases’ the McDonald’s Brand Name in exchange for a considerable fee.

Differentiation for Success

What makes the company so unique is that, unlike other similar fast-food giants, McDonald’s makes the majority of those franchise revenue from rents and not food which it serves. To be more precise, in 2019, 64%, of its 11.6 billion dollars in franchise fees came in the form of rent. McDonald’s has decades of experience buying and selling properties, it knows the precise ingredients of a successful location :

McDonald's Revenue Breakup
  • It shops around usually for intersections between two high-traffic roads and buys space in whichever corner has the most parking.
  • The ideal space is around 50,000 square feet 4,500for building space.
  • The intersection should also have traffic lights.
  • It then buys the property with long-term fixed interest rates.

Then, when someone applies to operate their own McDonald’s location, they sign with the company a Franchise Agreement stipulating nearly every detail of how the business will operate from how the burgers are cooked, to the hours of operation.

Business Structure

Similar to all other franchise agreements even franchise of McDonald’s is generally required to makes a total upfront investment which maybe of around $1-2 million for a single location, including an initial down payment paid in cash, a one-time franchise fee of $45,000, and a percent royalty of every month’s revenues.

These, usually 20-year contracts, also have the unusual but highly consequential stipulation that the restaurant is located at that specific address the one McDonald’s, the corporation, just bought. In other words, McDonald’s instantly has a tenant and one who will always pay above-market rates

Some franchise unions found that the average franchise tends to pay an average of 6-10% of its sales in rent, while McDonald’s franchisees pay 8.5-15%. And if a location fails to perform as expected, the company can simply find a new franchisee for that location after the contract has expired, or sell the land to someone else entirely, likely at a significant profit.

Why is it Lucrative?

So, why do franchisees agree to these stringent requirements? Simply put: because it’s seen as an incredibly safe investment. The advantage of this model is despite its abnormally high fees, the initial startup costs, and even the annual revenues the odds of success are relatively high.

For example, the average location makes $2.7 million in sales every year, with a respectable but not incredible, all-things-considered, $154,000 in final take-home profit. But precisely because McDonald’s is so demanding, can it be such a solid investment. Sure, applicants have to meet high standards to become franchisees and once they do, they have little control over their own business, but all these factors also reduce their risk. While other franchises may have fewer requirements, they also come with greater risk.

McDonald's Hamburger University

The owner of a McDonald’s can be pretty sure they have qualified staff for the job, have a good location, and are meeting customer’s standards because otherwise, they wouldn’t be allowed in the first place. The company trains its franchisees in what it calls “Hamburger University” the company’s internal system of teaching business owners all the skills and knowledge they need

Pros of this Strategy

As we can see that the company is among the most famous and valuable brands in the whole world and a top player in the fast-food sector worldwide. For the company benefits of owning property are far greater than just an additional source of revenue. It’s no exaggeration to call it an entirely different business model: It understands that real estate is a far better business than hamburgers and other fast foods.

McDonald's Balance Sheet 2019
McDonald's Balance Sheet 2019

The first reason is just a function of American tax law which offers heavy tax breaks for depreciation, even while that same property may increase in value over time. The biggest advantage is the long-term stability of property prices and the revenue in addition to Royalty, Franchise fees.

Recessions are only a welcome opportunity to buy up discounted properties. When things are truly catastrophic like during a pandemic the real estate model outsources its risk to franchisees who are contractually obligated to pay a minimum amount of rent regardless of sales. All of this is reflected in the upward trend of franchised McDonald’s locations and the downward trend of the few remaining company-operated locations.

The logic behind this duality of Business Model

But this naturally raises a question: If McDonald’s makes a huge portion of its profits in the form of rent, and managing real estate is a fairly separate skill from creating new McThings, why not split-off the real estate holdings into a new company? Do that, and you have a very stable, active, and profitable real estate investment trust,  one immune from the variability of fast food and/ changing consumer appetites.

A group of investors suggested this very idea in 2015 and the company, however, decided not to, believing that its property model is what makes it unique and that its remarkable efficiency is a function of doing both. Along with Wal-Mart, McDonald’s was one of the only two stocks in the Dow Jones Industrial Average to increase in value in 2008. It’s also one of the 60 or so members of the so-called “Dividend Aristocrats” stocks that have increased their dividends annually for 25 consecutive years.

Further Insights of McDonald’s History, Business Model and Origin we suggest you watch the movie The Founder.

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