The Business Of

Fast Food | McDonald’s | What Are Their Margins?

Morning All!

So, yesterday we dug into how McDonald’s makes money. And we saw that revenues surprisingly declined every year from 2014-2020. We saw that McDonald’s were ditching operating their own restaurants and were instead preferring to franchise. And we saw that, due to their landlord position, McDonald’s highest revenue stream was rent! The company made $9.0bn in rental income in 2022… which was higher than what Airbnb made in revenue last year!

But that’s enough of revenues. Let’s turn our attention to the company’s cost structure and margins! The chart below shows you how McDonald’s costs are split by segment. FYI, CO = Company operated!

We can see that food costs, employee costs and occupancy (rental) costs make up the majority of McDonald’s expenses. But instead of going through each of these cost lines. We’re going to do it slightly differently! Very excited for this!

The Dilemma - To Operate Or Not To Operate!

Okay, so we start with a bit of a dilemma! Because yesterday, we saw that when McDonald’s own and operate their own restaurant they take all 100% of the sales. But when McDonald’s have a franchised restaurant, they only take 6% of sales in a royalty fee. And then also make revenues through charging franchisees rent.

But some of you may be thinking… ‘100% of sales’ is going to be much bigger than ‘6% of sales + rent’. So, surely franchised restaurants are a bad deal for McDonald’s?! Well, to answer that, we can’t just look at revenues. We need to bring costs into the picture. Because remember, the ultimate prize isn’t revenues, it’s profits!

The chart below shows us how the EBIT margin differs for McDonald’s based on the type of restaurant. What we can see is that, whilst the company operated restaurants have a solid EBIT margin of 16%. McDonald’s makes an extraordinary EBIT margin of 82% from their franchised restaurants!

But what’s going on here?! Why is the margin of a franchised restaurant 5x higher?! Well, it’s because the costs involved are completely different. In a company operated restaurant, McDonald’s is responsible for everything. Hiring the staff, buying the food, paying the rent, the lights, the equipment, everything. And when you take all those expenses away from a restaurant’s revenues, you’re left with an EBIT margin of ~16%.

However, for franchised restaurants. Yes, the restaurants still need staff, food, lights and equipment obviously! But it’s not McDonald’s who pay for those things… it’s the franchisee! McDonald’s only real cost is when they don’t own the restaurant building. And then have to rent it from the landlord. The table below is a breakdown of how these costs would work for two restaurants with the same sales. But one’s franchised and one’s company operated…

As we can see, total revenue from a franchised restaurant is only 1/6th of the revenue from a company operated restaurant. However, because its franchisees who pay for food, paper, employees - NOT McDonald’s - the costs for the franchised restaurant are a lot less. And this results in an EBIT ($413,280) that isn’t miles less than company operated restaurants ($480,000).

But it is still less! And so some of you may still be wondering - hold on, company operated restaurants bring in more profit. Surely they’re better! Well, not quite. And tomorrow, we’ll settle the franchised vs company operated debate. Because the other noticeable difference between the two is the increased capex required for company operated restaurants vs franchised restaurants. All revealed tomorrow!

Making The Margin Shift

Okay, so franchised restaurants have much higher margins for McDonald’s as a company. And didn’t we see something yesterday which showed us McDonald’s were franchising more and operating less restaurants themselves?

Well, yes - well remembered! The chart below (from yesterday) shows us how McDonald’s have been reducing the number of restaurants they own and operate. And opening more franchised restaurants. Now, it’s not like McDonald’s are closing all of their own operated restaurants. Some, yes. But for a lot of these restaurants, McDonald’s are simply selling them to franchisees.

What’s been the impact of this? Well, you guessed it! McDonald’s EBIT margin has expanded hugely from 17% in 2003 to 40% in 2022. As the company has shifted more of its business towards the higher margin part. The overall margin for the company has benefitted greatly! The chart below illustrates this consistent progress…

One important thing to note here though is the difference between the margin improvements we see here with McDonald’s. Versus the margin improvements we saw with the semiconductor companies we covered before the break. For Nvidia, TSMC, and ASML, we saw their EBIT margins grew as their toplines grew. And the companies took advantage of increased scale.

However, that’s not the case for McDonald’s. Remember, their topline has shrunk since 2014! But margins have continued to expand. I just wanted to make that distinction clear because margin improvements through (i) scale and (ii) mix shift are different animals.

But Hold On - Fast Food Isn’t Semiconductors!

Okay, so McDonald’s EBIT margin is very high at 40%. And last week we saw 3 semiconductor companies with super high EBIT margins too. And some of you may be thinking - are super high margins common in the fast food industry? Like it was in the semiconductor one?

And the answer is absolutely not! McDonald’s is a huge anomaly in this industry. And the chart below shows us that the majority of fast food companies have much lower margins. FYI, Restaurant Brands International is the company that owns Burger King. And Yum! Brands owns KFC and Pizza Hut!

But then, the question is - why do McDonald’s have such high margins vs its competitors? And the answer is 2 parts. (i) Franchising and (ii) Property. Let’s first talk about franchising.

And this is fairly simple. We saw earlier that franchised restaurants have a much higher margin for fast food companies. Compared to when they operate their own restaurants. And so McDonald’s, KFC, Pizza Hut, Burger King and Domino’s Pizza all have >90% of their restaurants operated by franchisees. However, at Starbucks, only 49% of their stores are franchised. And this strategy has resulted in lower margins for the coffee chain! Clearly Starbucks aren’t too keen on sharing their brand…

But the second part here is property. Now, what do I mean by this? Well, as we’ve seen with McDonald’s. The highest revenue stream for the company is actually rental income. And because McDonald’s owns 80% of their restaurant buildings. They receive a lot of rental income by renting out these buildings to franchisees. And so they’re effectively the landlord for most of their franchisees! But is this common?

No! In fact, it’s incredibly different to what we see at other fast food companies. And it’s really the difference between McDonald’s vs the rest. The chart below shows us that RBI (owners of Burger King) only rent out 16% of buildings to franchisees. And for Yum! Brands (owners of KFC and Pizza) - they only rent out 1% of buildings to franchisees! This means that for the majority of their franchisees, RBI and Yum! aren’t the landlords. And so they don’t make any rental income…

So, when it comes to food - you might prefer Burger King or KFC to McDonald’s. But when it comes to business models… it’s tough to pick anyone above Maccy D’s!

31st May 2023

Nigel Jacob CFA