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McDonald's Corporation (MCD)

Founded in 1940, McDonald's is the world's largest quick-serve restaurant chain, with about 37,000 locations in more than 100 countries. Approximately 92% of its locations are franchised, meaning the stores are owned and operated by independent business owners.

Under a typical franchise arrangement, McDonald's owns the land and building or secures a long-term lease for the restaurant location, and the franchisee pays for equipment, signs, seating, and décor.

The company believes that ownership of real estate, combined with the co-investment by franchisees, enables it to achieve restaurant performance levels that are among the highest in the industry. Franchisees are responsible for reinvesting capital in their businesses over time, but McDonald's frequently co-invests with them to help improve their restaurants and operating systems to maintain the company's brand value.

A typical franchise term is 20 years and requires franchisees to meet rigorous standards, helping assure consistency and high quality at all McDonald's restaurants. Franchisees contribute to McDonald's revenue through the payment of rent and royalties based upon a percent of sales (typically 4%), with specified minimum rent payments, along with initial fees paid upon the opening of a new restaurant or grant of a new franchise. 

This structure enables McDonald’s to generate significant levels of cash flow while franchisees benefit from the company's brand and marketing.

By geography, the business is very international; just under half of McDonald’s operating income is derived in the U.S. McDonald's breaks down its stores by global geography:

  • U.S. Market (34% of sales): - Same-store sales growing 4-5% a year
  • International Lead Markets (29%): Includes some of the largest, best resourced and most established markets in the System (most mature and developed countries) - same-store sales growing 6% a year
  • High Growth Markets (25%): Relatively higher restaurant expansion and franchising potential, specifically eight key markets across Asia and Europe (China, Korea, Russia, Poland, Italy, Spain, the Netherlands and Switzerland) - same-store sales growing 4% a year
  • Foundational Markets (12%): Largest and most diverse geographical segment spanning over 80 markets across parts of Asia, Europe, Middle East & Africa and Latin America- same-store sales growing 8% a year

Business Analysis

McDonald's rise to success in the fast food industry was largely attributable to the company's focus on convenience, consistency, and value, all tied together by its very successful and unique franchising model. 

Most notably, McDonald's former president and chief executive Harry Sonneborn once said: 

"We (McDonald's) are not technically in the food business. We are in the real estate business. The only reason we sell fifteen-cent hamburgers is because they are the greatest producer of revenue, from which our tenants can pay us our rent."

McDonald's is one of the largest real estate owners in the world, having snapped up thousands of property locations along highways and within busy cities all around the world over the course of many decades. The best part is McDonald's locations are essentially financed by independent operators (the franchisees), who must pay an upfront fee to open a restaurant and send as much as 16% of their restaurant sales back to McDonald's for rent under their long-term lease agreements, according to The Wall Street Journal.

Importantly, by taking a more supportive approach with its franchisees (co-investing, collecting a reasonable percentage of sales instead of forcing franchisees to buy overpriced supplies from the company, etc.), McDonald's has done a great job maintaining consistency across its locations, whether they are owned by franchisees or the company itself. 

When combined with some of the company's unique productivity innovations, such as multiple drive-thru lanes and windows and industrial-like assembly lines in the kitchen, McDonald's was able to delight customers with very fast service, consistently hot food, and predictable quality. The company's simple, standardized menu and memorable marketing efforts further fueled its growth.

As McDonald's gained significant scale and continued to maintain a rather basic menu, it could provide consumers with even more value in the form of cheap prices. McDonald's is one of the largest purchasers of beef, chicken, and potatoes in the country, for example. As a result, it can exert meaningful pressure on its suppliers, resulting in lower food costs that can be passed on to its customers.  

Despite McDonald's focus on owning prime real estate locations, collecting lucrative rent payments from franchisees, and providing fast and consistent service, the restaurant fell on hard times in recent years. Specifically, the rise of fast-casual competitors, shifting consumer tastes for healthier food, and several managerial missteps at the company (declining service, more complicated menu, etc.) resulted in several years of flat or negative sales and earnings growth. 

In 2015, new CEO Steve Easterbrook unveiled a bold three-part plan for revitalizing McDonald's.

Part one was re-franchising 4,000 of its company-owned stores by the end of 2018, with an ultimate goal of 95% of its locations being franchisee-owned. At the end of 2017, franchised stores hit 92% of total store locations, up from 81% in 2015. This shift means that the company is selling its stores to independent businessmen and women and is therefore losing the vast majority of cash flow from these company-owned locations.

While this results in a temporary decline in revenue (down 7% in 2017), an increased mix of franchised locations will ultimately mean a far more profitable and free cash flow-rich company.

That's because McDonald’s will be responsible only for advertising, brand awareness, and global business strategy, with the franchisees responsible for most of the actual costs of building, maintaining, operating, and upgrading its physical locations. The company expects that after refranchising is complete, it will achieve $500 million a year in cost savings.

Step two of the turnaround plan was a major focus on improving its customer experience. This is exemplified by what management calls its "experience of the future," or EOTF, which encompasses everything from self-ordering kiosks, ordering and payment via a mobile app, curbside pickup, as well as a much more modern store layout and appearance.

EOTF has been rolled out to about 12,000 global locations, including 3,000 in the U.S. (about 25% of domestic stores).

                                        McDonald's Experience Of The Future

EOTF includes not only much nicer stores and self-ordering kiosks (to further improve efficiency and throughput), but also a mobile app that lets customers order before they go to the store (food is waiting for them when they arrive). As of the end of 2017, McDonald's app has around 20 million registered users.

McDonald's has also been making big inroads into food delivery. For example, in 2017 it partnered with UberEats to test home delivery of food in 200 restaurants in three cities in Florida.

According to Easterbrook, delivery orders tend to have high levels of repeat business and are usually 1.5 to 2 times larger than in-store orders. The success of the program is causing McDonald's to expand it in 2018 to 7,000 additional locations in 21 countries. That will bring the number of stores participating in home delivery (already popular in Asia and the Middle East) to about 17,000, or close to half of its global store count.

Finally, McDonald's has spent the last few years experimenting with its menu, both on the high and low end. For example, it replaced frozen beef patties with fresh, in order to improve the quality of its food. In addition, McDonald's has invested heavily into the McCafe brand, including rolling out premium coffees and ice beverages that it hopes will attract a higher end clientele. 

On the low end of the price spectrum, McDonald's has had big success with all-day breakfast. The company has also revamped its value menu, which offers $1, $2, and $3 food choices that cater to the company's traditionally frugal core user base. The idea is to draw in more traffic with cheap offerings, then up-sell customers with pricier menu items once they are in the door.

The company has also streamlined its food preparation process to improve delivery time and provide hotter and fresher food, which customer satisfaction surveys indicate are paying big dividends. 

The overall results of the turnaround plan have been a success. For example, McDonald's U.S. stores saw 4.5% same-store sales growth in 2017 (5.5% globally), including a 1.9% increase in customer traffic. Approximately one third of that growth was driven by its new value menu, according to surveys of store owners by analyst firm Instinet. 

Company-wide results were simply excellent in 2017: 

  • Global same-store sales: +5.5%
  • Global store revenue growth: 7%
  • Operating margin increased from 31.5% to 42%
  • Operating income growth: 9%
  • Diluted EPS growth: 17%
  • Dividend increase: 7%

These results are in line with or exceed management's long-term guidance.
Source: McDonald's Investor Presentation
More importantly, if McDonald's can continue to execute well on its plans, then it should be able to achieve high-single digits (6% to 9%) dividend growth over the long term as well, making the company an appealing candidate for long-term dividend growth portfolios. 

However, there is no guarantee that McDonald's impressive turnaround can continue without some potential hiccups along the way. 

Key Risks

McDonald's turnaround under Steve Easterbrook has been impressive, but there are still numerous challenges facing the company. 

For one thing, because of its global presence, McDonald's has a lot of foreign currency exposure; the company's local sales and earnings can be greatly affected when converted to U.S. dollars for accounting purposes. 

For example, negative currency effects resulted in a 4% decline in revenue compared to a constant currency basis during the fourth quarter of 2017. Fortunately, volatile exchange rates are unlikely to threaten the company's long-term earnings power. 

More fundamentally, a potential problem McDonald's faces is its dependence on a franchise business model. While this strategy certainly generates very high margins, it also comes with its own challenges. Specifically, many of the company's franchisees are not necessarily so thrilled by some of McDonald's initiatives. 

For example, revamping stores to meet the "experience of the future" model is a high cost that franchisees must pay for. In addition, the recent revamping of the value menu, while boosting same-store sales by drawing more traffic, has some store operators worried about profitability. While low-cost food may attract more guests, franchisees may end up with lower profits unless those guests also then buy additional, higher-margin food and beverages (which is far from guaranteed). 

This brings us to one of McDonald's biggest challenges - it's rocky relationship with franchisees in recent years. For example, according to a survey conducted in 2015 of the 3,000 or so franchise operators of McDonald's U.S. locations, relations between McDonald's and its franchisees were at a 12-year low.

Richard Adams, an advisor to franchise operators, summarized it well:

"They (franchisees) don't work for him, and he can't order them around...For him to get anything done, he needs franchisee cooperation."

The issues that franchisees have had is that the frequent changes to the menu, while necessary to find the optimal sales mix, also mean a great burden on local store operators. That's especially true because in many U.S. states, minimum wage laws have been instituted that are significantly raising the labor costs (eventually up to $15 per hour per employee in some areas) on restaurants and thus pressuring profitability. 

Finally, we can't forget that while McDonald's does have a strong growth catalyst in terms of opening new stores in emerging markets and thus increasing its total global store count, it faces the risk of changing consumer tastes across the globe. 

Consumers are becoming increasingly health conscious and thus McDonald's core food offerings may prove less appealing in the years ahead. That could potentially limit its long-term growth in more saturated markets such as in the U.S. and Europe. 

As a result, management could face increased pressure to continually evolve the menu in order to keep up customer traffic and keep same-store sales growing. However, frequent menu changes could further strain relations with franchisees, upon whom the company is becoming ever-more dependent for its cash flow. 

Closing Thoughts on McDonald's

McDonald's has an impressive track record of delivering strong growth for many decades, both in the U.S. and overseas. As a result, the company has become a darling among dividend growth investors, and for good reason. 

For one thing, McDonald's is notably a dividend aristocrat that has delivered 41 consecutive annual dividend increases. More importantly, management's turnaround strategy, now in its third year, does indeed seem to be delivering strong results. While there are numerous challenges that could potentially derail McDonald's in the future, management's goal of high-single digit earnings and dividend growth appears to be reasonable and achievable. 

When combined with the company's valuable real estate portfolio and predictable stream of high-margin rent payments and royalty fees from its franchisees, McDonald's seems to represent a fundamentally lower-risk dividend growth investment. 

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