mcdonald's-business-model

McDonald’s Heavy Franchised Business Model In A Nutshell

McDonald’s is a heavy-franchised business model. In 2018, of McDonald’s total restaurants, 93% were franchised. The long-term goal of the company is to transition toward 95% of franchised restaurants. The company’s operating income in 2018 was $8.8 billion compared to $9.55 in operating income for 2017.

McDonald’s origin story: from the McDonald Brothers to Mr. Ray Kroc

As explained on McDonald’s website “Dick and Mac McDonald moved to California to seek opportunities they felt unavailable in New England.” In 1948 they launched Speedee Service System featuring 15 cent hamburgers. As the restaurants gained traction that led the brothers to begin franchising their concept until they reached nine operating restaurants.

A native Chicagoan, Ray Kroc, in 1939 was the exclusive distributor of a milkshake mixing machine, called Multimixer. In short, he was a salesman.

He visited the McDonald brothers in 1954 and was impressed to their business model which led to him becoming their franchise agent. He opened up the first restaurant for McDonald’s System, Inc., until in 1961 he acquired McDonald’s rights to the brother’s company for $2.7 million.

Ray Kroc, died on January 1,4 1984, all the rest is a legend.

Is McDonald’s a franchising? You bet, and a heavy one!

Of the 37,855 restaurants in 120 countries at year-end 2018, 35,085 were franchised, and the Company operated 2,770 restaurants.

This makes the heavily franchised model running at 93% total capacity, compared to McDonald’s long-term goal of 95%.

As specified in its 2018 annual report “McDonald’s is primarily a franchisor and believes franchising is paramount to delivering great-tasting food, locally-relevant customer experiences and driving profitability. Franchising enables an individual to be his or her own employer and maintain control over all employment-related matters, marketing, and pricing decisions, while also benefiting from the financial strength and global experience of McDonald’s. However, directly operating restaurants is important to being a credible franchisor and provides Company personnel with restaurant operations experience.”

How do McDonald’s partnerships work?

As specified in its annual report “under McDonald’s conventional franchise arrangement, franchisees provide a portion of the capital required by initially investing in the equipment, signs, seating, and décor of their restaurant business, and by reinvesting in the business over time. The Company generally owns the land and building or secures long-term leases for both Company-operated and conventional franchised restaurant sites. This maintains long-term occupancy rights, helps control related costs and assists in alignment with franchisees enabling restaurant performance levels that are among the highest in the industry.

In short, the model is pretty smart. McDonald’s keeps control over the land and or long-term leases to leverage its market position to negotiate deals. At the same time, this kind of deal serves as an alignment between the company and its franchisees.

What are McDonald’s segments?

At the qualitative level the segments can be organized in four main ones:

  • The U.S., which as of 2018 represents still the most significant market.
  • International Lead Markets include Australia, Canada, France, Germany, the U.K., and related markets.
  • High Growth Markets that comprise markets with high growth potentials include China, Italy, Korea, the Netherlands, Poland, Russia, Spain, Switzerland, and related markets.
  • Foundational Markets & Corporate, the remaining markets in the McDonald’s system, most of which operate under a primarily franchised model.

As of 2017, the U.S., International Lead Markets, and High Growth Markets accounted for 35%, 32% and 24% of total revenues, respectively.

Who are McDonald’s key partners?

McDonald’s business model is based on three key players. Franchisees, suppliers, and employees are the piece of the puzzle of McDonald’s successful business model.

  • Franchisees are entrepreneurs that at local level allow McDonald’s to expand rapidly while keeping a global focus
  • Suppliers across the globe guarantee McDonald’s ability to operate at a high level
  • The continuous training of employees across the over thirty-six thousand restaurants around the world allow McDonald’s to perform at full speed

What management metrics McDonald’s uses to asses its growth?

Any organization has a set of management ratios and metrics to understand and assess the growth of the business.

McDonald’s looks at the following metrics:

  • Comparable sales and comparable guest counts: the percent change in sales and transactions, respectively, from the same period in the prior year for all restaurants, whether operated by the Company or franchisees, in operation at least thirteen months, including those temporarily closed
  • ROIIC: calculated by dividing the change in operating income plus depreciation and amortization (numerator) by the cash used for investing activities (denominator), primarily capital expenditures
  • Free cash flow: defined as cash provided by operations minus the capital expenditures 
  • Free cash flow conversion rate: defined as free cash flow divided by net income, are measures reviewed by management to evaluate the Company’s ability to convert net profits into cash resources

McDonald’s velocity growth plan in action

McDonald’s has launched and developed a velocity growth plan based on three pillars:

  • Retain the customers they have
  • Regain the customers lost by improving the taste and quality of food, enhancing the convenience and offering strong value
  • Convert casual customers to more committed customers with coffee and snacks

They also identified three accelerators, intended to drive growth:

  • Digital by re-shaping interactions with customers
  • Delivery by bringing the McDonald’s experience in their homes
  • Experience of the Future in the U.S. which consist of a set of new technologies within the restaurants to enhance the efficiency and improve the experience

Why is McDonalds’ transitioning to a heavy franchised business model?

The transition to a more heavily franchised business model is part of the long-term company’s strategy. In fact, as the rent and royalty income received from franchisees provides a more predictable and stable revenue stream with significantly lower operating costs and risks.

In a way, it is almost like McDonald’s is introducing a subscription business model, where franchisees pay a fixed amount each month. That makes McDonald’s income more stable over time.

Also, the operating and net income coming from franchising operations makes it easier for the company to grow its profitability.

Understanding the company-operated business model vs the franchised-based business model

McDonald’s business model has a double soul. On the one hand, when it comes to its operated restaurants, we can still call McDonald’s a restaurant business when it comes to the franchised restaurants McDonald looks way more like a commercial real estate company.

Understanding the function of company-operated restaurants

Directly operating McDonald’s restaurants contributes significantly to our ability to act as a credible franchisor. One of the strengths of the franchising model is that the expertise from operating Company-owned restaurants allows McDonald’s to improve the operations and success of all restaurants while innovations from franchisees can be tested and, when viable, efficiently implemented across relevant restaurants. Having Company-owned and operated restaurants provides Company personnel with a venue for restaurant operations training experience. In addition, in our Company-owned and operated restaurants, and in collaboration with franchisees, we are able to further develop and refine operating standards, marketing concepts and product and pricing strategies that will ultimately benefit McDonald’s restaurants.

As highlighted in the 2018 financial reports, the company-owned restaurants are important for a series of reasons:

  • Credibility as a franchisor: how can you teach others how to run a restaurant if you don’t run it yourself?
  • Experimentation: company-owned restaurants enable McDonald to test things quickly, and roll out only when they have proved to work on the company’s owned restaurants to the franchised restaurants.
  • Training: company-owned restaurants also act as training venues for franchised restaurants.
  • Innovation: as McDonald’s has full control of its owned restaurants it can freely innovate, and bring these processes to other franchised restaurants. So that processes can be reviewed and improved periodically
  • Control: the company-owned restaurants guarantee the complete control of processes, innovation, and standards that can be applied elsewhere.

Understanding the economics of the franchised business model: a $37 billion dollar commercial real estate company

As reported on McDonald’s financial statements:

Revenues from conventional franchised restaurants include rent and royalties based on a percent of sales along with minimum rent payments, and initial fees. Revenues from developmental licensees and affiliate restaurants include a royalty based on a percent of sales, and generally include initial fees upon the opening of a new restaurant or grant of a new license. Fees vary by type of site, amount of Company investment, if any, and local business conditions. These fees, along with occupancy and operating rights, are stipulated in franchise/license agreements that generally have 20-year terms.

Therefore, a good chunk of the revenues coming from McDonald’s franchisee comes from rent and royalties.

As further explained on McDonald’s financial statements:

Under McDonald’s conventional franchise arrangement, the Company generally 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 us to achieve restaurant performance levels that are among the highest in the industry.

mcdonald's-properties-2018

Source: McDonald’s financial statements 2018

To have an idea of how big is the McDonald’s real estate business, as of 2018 the company reported over $37 billion in property and equipment, which makes it a mammoth commercial real estate owner!

Key highlights from McDonald’s business model

  • McDonald’s uses a heavy franchised business model. As of 2018, the company had 93% of total restaurants as franchising.
  • Its long-term target is 95% of franchised restaurants worldwide.
  • Even though revenues have decreased since 2013, it’s important to understand this is part of the transition to a heavy-franchised business model.
  • Indeed, according to McDonald’s financial reports in 2018 Franchised margin dollars represented about 85% of the combined restaurant margins in 2018, about 80% in 2017, and about 75% in 2016.
  • Therefore as McDonald’s business model primarily shift toward a heavy-franchised model we might expect this effect of reduced revenues and increased margins.
  • That is also due to how revenues are reported for each segment
  • Although company-operated restaurants have higher revenues compared to franchised restaurants, they contribute less to the company’s gross margins and net income.
  • It’s important to understand the key difference between McDonald’s company-owned restaurant business model vs the McDonald’s franchised restaurant business model.
  • McDonald’s can be considered a restaurant business in the McDonald’s company-owned side of the business.
  • However, it can be considered a mammoth commercial real estate company on the franchising restaurant side of the business. Indeed, in 2018, McDonald’s reported at cost over $37 billion in property and equipment, which makes it one of the largest commercial real estate companies on earth.

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Published by

Gennaro Cuofano

Gennaro is the creator of FourWeekMBA which reached over a million business students, professionals, and entrepreneurs in 2019 alone | Gennaro is also Head of Business Development for a high-tech startup, which he helped grow at double-digit rate and become profitable | Gennaro is an International MBA with emphasis on Corporate Finance | Subscribe to the FourWeekMBA Newsletter | Or Get in touch with Gennaro here

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