Analyzing McDonald’s Franchise Agreement and Structure

McDonald’s has a mix of franchises and company-owned stores. In this article, we’ll look at McDonald’s franchise agreement. We’ll also look at McDonald’s franchising model and compare it with its company-owned stores.

Notably, the company’s franchising model makes it looks like a real estate company as well as a fast-food chain. Gradually, the share of franchised stores in its overall stores has risen. McDonald’s intends to increase this share even further. That said, company-owned stores are a key component for McDonald’s despite their falling share in its revenue mix.

Like most other fast-food chains, McDonald’s has a mix of company-owned and franchise stores. The company enters into an agreement with a franchise that then operates a restaurant or a set of restaurants.

According to McDonald’s, about 93% of its stores were owned and operated by franchisees at the end of 2018. The company aims to increase the share of franchises to 95% in the long term. Notably, the contribution of franchises to McDonald’s revenues has increased gradually.

Each of the company’s franchisees usually has a standard 20-year franchise license agreement. A franchise license is an authorization granted by either a company or a government body to an individual or a group. This authorization enables them to perform specific commercial activities. For McDonald’s, the franchise model has led to years of profitability, growth, and risk mitigation.

McDonald’s has the following types of franchise structures

• Conventional franchise: Under this model, McDonald’s either owns the land or leases it for the long term. Under the agreement, the franchisee pays for other items such as seating, equipment, and décor.
• Development license or affiliate: Under this type of franchise agreement, the franchisee also provides capital for real estate. Typically, under such a franchise agreement, McDonald’s does not invest capital and earns a royalty plus an initial fee.

According to McDonald’s guidelines, it requires “a minimum of $500,000 of non-borrowed personal resources” to be considered for a US franchise. According to the company, the down payment required to start a new McDonald’s franchise is about 40%. The down payment required to purchase an existing franchise is 25%.

McDonald’s specifies that the down payment must come from non-borrowed personal resources. In addition to monetary capital, significant human capital is required in the form of business experience, customer service experience, business planning skills, and accounting skills. Also, a significant time investment is required, including formal training in company policies and procedures.

Under the McDonald’s franchise agreement, the franchise also pays:

• A service fee: The company has a service fee of 4.0% of monthly sales.
• Rent: McDonald’s also charges monthly rent. This can be a base rent or based on sales.

The risks associated with McDonald’s franchise business model include the counterparty risk, like in any other agreement. These include whether its franchisees have the experience and financial resources to be effective operators. Plus, the franchisees are expected to remain aligned with the company on operational, promotional, and capital-intensive initiatives.

Potential risks for McDonald’s include food safety issues, other operational problems, or projecting a brand image inconsistent with the company’s values.

So far in this article, we’ve looked at McDonald’s (MCD) franchise structure and agreement. Overall, franchising is crucial to McDonald’s profitability. However, the growth of this business is coming under pressure, given market saturation in key developed markets—especially the US market.

McDonald’s company-owned store revenues have been falling as it moves toward franchising. However, the company-owned model provides McDonald’s with some key strategic and competitive advantages.

As McDonald’s also operates its own stores, its expertise can also improve the franchisees’ experience at these stores. Having its own stores also provides McDonald’s with trained personnel who can then work in collaboration with franchisees.

To understand what’s driving McDonald’s earnings and free cash flows, it’s essential to understand same-store sales and guest counts. Same-store sales compare the sales from restaurants, or stores, that have been open for at least one year. This statistic helps analysts evaluate what percentage of new sales comes from organic sales growth versus opening new stores. The average spend per customer and total guest count drive same-store sales.

Last year, McDonald’s same-store sales increased 2.5% in the US despite a 2.2% fall in guest count. In the company’s International Lead markets, its same-store sales increased by 5.8%. Higher average check per customer and higher guest count drove this increase.

Notably, its same-store sales increased in the High Growth segment and Foundation markets. McDonald’s has been facing challenges in the US market as consumers shift toward newer brands and healthy foods.

After looking at McDonald’s franchise agreement and company-owned stores, let’s drill down into another pertinent aspect. Specifically, what business is McDonald’s in? Ray Kroc, who purchased McDonald’s in 1964, once famously told Harvard MBA students, “Ladies and gentlemen, I’m not in the hamburger business. My business is real estate.”

So, can a company that we perceive as a fast-food chain actually be a real estate play? Let’s discuss this in perspective.

At the end of 2018, McDonald’s had total assets of $32.8 billion. Out of this, 70% is net property and equipment—totaling $23 billion. Generally, companies value real estate on a cost basis. So, the actual market value of these real estate properties might be much higher. Under the conventional franchise agreement, McDonald’s owns the real estate while the franchisee pays rent.

In the past, some activist investors have raised the issue of unlocking value by spinning off McDonald’s real estate assets. However, McDonald’s did not agree with the spin-off. Management believes that spinning off the real estate assets would harm the company more than it would create value for investors.