How McDonald's Makes Money

The story of McDonald's (MCD) often begins with Ray Kroc, the native Chicago milkshake mixing machine salesperson who had the vision to see what the business model deployed by one of his clients, Speedee Service System, could become. Speedee Service System, launched in 1948, was the brainchild of two brothers, Richard James (Dick) and Maurice James (Mac) McDonald, who successfully applied the drive-in concept to food delivery and, ultimately, franchising opportunities.

Impressed by what he saw, Ray Kroc became their franchise agent in 1954. He opened up the first McDonald's franchise in 1955 and bought out the McDonald brothers six years later for the then hefty sum of $2.7 million. The rest is part of the entrepreneurial lore that is the hallmark of iconic businesses.

McDonald's Today

Since its founding, the enterprise has about 38,000 restaurants globally that serve close to 68 million customers in 118 countries per day. That represents about 1% of the world's population who want a burger, fries, and/or chicken nuggets as quickly as possible. It has, effectively, morphed into the most popular family restaurant that appeals to children and adults alike and emerged as the dominant force in the quick service restaurant end of the market.

This restaurant model isn't unique to McDonald's. In fact, there are a number of other popular franchises in this category, including KFC and Taco Bell (YUM), Wendy’s (WEN), and Burger King. McDonald's ruled as one of the most valuable fast-food chains in the world with a brand value of over $40 billion (Starbucks edged out McDonald's for the #1 spot). McDonald's is consistently among the leaders of this market segment in terms of brand recognition, overall sales, and the number of restaurants globally, along with Starbucks (SBUX), KFC, Domino's, and Subway.

On the way to serving hundreds of billions of people, McDonald's has blazed multiple corporate trails since its 1955 incorporation, such as franchising and institutionalized training. McDonald's even had a mission statement long before mission statements were a thing. "Quality, Service, Cleanliness and Value" is self-explanatory, and McDonald's has set standards for at least the first and fourth of those qualities.

Business Model

McDonald's makes money by leveraging its product (fast food) to franchisees who have to lease properties that are owned by McDonald's. This often comes at a large markup. As reported in the 2021 10-K, 37,295 (93%) McDonald's locations were franchised at the end of 2021.

The advantage of this model is that the revenue stream (rent and royalty income received from franchisees) is far more stable and predictable. The operating costs, on the other hand, are measurably lower, which allows for an easier path to profitability. McDonald's can leverage its market position to negotiate deals because it has control over the land and long-term leases. This is akin to a subscription, where the subscriber (the franchisee) pays a fixed amount each month.

According to industry analysts, McDonald's keeps about 82% of the profit generated by franchisees, compared with only about 16% from its company-operated locations, further trimmed by the costs incurred in operating these units. In other words, it costs way more money to run your own store than it does to sit back and collect cash. Note that McDonald's company-operated locations earn more revenue for the entire company than the franchisees; however, the overhead expenses are larger for the company-operated locations than for the franchisees, which collect more overall revenue on an absolute level.

Why McDonald's Franchises Are in Demand

McDonald's has notoriously strict criteria for its franchisees (including net worth and liquidity). Franchisees are also responsible for paying salaries, ordering supplies, and paying the rent or mortgage. So, why become a franchisee? The lure is that McDonald's provides its franchisees with an almost guaranteed moneymaker due to the impressive margins.

The restaurant industry is infamous for its turnover. As any restaurateur will tell you, one major reason for this is that the margins can be thinner than a slice of processed American cheese. Yet, McDonald's operating margins are Double Quarter Pounder thick—north of 40%. How is that possible in a business whose very purpose is to provide inexpensive food? The answer lies in the fact that some food and drink items, such as coffee, for instance, are quite inexpensive to prepare. They are then sold for a few times their price.

MCD Financial Picture

McDonald's operates with the following global business segments: the U.S., International Operated Markets, and International Developmental Licensed Markets and Corporate. Each sector accounted for 38%, 53%, and 9% of revenues, respectively, as of the company's most recent annual report. 

Financial Statements

According to the company's 10-K, 2021 free cash flow was $7.1 billion, a 46% increase over 2020, and 1,500 new stores were opened worldwide.

Growth Strategy

McDonald's has a long-term goal of franchising approximately 95% of its locations. McDonald's will continue to make progress toward this long-term goal primarily by re-franchising restaurants to conventional licensees. As a result of the continued evolution of its business model, several organizational changes to its global business structure were implemented that are designed to continue the company's efforts toward efficiently driving growth as a better McDonald’s through the Velocity Growth Plan.

The Velocity Growth Plan, which was first introduced in 2017, is McDonald's customer-centric strategy that focuses on the key drivers of the business, namely food, value, and customer experience. Here's its main focus:

• Retaining Existing Customers: Focusing on areas where it already has a strong foothold in the Informal Eating Out category, including family occasions and food-led breakfast.
• Regaining Customers Who Visit Less Often: Recommitting to areas of historic strength, namely quality, taste, quality, and convenience of its product: food.
• Converting Casual to Committed Customers: Building stronger relationships with customers so they visit more often, by elevating and leveraging the McCafé coffee brand and enhancing snack and treat offerings.

McDonald's remains committed to continuing its aggressive deployment of the three growth accelerators. The growth accelerators are:

1. Experience of the Future: Restaurant modernization and technological upgrades to transform the restaurant service experience and enhance customer perceptions of the brand.
2. Digital: By evolving the technology platform, McDonald's is expanding choices for how customers order, how they pay, and how they're served through additional functionality on its global mobile app, self-order kiosks, and technologies that enable conveniences such as table service and curbside pick-up.
3. Delivery: McDonald's expanded the number of restaurants offering delivery. It is now available in over half of the global system. McDonald's was and intends to be quite proactive in keeping up with the current trends when it comes to expanding its brand and business. The company announced a partnership with Uber Eats for home delivery for the first time in the U.S. and followed that up by adding Doordash and GrubHub. These partnerships are part of a strategy to keep up with the newer generations who prefer home delivery over pick-up.

Key Challenges

McDonald's has managed to stay comfortably ahead of its main competitors in the fast food arena, such as Burger King, Wendy's, and KFC, but its key challenge might just be consumers demanding healthier, organic menu choices coupled with fast-food convenience.

Over the past few years, another restaurant model, one that offers consumers freshly prepared, higher-quality food in an informal setting and with efficient counter service, has been making a bid to garner the attention of the consumer, or more appropriately, their palates. Dubbed as fast-casual restaurants, these entities (Chipotle (CMG), Shake Shack (SHAK), and Cheesecake Factory (CAKE), among others) have been making inroads into the space long dominated by chains like McDonald's.

Fast-casual differs from fast food in that its aim is to provide consumers with healthier selections but with fast food convenience at a slightly higher price point that consumers would be willing to pay. The growing consumption trends for food that is healthy, economical, and available with minimal wait times have begun to eat into the market share of leading fast-food restaurants.

This didn't go unnoticed by McDonald's. In 2018, it announced that it was removing all preservatives, fake colors, and other artificial ingredients from seven of its burger selections. Its menu features a Southwest Grilled Chicken Salad, and you can get apple slices with a kid's Happy Meal.

The Bottom Line

Fast food should be as stable an industry as any. People need to eat and they want their food fresh and fast without having to spend unnecessarily. That said, the industry does face challenges relating to a shift in demand toward healthy eating. A restaurant chain that sells familiarity and consistency needs to recognize that those qualities themselves are enormous assets. Even when McDonald's has an under-performing year, it's still profitable. When operating at its peak, it's a must-have stock in any comprehensive portfolio, especially since it has similarities with real estate investment trusts (REITs) as well.