Feeding
people
Managing
a franchising operation
Responding
to the right competitors?
The
risks to the strategy
SeekingAlpha.com has had a number of very good articles
on McDonald's recently. Two of them focused on the balance sheet implications
of McDonald's current strategy. Another focused specifically on the strategy.
There would be no point to replicating that analysis. Suffice it to summarize
by pointing out that, for better or worse, McDonald's has increased its
leverage as part of the strategy to shift to a more asset-light model for their
business. McDonald's just reported earnings that pleased Wall Street, but this
article was largely written before the earnings report and focuses on longer-run
issues.
Addressing whether the moves described in the SeekingAlpha
articles are for better or worse requires some thought about what McDonald's
business is. As one of the articles points out, “The typical consumer
experience at McDonald’s (MCD) involves either waiting in a queue or going for
a drive-thru at one of its many outlets.” That may be how the consumer
experiences McDonald's currently, but it is not the essence of their business.
The essence of their business is figuring out how to feed people and leveraging
that information.
Feeding people is necessary practical experience
relevant to figuring out the best systems for accomplishing the objective of
feeding people. Once they figure that out, they maximize the value by
franchising their system. Their move to switch many of their outlets from
corporate-owned outlets to franchises can be seen as just reflecting a high
degree of confidence that they have figured that out. As a consequence, they have value in the
intellectual property embodied in their franchise agreements.
Even at its current price, McDonald's stock is a
justifiable core holding. However, it's only justifiable if an investor is
willing to hold a company pursuing the strategy outlined above. So, it makes
sense to look at some aspects of their operation that are relevant to that
strategy.
Background
There are a couple of aspects of McDonald's
operations that are often overlooked when assessing the company.
First, it would be an error to view McDonald's as
just a restaurant chain. The previous Chief Executive Officer seemed not to
appreciate that fact. However, McDonald's serves more customers at the
drive-through window than as walk-ins who eat in the restaurant. I believe that
corporate wide, drive-through accounts for about 60% of the business, and in
some franchises it is as high as 80%. In the 1980s and 90s it was fashionable
to discuss trends in consumer consumption of meals at home versus meals eaten
away from home when discussing McDonald's. Analysts and McDonald's executives
focused on how to feed people, not how to run restaurants. They recognize that
competition with other restaurants was only part of the story relevant to
McDonald's value. It also explains why the “You deserve a break today”
marketing campaign was so successful. It positioned McDonald's against any
alternative, not just fast food.
Second, the intellectual property that McDonald's
capitalizes on includes the strength of the brand. Consequently, although
McDonald's was identified as a potential core holding in a posting as early as
January of 2011, as long as it was being operated as if it was a restaurant
that competed with the fast- casual restaurants like Chipotle Mexican Grill and Panera
Bread, it was hard to see it as other than a “hold.” In the $90s it might be
justified as a dividend-paying
bond substitute, but in the $90s it was a screaming “buy” once it became
apparent that they were going to have to focus on their brand’s strength rather
than the brand strengths of other restaurants. The previous CEO was chasing
business where their brand did not have value; but once that stopped, the
strength of their brand created the potential that McDonald's was going to
become a dividend grower.
Third, McDonald's seems to have developed a better
understanding of their competition and their customers. That extends beyond
just realizing that they were losing market share to other fast food chains,
not the fast-casual dining establishments. In fact, the new program referred to
as “Experience of the Future” may manifest itself in the form of purchases
using a cell phone, ordering on kiosks, or pre-ordering for pickup or something
else. However, all of the initiatives, both those that succeed and those that are
phased out, represent an effort to keep the brand relevant. In an environment
where the definition of convenience and speed, two hallmarks of their brand,
are being changed by companies as far afield from fast food as Apple and Amazon,
the initiatives represent important steps to defend their brand and, thus, the
value of their intellectual property.
Fourth, McDonald's decision to hand over a large
number of their company-owned stores to franchisees is not a bit of financial
engineering. Granted, pushing the number of franchisee-operated global
locations up to 93% of all units will increase profitability. But it will
increase profitability because it is an efficient way to allocate capital. Further,
it reduces risk since it shifts much of the rest of the operations to the
franchisee. Because it shifts some of the operating risk off of the corporate
entity, it allows the company to increase financial risk by increasing leverage
without increasing the overall risk.
Franchising leverages the intellectual property that
has made McDonald's franchises such good investments. It's easy to overlook
some of that intellectual property. So, when evaluating the strategy, it's
useful to consider some of that intellectual property that isn't immediately
apparent:
1. McDonald's is an expert at locating their outlets.
When marketing economic information that could be used to locate outlets, it
was not unusual for McDonald's fast food competitors to describe their location
strategy as simply getting as close to a McDonald's store as possible.
2. McDonald's scale has allowed them to develop a
supply-chain and supply-chain management techniques that have their maximum
value when applied to as many stores as possible, and the effectiveness of
their supply chain enhances the value of their franchises.
3. McDonald's scale also allows their franchisees to
benefit from economies of scale in marketing. That was especially true when
broadcasting was a primary promotional media, but it is still true even though
marketing efforts can now be more targeted.
4. It's easy to overlook the fact that McDonald's has
built up tremendous intellectual property in the form of an understanding of
how to operate through franchises. Knowing how to protect your brand and ensure
a reasonable amount of uniformity in operations when operating through
thousands of independent businesses is a skill McDonald's has, to date,
perfected.
Risks
This strategy seems sound; however, it is not
without risk. One of the principal risks is that by reducing the number of
company-owned stores, McDonald's is reducing the scale of their ability to
experiment without forcing their franchisees to bear the risk associated with
their experiments. Looked at differently, McDonald's is narrowing the scope of
their direct interaction with the ultimate customers. It is quite possible that
McDonald's is appropriately scaling the company-owned operation in order to
maximize value of the information they gained from operating some of the
outlets. The risk is that they judged that wrong.
As mentioned, increasing the scale of the franchise
operation shifts operational risk to franchisees. That may justify the
increased leverage for the corporate balance sheet. The risk is that they
misjudge the balance between operational risk and financial risk and in the
process of implementing the strategy increase the overall risk to the company.
Finally, if the Corporation errs in its judgment on
either the items above, it could stress their franchise system. The success of
their strategy depends upon both the success of corporate entity and the
success of the franchisees. Historically McDonald's has managed that balance
well, but the change in corporate strategy will require that they adjust their
thinking regarding the role of the franchisees. For example, they seem to have
placed far more emphasis on making sure franchisees understand the strategy
behind “Signature” sandwiches than was true of previous similar initiatives.
That's totally appropriate to their efforts to streamline the process by which
they bring franchisees into new initiatives.
Disclosure: The author of this article owns shares
of McDonald's Corporation. It has been part of my portfolio off and on since
shortly after Pepsi spun off Yum Brands. However, holdings were expanded
significantly when McDonald's was trading in the $90s. I have no intention to
buy or sell additional shares over the foreseeable future.
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