Wednesday, July 26, 2017

McDonald's Two Businesses, One Strategy

Feeding people

Managing a franchising operation

Responding to the right competitors?

The risks to the strategy 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.


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.


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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