How does McDonald's, the world's largest fast food leader, make money?

Table of Contents

Successful capital alchemy

McDonald’s current dividend yield is as high as 53.6%; this is the 47th consecutive year that McDonald’s has increased its dividend since it first paid dividends in 1976.

In the past ten years, McDonald’s has done two things in the capital market: buybacks and dividends. Take repurchases as an example. In the ten years from 2010 to 2019, except for 2012, 2013 and 2014, the amount of McDonald’s stock repurchases exceeded the amount of cash dividends in other years. In 2016, the amount of McDonald’s stock repurchases reached US$11.141 billion, exceeding Twice the net profit for the year.

Against the background of large-scale buybacks and high dividends, McDonald’s stock price has quadrupled despite little change in performance. But here lies the hidden worry. Because McDonald’s pays back to shareholders, in addition to what it earns, a large part of it is borrowed from banks. In 2013, McDonald’s debt was only $20.617 billion. By 2022, McDonald’s liabilities will be as high as US$56.439 billion, and its net assets will be -US$6.003 billion.

Very popular

Take a closer look at McDonald’s business and you’ll see how McDonald’s achieves this impressive financial feat. Same-store sales rose 12% in the most recent quarter and were up 10% in the U.S. market. At a time when many consumers are looking to save cash and maximize convenience, McDonald’s is meeting those needs well and is being rewarded with rising market share.

McDonald’s profit margins are now at an all-time high, with the chain now converting more than 40% of sales into operating income, thanks in part to steady franchise fees, royalties and real estate revenue.

McDonald’s does need to continually respond to changing consumer preferences. Falling behind in this area would open the door to competitors that have been looking for ways to chip away at its leadership in the fast-food industry. But the company has proven over decades that it can adapt. This is a valuable attribute for any company you want to keep in your portfolio for many years.

Asset-light and franchise models

McDonald’s profit improvement comes more from its asset-light business model. As the world’s most successful fast-food chain brand giant, McDonald’s has almost no difficulty doing business around the world, mainly due to its asset-light business model.

As of September 30, 2022, McDonald’s operated 39,980 fast food restaurants around the world, of which 37,930 were franchised stores and only 2,050 self-operated stores, with a franchise rate of 94.87%. Among them, in the United States, the largest market, McDonald’s franchise rate has reached 95%.

In terms of franchise business, McDonald’s main income comes from land rent. Specifically, in the third quarter of 2022, McDonald’s revenue from franchise stores was US$3.671 billion, of which revenue from land rent reached US$2.358 billion, and revenue from licensing was US$1.301 billion.

It can be seen that the core source of income for McDonald’s franchise stores is land rent. In fact, under the conventional franchise model, McDonald’s usually owns the store and leases it to the licensee, and the rent is divided according to the store revenue based on the base rent. In 2021, among all McDonald’s stores, about 55% of the store land and 80% of the store buildings are owned by the company. For this reason, McDonald’s is often called one of the largest real estate developers in the United States.

Under this model, McDonald’s core profits come from franchise stores. Data shows that the total gross profit of McDonald’s stores in 2021 reached US$12.490 billion, of which franchised stores contributed US$10.750 billion and self-operated stores contributed US$1.740 billion.

This model has also greatly improved McDonald’s ability to resist risks. For example, in 2020, the gross profit of McDonald’s franchise stores dropped from US$9.455 billion in 2019 to US$8.519 billion, a decrease of 9.90%. The gross profit of self-operated stores dropped from US$1.66 billion to US$1.158 billion, a drop of as much as 30.24%.

Of course, performance and business model are indeed the keys to McDonald’s long-term business success.

Shareholders reward

Dividend

McDonald’s Big Mac has been popular with fast-food lovers for more than 50 years. The restaurant chain is popular with income investors, in part because it has raised its dividend for an equally impressive 46 consecutive years.

In 2010, McDonald’s achieved a net profit of US$4.946 billion, a cash dividend of US$2.408 billion, and a cash dividend rate of nearly 50%. In 2012, when the economic environment underwent severe changes, McDonald’s achieved a full-year net profit of US$5.465 billion, a slight year-on-year decline. However, cash dividends that year had reached US$2.897 billion, and the dividend rate exceeded 50%.

Since then, McDonald’s cash dividend rate has continued to exceed 50%. From 2019 to 2021, McDonald’s cash dividends were US$3.582 billion, US$3.753 billion, and US$3.919 billion respectively, while McDonald’s net profits during the same period were US$6.025 billion, US$4.731 billion, and US$7.545 billion respectively. In 2020, when profits have declined due to the epidemic, McDonald’s cash dividend rate has reached as high as 79.33%.

Repurchase

On the other hand, McDonald’s high returns are reflected in stock repurchases. For ordinary shareholders, a listed company’s use of cash to repurchase shares is essentially equivalent to cash dividends. It reduces the number of shares circulating in the market, increases earnings per share, and at the same time increases the scarcity of shares in the market, driving up stock prices.

In fact, at the current stage, high returns, especially stocks with high buybacks, are what capital prefers. For example, T-Mobile, which rose sharply last year, has a major feature: it does not pay dividends, but it has a large amount of cash. It can more effectively return cash to shareholders through repurchases, which is more attractive than direct dividend payments. As a result, T-Mobile has attracted the attention of many hedge funds.

McDonald’s has always been a major buyback player in the U.S. stock market. In the ten years from 2010 to 2019, except for 2012, 2013 and 2014, in other years, the amount of McDonald’s stock repurchases exceeded the amount of cash dividends. In 2016, the amount of McDonald’s stock repurchases was as high as US$11.141 billion, which exceeded the net profit of that year. double. In fact, during this decade, except for 2013, the total amount of McDonald’s cash dividends and stock buybacks exceeded the net profit level of that year.

Since the outbreak of the new crown epidemic, McDonald’s cash repurchase amount has dropped significantly amid the bull market in the U.S. stock market. In 2020 and 2021, McDonald’s cash repurchase amount is only 874 and 846 million US dollars respectively, which is significantly reduced from the 4.980 billion yuan repurchase amount in 2019.

But starting last year, McDonald’s restarted the pace of stock buybacks. In the first three quarters of last year alone, McDonald’s stock repurchases amounted to US$3.487 billion.

Under the long-term high dividends and high buybacks, McDonald’s total liabilities far exceed its total assets, and its net assets have been negative for a long time. At the same time, in order to maintain high dividends and high buybacks, McDonald’s has continued to sell its own assets in recent years. In 2013, McDonald’s liabilities were only US$20.617 billion, of which long-term liabilities were US$14.130 billion, and net assets were US$16.010 billion. By 2022, McDonald’s liabilities will be as high as US$56.439 billion, of which long-term liabilities will be US$35.904 billion, and net assets will be -US$6.003 billion.

Impacts

At this point, McDonald’s market value growth logic has gradually become clear:

In the past ten years, McDonald’s profits totaled approximately US$55 billion, long-term liabilities increased by US$21.8 billion, and total cash flow amounted to approximately US$77 billion. This money is mainly spent on buybacks and dividends, the former is about 40 billion U.S. dollars, and the latter is about 35 billion U.S. dollars.

Ten years ago, McDonald’s market value was US$48 billion. Based on an 80% increase in valuation, that is, the initial 48 billion US dollars increased to US$86.4 billion. Taking into account that the 75 billion dividend and repurchase portion will be added one after another, assuming that the valuation increases by 40%, the market value of this part will increase to 105 billion US dollars, which adds up to about 190 billion US dollars, which is basically equivalent to the current market.

In other words, of McDonald’s 5-fold increase in ten years, 80% came from the increase in valuation, and the rest came from dividends and buybacks. The reason why McDonald’s can do this is due to the long-term low interest rates in the United States. However, as the Federal Reserve continues to raise interest rates, this model may be unsustainable.

Operational Outlook

Fututre plan

McDonald’s announced before the investor event day in November 2023:

It hopes to add approximately 10,000 stores and 100 million new members by 2027. McDonald’s hopes to have 50,000 stores worldwide by the end of 2027. According to its latest quarterly financial report, McDonald’s currently operates 41,198 stores worldwide.
There will be 100 million new members by 2027, and the membership plan will increase from 150 million to 250 million by 2027.

McDonald’s business in Greater China

In 2017, McDonald’s land port business changed hands.

In 2017, McDonald’s sold 80% of its China business to a group including CITIC Capital, an investment subsidiary of CITIC Limited, and Carlyle Group (US stock code: CG). When Carlyle withdraws from McDonald’s China business in November 2023, McDonald’s shareholding in the Chinese business will increase from 20% to 48%, while CITIC Capital will continue to hold 52% of the equity.

In the same year, McDonald’s Taiwan was sold to a new operating consortium composed of state guest general manager Li Changlin for NT$5.1 billion.

McDonald’s China has set a goal that the company will have 10,000 restaurants by 2028; it will open 700 new stores in mainland China in 2022, and plans to open another 900 stores in 2023. And McDonald’s not only sells fast food, there will also be 2,500 McCafé stores in China by 2022.

Growth

Both companies are seeing steady sales growth, with McDonald’s having a slight edge. The fast-food giant’s same-store sales grew 12% last quarter, a slight slowdown from the 13% gain in the previous quarter. Consumers are enjoying McDonald’s improved service and its focus on value at a time when inflation is squeezing many people’s budgets.

Neither company has had problems offering higher prices to customers, either. In fact, McDonald’s operating profit margin hit an all-time high at nearly 46% of sales. Although Starbucks is less reliant on franchising, its profitability is also near record levels due to higher prices, cost cutting and strong sales.

McDonald’s once again emerged victorious in this head-to-head duel with its massive global sales base and a steady stream of franchise fees, royalties and real estate fees. However, Starbucks’ expanding profit margins in recent quarters are also a testament to its market strength. “I am confident in the company’s multiple paths to driving significant growth and margin improvement,” Chief Executive Laxman Narasimhan told investors in early August.

Risk and market valuation

You may be wondering why these two stocks are still down this year despite all this good news. Wall Street worries about slower growth ahead due to weak consumer spending patterns and the end of recent rounds of price increases.

McDonald’s executives said in July that the sales environment had become more challenging. “Costs remain high, consumers have limited discretionary spending, and industry traffic is under pressure,” they told investors on a recent conference call. They expect revenue growth to slow in the second half of 2023. Starbucks may face many of the same pressures.

Fortunately, this pessimism is reflected in the stock’s valuation today. McDonald’s shares currently trade at just 7.5 times annual sales, down from nearly 10 times sales in May. Starbucks is pricing at 3 times revenue, down from 4 times just a few months ago.

While both stocks are likely to earn positive long-term returns from here, McDonald’s appears to be more worthy of the premium than Starbucks. Its faster growth and higher profitability provide flexibility in what is likely to be a tough operating environment in 2024.

McDonald’s shareholders also receive a higher-yielding dividend, which has a long and steady track record of annual pay increases. Opting to automatically reinvest these quarterly payouts allows you to accumulate more shares when fast-food stocks are cheaper (like they are now), amplifying your returns.

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