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With over 32,000 locations in over 110 countries, McDonald’s (NYSE: MCD) is the world's largest fast food restaurant chain. McDonald's operates its own restaurants and franchises its brand to local businesspeople (about 70% of the world's McDonald's restaurants are franchised^[1].) The company experienced a dramatic turnaround in 2003, driven by a two-pronged strategy. In the U.S., McDonald's focused on increasing sales at existing locations by renovating stores, expanding menu options and extending store hours. Internationally, McDonald's expanded aggressively, opting to franchise rather than operate its new locations, providing new income with little overhead.

Both strategies have paid dividends - despite its size, sales have grown by a third since 2003^[2]. Domestically, McDonald's continues to perform well despite a pullback in consumer spending and is even benefiting as consumers trade down from more expensive eating options. At the same time, international operations are driving profit growth. A growing global middle class, particularly in emerging markets like China, India, and Latin America, represents a massive opportunity for McDonald's. McDonald's aggressive efforts to expand its global presence - most notably at the 2008 Beijing Summer Olympics - have produced strong comparable sales and profit growth.

Business Overview

Business Model

McDonald's makes money by operating its own restaurants and franchising to third parties. Of its 32,278 restaurants around the world as of September 30, 2009, 25,975 (80%) were franchises and 6,303 (20%) were company-operated. .^[3] Franchises provide the initial capital required to build the restaurant and maintain it through reinvestment reinvestment, whereas direct restaurant operation is more capital-intensive relative to franchising and results in lower restaurant margins as a percent of revenues.

McDonald’s revenues come from sales by its company-operated restaurants as well as fees from its franchise restaurants. Revenues from conventional franchised restaurants include rent and royalties based on a percent of sales along with minimum rent payments, and initial fees. Revenues from restaurants licensed to affiliates and developmental licensees include royalties based on a percent of sales, and generally include initial fees.

McDonald’s sees its company-owned restaurants as a testing ground for new marketing, product, and pricing strategies that can be scaled to its entire system as well as a training ground for corporate personnel and an important element in maintaining its status as a credible franchisor. In the last few years, however, McDonald’s has sought to shift toward franchises. In 2007, it sold its businesses in Brazil, Argentina, Mexico, Puerto Rico, Venezuela and 13 other Latin American/Caribbean countries to one franchisee^[4]. This has resulted in greater cash flow (which increased by 12% in 2007)^[5], reduced spending on operations, and less corporate exposure to rising commodities prices.

Business Strategies

McDonald’s has pursued two strategies since 2003. To keep up with rapidly changing consumer preferences, demographics, and spending patterns, McDonald's has introduced new items (Premium Chicken sandwiches and the Angus Beef Burger) and campaigns to create more healthy foods (Premium Salads). The strategy reflects the philosophy that novelty, as opposed to loyalty to traditional products, is the key determinant of sales in the fast food industry.

McDonald’s has also focused on increasing sales at existing restaurants instead of opening new ones^[6]. To do so, McDonald's has remodeled many restaurants, kept stores open longer, and increased menu options. Nevertheless, new McDonald’s restaurants are still opening around the world at a rapid rate - the company plans to open about 1,000 units in 2008, and continues to grow its restaurant base by 1-2% each year.^[7]

Size Matters

McDonald's size has three key advantages:

• Uniform menu offerings can be mass produced, lowering production costs.
• Bargaining power with suppliers lowers input costs and boosts margins.
• Large advertising budget means lots of domestic and international exposure.

International Expansion

McDonald’s is well-established in Europe, Asia/Pacific Islands, the Middle East, and Africa. Its growth in Europe is mainly driven by France, Germany and the United Kingdom. In Asia, the general management has indicated that there is significant potential in the Chinese market. The corporation has adapted its menu items to local cultures, such as the Teriyaki Mac in Japan, variants of Filet-O-Fish in China, and lamb in place of beef in India.

In neighboring China, McDonald’s has been selected as the Official Restaurant of the Beijing 2008 Olympic Games - an honor that will further bolster its global reputation.

Current Financials

McDonald's revenues for the first three quarters of 2009 (ending September 30, 2009), were $11.4 billion, down 10.1% from the first nine months of 2008. At the same time, operating income increased 1.5% over the same period last year, reaching $5.0 billion. The declines in revenue were offset by larger declines in operating cost.

In the third quarter of 2009 (ending September 30, 2009), revenues were $4.1 billion, down 7.2% from the same quarter in 2008, with operating income increasing 6.0% over the same period last year to a total of $1.9 billion. .^[13]

In Q2, much of the revenue decline was attributed to company-operated restaurants, whose revenue numbers decreased by 10% from $4.3 billion in the previous year to $3.8 billion. Revenue from franchised restaurants, on the other hand, actually increased 1% from $1.78 to $1.80 billion.^[14] Since the margins on franchised restaurants are higher than those of company-operated restaurants, the higher contribution from franchised restaurants in the revenue mix positively impacted McDonald's operating margins (from 27.2% to 29.8%).

McDonald’s chalked up its success in the third quarter to the success of its new Angus burgers and McCafé coffees, as well as the appeal of its value items. .^[15]

In August 2009, McDonald's reported sales growth of 2.2% for existing restaurants, with 1.7% growth in the United States and 3.5% growth in Europe. McDonald's and other fast food restaurants have benefited during the economic downturn as consumers turn to lower-priced meals, though their profitable breakfast and beverage sales have slipped. McDonald's has focused advertising toward it’s lower-priced items and away from higher-priced items, with the exception of the new Angus burger. ^[16]

Key Trends and Forces

McDonald's looks to compete in the high-margin beverages market with "McCafe"

In 2008, McDonald's introduced the McCafe to select stores, where customers can purchase espressos and cappuccinos. These drinks, which are priced in the $2-4 range, represent McDonald's foray into the high-margin caffeinated beverages market, currently dominated by Starbucks. McDonald's expects to eventually add $1 billion to annual sales through McCafe-related beverages^[17] Coffee sales now make up 5% of McDonald's total sales.^[18]

Analysts have taken notice of this threat and expect McCafe to have a negative impact on Starbucks' same-store sales.^[19] Some analysts believe the two competitors will eventually settle into separate niches, with McDonald's being the better value proposition and Starbucks offering more of a quality experience.^[20]

Strong International Growth is Driving Sales

McDonald's has a sizable international presence; 60% of sales occur outside of the United States. In addition to developed markets like the U.K., Canada, South Korea and Australia, McDonald's operates in fast growing emerging markets like China, India, Russia and Eastern Europe. By tapping into a growing global middle class, the company's international operations have consistently posted strong same-store sales growth. China is a particularly promising opportunity. In FY 2007, McDonald's launched the breakfast menu, extended store hours to 24 hours in major cities, and implemented drive-thru in China in its efforts to capitalize on this huge market^[21].

Changes in consumer preferences could decrease sales

Consumer preferences that gravitate towards more nutritional food (see Natural & Organic Foods Consumption and Health & Wellness) decrease the appeal of eating at McDonald’s. As these consumer trends continue to shift towards the mainstream, public perception of McDonald's becomes increasingly negative. These changes may climax in lawsuits or media publications like Super Size Me, which criticizes McDonald’s products for causing obesity, and Fast Food Nation, which decries McDonald's business practices. Since McDonald's is the most recognized brand name in the fast food industry, these negative publicity events have widespread impact on its brand equity. Furthermore, because there are many alternatives to fast food (such as cheap dine-in restaurants, street vendors and convenience stores), the corporation's sales depend on its ability to maintain its brand name and attract new customers. The introduction of salads and public nutrition campaigns are examples of McDonald's efforts to adapt its business model to changing trends in the market.

Commodity Costs can Impact Margins

McDonald's earnings are sensitive to prices of commodities such as beef, corn, cheese and poultry. Since 2005, food prices have increased substantially, but competition has prevented McDonald's from passing costs along to customers. Thus, increasing input prices have come at the expense of margins.

Sensitive to the Dollar

McDonald's is also sensitive to the relative strength of the dollar. Although the company is based in the US, McDonald's does 60% of its business overseas. As foreign currencies strengthen relative to the dollar, goods sold in foreign markets are suddenly worth more dollars back in the US, boosting earnings. On the other hand a strengthening dollar reduces the value of sales from abroad.

Competition

Although McDonald's is the clear leader of the fast food industry in terms of revenues generated and restaurants established, it faces competition from other fast food chains, which are introducing new products themselves.

Major direct competitors in the (hamburger-based) fast food industry include:

• Burger King Holdings is the second largest hamburger fast food chain. Although more of Burger King’s restaurants are franchised than McDonald’s restaurants, Burger King franchise revenues trail behind that of its competitor, mainly due to the McDonald’s size advantage.
• Wendy's is the third largest hamburger fast food chain. It has a lower operating margin that McDonald’s, so it is likely to be more negatively impacted during a recession.
• Yum! Brands runs Kentucky Fried Chicken, Taco Bell, Pizza Hut, Long John Silver’s, and A&W All-American Food Restaurants. Currently, Yum! brands are dominating the China market, posing a challenge to McDonald's attempts to enter the market. While McDonald’s Corporation focuses on its flagship brand, Yum! splits its resources among a wide variety of restaurants.

In addition to the above competitors, McDonald’s also competes with non-hamburger-based fast food restaurants (such as Panera Bread Company (PNRA), Panda Express and Qdoba), local and national dine-in restaurants (such as Red Robin’s and Shari’s), pizza parlors, coffee shops (Starbucks), street vendors, convenience stores and supermarkets.

Market Share

The major players in the fast-food market, which generates around $120B^[22] in annual revenues, are: Domino's, Inc.^[23], Burger King Corporation^[24], Wendy's International, Inc.^[25], Jack in the Box, Inc.^[26], Yum! Brands, Inc.^[27], Doctor's Associates, Inc.^[28], and McDonald's Corporation^[29]. As can be seen, the fast food industry is somewhat fragmented. The seven major competitors only account for 45% of total revenues.

The Fast Food Hamburger Restaurant industry, on the other hand, is dominated by McDonald's, who possesses approximately 90% of the market share for this component. The FFHR is a $67 billion segment. Burger King is second behind McDonalds with a 4% share of the segment. The QSR segment and FFHR category are extremely competitive because each FFHR restaurant offers similar menus and prices.

McDonald's is first in the Fast Food Hamburger Restaurant category for revenue followed by Burger King and then Wendy's.^[30]

References

1. ↑ McDonald's Investor Relations- About McDonald's
2. ↑ WSJ.com McDonald's Annual Earnings
3. ↑ McDonald's Corporation Q3 2009 Quarterly Report
4. ↑ MCD 10-K 2007, Item 7, pg. 11
5. ↑ MCD 10-K 2007, Item 6, pg. 9
6. ↑ MCD 10-K 2007, Item 1, pg. 3
7. ↑ MCD Q4 2007 Earnings Call
8. ↑ MCD 10-K 2007, Item 7, pg. 1
9. ↑ MCD 10-K 2007, Item 7, pg. 1
10. ↑ MCD 10-K 2007, Item 7, pg. 1
11. ↑ MCD 10-K 2007, Item 7, pg. 1
12. ↑ MCD 10-K 2007, Item 7, pg. 1
13. ↑ McDonald's Corporation Q3 2009 Quarterly Report
14. ↑ McDonald's Delivers Strong Second Quarter Results
15. ↑ McDonald's Corporation Q3 2009 Quarterly Report
16. ↑ McDonald's August same-store sales rise 2.2 pct
17. ↑ McDonald's owners eye Starbucks with McCafe drinks
18. ↑ McDonalds reports 8p decline in second-quarter profits
19. ↑ Deutsche Bank Cuts Starbucks to Sell, Says McDonald's McCafe Rollout to Hurt Company
20. ↑ Starbucks, McDonald's carve coffee niches
21. ↑ MCD 10-K 2007, Item 5, pg. 12
22. ↑ Fast Food Industry Abstract
23. ↑ Domino's Corporate Website
24. ↑ BKC 10-K 2007, Item 6, pg. 36
25. ↑ WEN 10-K 2007, Item 6, pg. 44
26. ↑ JBS 10-K 2007 pg. 19
27. ↑ YUM 10-K 2007 pg. 19
28. ↑ Subway's Corporate Website
29. ↑ MCD 10-K 2007, Item 6, pg. 9
30. ↑ Burger King Company Report