McDonald’s Asia: Don’t Let the Rising Margins Fool You

McDonald’s (NYSE:MCD) recently announced its decision to expand franchising in China. While more than 80% of McDonald’s 33,000 restaurants globally are franchised, in China only 36 out of its 1,400 restaurants are franchised. ^[1] A higher mix of franchised restaurants in a region leads to higher margins which can give a misleading impression that a company doing better than it actually is. McDonald’s opened 200 new outlets in China in 2011 and will add another 225-250 this year, although the proportion of franchised restaurants is not known.

McDonald’s will also double the number of restaurants to 500 by 2014 in India, a country in which it has no company-operated restaurant. The company competes with Yum! Brands (NYSE:YUM), Subway, Starbucks (NASDAQ:SBUX), Wendy’s (NYSE:WEN), Chipotle Mexican Grill (NYSE:CMG), among many others.

We have a Trefis price estimate of $100 for McDonald’s, which is in line with the market price.

See our complete analysis for MCD stock here

Franchise Margins Are More Than 3 Times the Company-Operated Margins

McDonald’s franchised EBITDA margins are as high as 87%. The company earns its revenue in a franchised restaurant as a percentage of sales (along with initial fees and rent). Thus, the company does not have to bear the cost of food, labor, etc., in its franchised restaurants, and this is the reason why McDonald’s is able to sustain such margins.

In the company-operated restaurant, the margins are naturally lower since McDonald’s has to incur food, labor and rental costs. Thus, a higher mix of franchised restaurants will lead to a higher overall margin.

The ideal way to gauge the company’s performance is to independently compare the performances of company-operated restaurants and franchised restaurants. For 2011, the company-operated margin for APMEA (Asia-Pacific, Middle East and Africa) was 16.3%, down 0.8% from a year ago, primarily due to higher commodity costs. The company expects commodity price increases to be in the range of 4.5%-5.5% for 2012.

McDonald’s reported that its franchised restaurants margins in the APMEA region witnessed a slight growth of 0.2% to 89.5%, primarily due to the contractual escalation in the royalty rate for Japan. Going forward, the company has to be careful about pricing because the rising food costs have to be incurred by franchisees, and pricing is something McDonald’s and franchisees don’t always agree upon.  Higher menu prices can lead to a drop in sales, which can directly impact McDonald’s profitability. We estimate McDonald’s to be fully valued at the moment.

Understand How a Company’s Products Impact its Stock Price at Trefis

1. McDonald’s plans to expand franchising in China, Reuters, February 28, 2012 [↩]