Here’s Why Investors Should Not Worry About McDonald’s Declining Revenues

McDonald’s (NYSE:MCD) is working aggressively on redefining itself – transforming from a “junk” fast food destination to a fast casual place serving healthier food. Another major initiative being undertaken by the company is to become a 95% franchised entity by 2018. The company is on track to refranchise 4,000 of its restaurants by 2017, bringing its global franchised percentage to 93%. As the company moves towards this model, revenues of company operated restaurants are being replaced by franchisee royalties and fees, leading to a decline in revenues. However, the company’s profitability is improving on the back of cost savings. The below chart shows how the company’s EBITDA (earnings before interest, tax, depreciation and amortization) margins and revenues have trended in the past few years and our estimates for the future.

The above chart clearly shows that while revenues have declined significantly in the past few years, margins have improved drastically, and this trend is likely to continue in the future.

Through a 95% franchised model, McDonald’s is improving its profitability and reducing its capital expenditures. This can make the company more operationally efficient, and does not require huge investments to grow its restaurants. While this model will lead to lower revenues as the company will recognize franchisee royalties and fees, which are calculated as a percentage of total franchisee revenues, it will improve the company’s profitability and cash flow, impacting its valuation positively. Competitors such as Starbucks believe that a franchise based model impacts company control over its restaurants, but others such as Burger King and Wendy’s have proven that the franchisee model is an efficient way of running restaurants. McDonald’s strategy to refranchise its restaurants should generate higher returns for its shareholders and allow the company to capture growth opportunities faster.

Further, McDonald’s is also generating significant revenues through rents received from its franchisees to whom the company leases out its real estate. Franchisee rent and fees are a significant revenue stream for McDonald’s, and account for more than 50% of the company’s valuation, according to our estimates. This strategy to generate revenues from rents on its property leased out to franchisees insulates McDonald’s from headwinds faced by its burger business. The company owns 45% of the land and 70% of the buildings at its 36,000+ locations. As the company moves towards a 95% franchised model and leases its land/buildings to these franchisees, McDonald’s can be assured of steady rental income and modest capital expenditures. As its growth strategy does not require significant capital investment, the company has been returning cash to shareholders and recently announced a $22-24 billion cash return target for the 3-year period ending 2019. These cash returns should boost the company’s earnings per share over the long run.

McDonald’s franchisee strategy has ensured that the company is not significantly impacted by headwinds faced by the restaurant industry. A business model which is franchise-based, where McDonald’s effectively acts as a landlord, will ensure steady rental income even if the revenues of the burger business are adversely impacted for a short period. Higher franchisee royalties are improving the profitability of the company, and this business model is likely to benefit McDonald’s shareholders in the long term.

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