McDonald's Dividend Depends On How Well Its Franchisees Do

Oct. 4.12 | About: McDonald's Corporation (MCD)

A franchising company's earning power (profits and dividends) is dependent on the attractiveness of investing in that company's franchise.

McDonald's (NYSE:MCD) founder understood this. Ray Kroc faced some stiff competition in the 1950s and 1960s, but only he provided the needed support for his franchisees. While his competition -- such as Burger King and Burger Chef -- sold big territorial franchises to make a quick buck, his operation was unique as it constantly monitored its franchisees one by one and provided strong central operations guidance.

Therefore, it's necessary to establish if McDonald's franchise is still an attractive proposition today.

What Are the Profits of a McDonald's Franchise?

This information is confidential between McDonald's and its franchisees, so it is pretty difficult to find. But some information is available online, and a few numbers can be extrapolated out of the company's annual financial reports.

Unlike many other franchise companies, McDonald's gives a lot of financial performance information in Item 19 of its FDD (Franchise Disclosure Document). Item 19 has pro forma financial results for restaurants that hit three different annual sales levels: $2 million, $2.2 million, and $2.4 million, showing cost of sales, gross profit, and operating profit at each level. The average sales volume for all U.S. McDonald's restaurants in operation a year was a little over $2 million in 2008. Profits are in the low six figures.

The above statement is supported by this article, which gives us the following income statement, apparently compiled by Janney Montgomery Scott restaurant analyst Mark Kalinowski:

Click to enlarge images.

It is clear that the quick service restaurant business is a high volume/low margins business. The only party that makes fat margins in this relationship is McDonald's, whose net profit margin is a whopping 20%.

McDonald's does it by being mostly a franchise royalty and real estate rent collector. It is a food technology company acting as a center for a network of 33,735 restaurants worldwide:

Restaurants as of June 30

2012

2011

Conventional franchised

19,580

19,279

Developmental licensed

4,042

3,748

Foreign affiliated

3,641

3,571

Total Franchised

27,263

26,598

Company-operated

6,472

6,345

System-wide restaurants

33,735

32,943

Click to enlarge

Source: McDonald's 10-Q, Q2 2012.

McDonald's is a big real estate owner, whose largest item on the asset side of its balance sheet is comprised of land and buildings:

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Source: McDonald's 2011 annual report.

Accordingly, the majority of McDonald's revenues from franchisees comes in the form of rents:

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Source: McDonald's 2011 annual report.

If we divide the total revenues of system-wide restaurants for the year 2011 of $67,648 million by the total number of franchised restaurants of 27,075, we arrive at an average revenue for a McDonald's restaurant of $2,498,541. Total royalties divided by the total number of franchised restaurants is $2,930 million / 27,075 = $108,218. So the average royalty fee divided by the average revenue gives us an average McDonald's (percentage of sales) royalty fee of $108,218 / $2,498,541 = 4.3%.

Sales by company-operated restaurants were $9.105 million for the six months ended June 30, 2012, and the cost structure for those is as follows:

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Source: McDonald's 10-Q, Q2 2012.

McDonald's is one of the safest franchise options out there, as noted by Forbes and Entrepreneur.com.

Source: "Why McDonald's Wins In Any Economy."

Largest Systems by Franchise-Wide Sales (2008)

#

Restaurant Chain

US Total Franchise Sales ($000)

US Franchise Units

Sales per Store

1

McDonald's

24,050,000

11,833

$2,032,452

2

Subway

8,200,000

21,195

$386,884

3

Burger King

7,610,000

6,280

$1,211,783

4

Wendy's

5,840,000

4,662

$1,252,681

5

Dunkin' Donuts

4,975,000

5,451

$912,677

6

Taco Bell

4,250,000

4,322

$983,341

7

KFC

3,980,000

4,302

$925,151

8

Pizza Hut

3,900,000

6,196

$629,438

9

Applebee's

3,310,000

1,343

$2,464,631

10

SONIC Drive-Ins

3,026,212

2,706

$1,118,334

Click to enlarge

Source: Technomic/Restaurant Finance, compiled by Blue MauMau.

It appears that Subway, 7-Eleven, and Applebee's are franchises that can be as financially rewarding as McDonald's. But from a dividend investor's point of view, Subway is privately owned; 7-Eleven is owned by the Japanese company Seven & I Holdings Co., which yields 2.5% (McDonald's currently yields 3.3%); and Applebee's is held by DineEquity (NYSE:DIN), which pays no dividend.

Franchising companies ought to be profitable and safe for their franchisees. On this criterion, McDonald's passes the test, as the size of its net profit margin of 20% and the above data prove. McDonald's profits will likely continue to grow at a double-digit clip, since becoming a McDonald's franchisee continues to be relatively profitable and global markets are far from saturated with McDonald's stores.

Also, McDonald's has recently done the expected and increased its quarterly dividend by 10%, from $0.70 to $0.77. This company is one of the safest dividend payers in the world today. There truly is gold behind the golden arches.

Disclosure: I am long MCD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.