McDonald's Margins Have Nothing To Do With Outsourcing To India

| About: McDonald's Corporation (MCD)
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When McDonald’s announced the movement of some jobs to India, some investors thought it was due to minimum wages.

The outsourced jobs were in accounting.

The real way McDonald’s works on margins is using French fries and soft drinks.

Even as McDonald’s moves to franchising more of their restaurants the large margins on drinks are critical to growth in stores.

As investors are aware that McDonald's (NYSE:MCD) is engaged in a discounting battle against other quick-service restaurants, the pressure on McDonald's to cut costs remains significant. While the discounting battles do more to harm future growth by discouraging franchisees, the attempts to cut costs are a frequent area of emphasis. Every management team wants to announce a new way they've found to shave some costs off the company's financial statements.

Moving Jobs to India

McDonald's recently announced that they were to move jobs to India. That seems to be getting more press than it deserves. This isn't outsourcing 10,000 jobs; it isn't even outsourcing 100 jobs. Quite literally, it is outsourcing about 70 jobs. While this brings up arguments about how higher minimum wages are encouraging companies to outsource, the dialogue is entirely irrelevant. The regional office being shut down was performing accounting functions. If an accountant can't earn $15/hour, I wouldn't want them handling my financial statements.

Rather than dwelling on the extremely minor impacts of such a move, it makes more sense to take a deeper look at the margins. Even though McDonald's is emphasizing a franchising model in which they operate almost zero stores, the viability of their business model still depends on franchisees being able to make money. If franchisees can't make money, no one will want to open a McDonald's restaurant.

Back to Discounting

When McDonald's announced their discounting strategy to compete with the discounting strategies of other quick-service restaurants, there were a few things that stood out to me. For readers seeking a full list of the different discounts, your wish is granted.

The first one is that McDonald's is offering the one combination that doesn't include fries or a drink. The irony of that combination is that fries and drinks have exceptionally strong margins. In a piece on Bloomberg, Alix Steel discusses the margins on fries. In a nutshell, the gross margins are estimated to be around 75%. In other words, the cost of sales (labor and overhead excluded) is around 25%. She suggests that this is as great as margins get, but I disagree. The best margins are on soft drinks.

For a discussion of the precise math on soft drink margins, I turn to a restaurant supply company. Their author, Wilton Marburger, (great last name for the industry) breaks it all down including the impact of adding ice to the cups. He estimates that the cost of soda comes to around $.0132 per ounce and that a 20 ounce cup can be filled with enough ice (almost free) to reduce the volume of soda to 8.75 ounces. Add in the cost of cups, straws, and lids to reach a total cost of $.22 per 20 ounce soda. At $1.25 per soda this would be 17.6%. The piece is very detailed and I think it is great reading for any investor focused on fast food companies. (Disclosure: I have no connection to the author or the company. I found his article through a search on Google.)

The price of a soft drink will vary, so I used to get an approximation of normal prices for a soft drink at McDonald's:

Using McDonald's nutrition guide I was able to verify the ounces per cup to be 16 ounces for a small and 21 ounces for a medium. The large came in at 30 ounces.

How Much Ice Does McDonald's Pack Into the Cup?

The next step is figuring out how much ice McDonald's put into the cups. The nutrition guide indicates that the 21 ounce medium filled with Dr. Pepper contains 51 grams of sugar. I checked that against the website for Dr. Pepper which indicated that their 20 ounce bottle contains 64 grams of sugar. 51/64 = .7969. For simplicity sake I'll round that to .8. That suggests that McDonald's is using 80% of 20 ounces to fill their cup or simply 16 ounces of soft drink on average. That is dramatically more than the initial estimate of 8.75 ounces for a 20 ounce cup.

Adding 7.25 ounces at $.0132 per ounce increases the cost by $.0957 per cup. Add that to the initial estimate of $.22 per 20 ounce cup (which was initially holding 8.75 ounces) and we reach $.32 per 20 ounce cup. Based on the medium costing $2.49, the cost of goods sold on this transaction is 12.85%. That is materially lower than the 17.6% estimate by the restaurant supply company because the increase in beverage costs was more than offset by pricing the drink at $2.49. The resulting gross margins of 87.15% easily dwarf even the 75% gross margins on fries.

Implications for Sales

If McDonald's wants to bring in more consumers and keep their franchisees happy, they need to design promotions to encourage consumption of the highest margin items. The king of high margins is the soft drink and the runner up is fries.

Providing promotions that lower the price on higher priced goods may be a way to quote higher savings to the consumer, but it only matters to the franchisee if they are able to tack on some of the highest margin items. Remember that the franchisee will need to pay royalties to McDonald's, rent on the structure, wages to employees, and so on.

In the short term this promotion could be very useful for driving up metrics like the average ticket. In the longer term it will lead to more angry franchisees if the customers coming in for the special items are not buying sides. Remember that the profitability of franchisees is a key factor in determining the growth rate of new restaurants, so the long term growth rate in revenues for McDonald's will be heavily tied to the success of their franchisees.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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