McDonald’s Franchisee Economic Conditions: It’s Complicated

Last week, a wave of complaints emerged in the US McDonald (MCD) franchisee community when the franchisor notified franchisees that a series of new fees and subsidy cuts would be initiated in 2021.[1]  The fees and subsidy cuts,  about $12,000 per location, were described as last-minute and uncoordinated by senior McDonald’s franchisees I know. The fees include costs for the “Archways Opportunity” employee tuition program  (of which franchisees certainly benefit; moving it to jointly funded ) as well as costs for digital/IT.  These fees in total apparently amount to $170 million in 2021; it is not difficult to see a corporate PowerPoint slide showing this number being used during corporate budget development sessions.

What Happened?

What surprised many is that just before MCD Quarter 3 earnings in September is that the US franchisee mood was said to be extremely positive—the highest ever—as reported by Mark Kalinowski’s Quarterly McDonald’s franchisee survey.  On its November 9th earnings call, Kevin Orzan the CFO mentioned the US business returned to positive comps and grew company-operated margin dollars in the US.[2] While not franchisee numbers, it is a proxy.  While McDonald’s corporate and franchisee relationships have been up and down, there had been an improvement with more field focus under Joel Erlanger, the US McDonald’s Division President, and with the creation of the McDonald’s National Owner Association two years ago. However, franchisees do not like fees;  almost every franchisee I’ve ever talked to over time doesn’t see why the royalty paid isn’t good enough.

The New Mix of Required Franchisor CAPEX   

What has to be understood by all including the investment community and franchisees is that the essential nature of retail and restaurant business today requires heavy start-up investment CAPEX and recurring bands of follow-on CAPEX for IT platforms for digital sales and back-office systems. In the old days, it was enough for POS systems that were pollable. Coming out of the 2008/2009 recession, Starbucks (SBUX) and Panera (PNRA) were the innovators in stored value cards and loyalty, which lead those brands to recovery. Those features and more are now expected everywhere, especially post COVID-19.  These investments have to be centrally funded and managed.  This could put some franchisors into a bind if they have other use of funds programmed. Depending on the brand and store base, easily IT CAPEX should be 40-50% of the total capital budget or more in some years. Franchisors have some options:

  • raise franchise fees or initial signing fees going forward
  • carefully scrub their other capital budget items so the IT items get funded
  • find other investor capital injections and restrict the cash for IT

The problem with looking just at the franchisee P&L: it is only half the story

The McDonald’s situation also calls out the reality that while the income statement view is important in assessing a franchisee’s economic position, the franchisee’s balance sheet, and especially, debt service and capital spending flows are essential. When restaurant brands have reported franchisee profitability in the past on earnings calls, it has been an EBITDA or EBITDAR number.[3]  This limited view has always been a problem. The issue of course is that there are many costs and outlays that fall below the store level EBITDA line, as Chart One displays:

CHART ONE: STORE LEVEL FREE CASH FLOW DISPLAY

 DISPLAY

Component Nominal Value Example, $
Store Level EBITDA $200,000
    Less: Taxes ($34,000)
    Less: G&A ( $40,000)
    Less: Principal [4] ($100,000)
    Less: Interest ($33,333)
Free Cash Flow, $ ($7,000)

Given the mathematics of this reality, the definition of terms becomes very important. And it is why the franchisor/franchisee reality about store economics always will be very complicated.

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[1]  McDonald’s Franchisees Blind sighted by New Charges for 2021, Restaurant Business Online, December 4 2020.

[2]   McDonald’s Q3 2020 Earnings Call Transcript, November 9 2020.

[3]   For example, McDonald’s, Domino’s, Popeye’s earnings call in the past.

[4]   Not every unit will have principal and interest expense all the time.

Originally published at wraysearch.com

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