2 Stealth Drivers of McDonald's Global Margins

Source: McDonalds.com.

With its crisp texture, salty and savory taste profile, and accessible price, the venerable McDonald's (NYSE: MCD  ) French fry is a gateway to other items on the company's menu. But it's also a long-term weapon in McDonald's arsenal for continued global expansion.

McDonald's sells nearly 3.3 billion pounds of French fries globally each year. The company's three primary suppliers are McCain Foods, J.R. Simplot, and ConAgra's Lamb Weston unit. As McDonald's has expanded globally, its suppliers have also pushed into international markets in order to help McDonald's source ingredients closer to its stores in each country.

For a global quick-service restaurant operator like McDonald's, an obvious benefit of localizing the supply chain is proximity: If a company can buy most its menu item ingredients locally, transportation and import costs are reduced, which boosts gross profit. In the case of French fries, buying locally in international markets leverages that boost, due to processes that McDonald's pioneered. The company essentially reaps a markup on a product that is mostly finished when it takes delivery. From receiving bags of processed, blanched frozen fries, to tossing the fries into fryers, to placing the iconic, overflowing red and yellow fry box package on a customer's tray, the product requires minimal touches.

The model is similar to McDonald's soft-drink offerings. McDonald's buys concentrate from Coca-Cola  (NYSE: KO  ) and adds water at the point of sale, thus enjoying a considerable profit margin. Compare this to a typical burger, such as the Big Mac, for which McDonald's must source beef, lettuce, bread, onions, pickles, cheese, and "special sauce," while setting a price point somewhere between a specialty burger and a dollar menu McDouble. Every Big Mac must be assembled, whereas a Coke cup is either filled on an automated carousel or by the customer for a dine-in order. Similarly, multiple orders of fries can be fried in a single batch and simply scooped into packaging as orders are placed (or scooped and placed under heat lamps during peak periods).

Stealth weapon No. 2: The supply chain itself
Increasing the inherent margin in French fries by establishing supply beachheads around the world takes an enormous amount of planning, as one might imagine. McDonald's may take years to build a supply chain when entering a new market -- in the case of India, it prepared its supply chain for more than six years. When McDonald's expands, however, most of the cost of localization is borne by its suppliers, on handshake agreements. McDonald's non-contractual agreements with suppliers large and small is built on trust. Many of the company's major supplier relationships run deep and have extended for decades, however, and this enables a company like McCain Foods to make investments overseas in the hundreds of millions once it knows McDonald's will enter a market. McDonald's supply chain is essentially 100% outsourced, and it's one of the drivers that has produced a profit machine that its competitors have a hard time replicating:

 

MCD Operating Margin TTM Chart

MCD Operating Margin TTM data by Charts.

Contrast McDonald's operating margin to Yum! Brands (NYSE: YUM  ) , which owns outright distinct portions of its supply chain and has chosen to own its distribution system in China, and operate 20 logistics facilities within this system. 

Facilitating geographical expansion
Over the years, as more revenue has shifted to Europe and the grouping known as Asia, the Pacific, and the Middle East (APMEA), McDonald's model has enabled it to maintain it gross margins. In fact, local sourcing has contributed to a net growth in margin over the last 10 years. Below, you can see how the composition of revenue is changing: 

Segment 2002 2012
U.S. $5,423 $8,814
Europe $5,136 $10,827
APMEA  $2,368 $6,391
Other $2,479 $1,535
Total $15,406 $27,567

Source: Company SEC filings. All dollar figures are in millions.

 

During this period, as McDonald's hasn't ceded any gross profit; in fact, by localizing production and having most of that cost borne by trusted suppliers, gross profit is on an upward slope:


MCD Gross Profit Margin Quarterly Chart

MCD Gross Profit Margin Quarterly data by YCharts.

What works for McDonald's can also be a boon for large-scale suppliers with an entrepreneurial bent. For example, McCain Foods has invested in a potato processing facility in the Indian state of Gujurat, where it buys from local contract farmers who farm on McCain's 4,000 acres. As McDonald's expands in India, McCain is doubling its contract farming area to 8,000 acres. This will allow it to meet McDonald's demand, but also the growing demand for its own frozen products in retail outlets in India, and thanks to the non-exclusivity and informal arrangement with McDonald's, increased demand from Yum! Brand's KFC and Pizza Hut operations in India. McCain now sells its own branded frozen potato items produced in India to China, the Middle East, the U.K., and the U.S. 

Risk and opportunity
Potentially, the non-contractual nature of McDonald's supply agreements presents a risk should major suppliers such as McCain and J.R. Simplot decide to stop doing business with the company on short notice. Yet as long as McDonald's maintains its operating philosophy of trust-based vendor relationships and, moreover, continues to present growth opportunities to vendors lucky enough to transact with the Golden Arches, this risk should be minimal. As McDonald's suppliers extend their farming, storage, and distribution systems around the world, look for the humble fry to continue to support the company's revenue and industry-leading margins for years to come.

McDonald's continued international expansion proves that profiting from our increasingly global economy can be as easy as investing in your own backyard. The Motley Fool's free report "3 American Companies Set to Dominate the World" details how Mickey D's and two other retailers are taking consumer markets by storm across the globe. Click here to get your free copy before it’s gone.


Read/Post Comments (20) | Recommend This Article (35)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On June 28, 2013, at 1:18 AM, kthor wrote:

    McD's fries are usually old and stale ... in and out and jack and the box are the better choise ... usually hot fries and food unlike McD's 5-10 hour old food

  • Report this Comment On June 28, 2013, at 10:27 AM, mikecart1 wrote:

    It doesn't matter how close McDonald's can ship their fries. They have and will always be one of the leading unspoken about causes of most of the health problems in this country. If the obesity epidemic can be centered on a single food item in this entire country, across all age ranges and backgrounds, the french fry tops them all. Many restaurants still use oils and greases that lead to trans fat which is extremely hard to burn off - hence why all these diet failures where people appear to be eating a caloric deficit - only to see the weight drop suddenly stop. Oh, but we are talking about stocks!

    Yes, MCD all the way!!! :)

  • Report this Comment On June 28, 2013, at 11:02 AM, maninatl wrote:

    This is one of the sin stocks which make money by damaging peoples health. Personally I am attracted to the fries they sell even though I know that it produces trans fats and other health damaging substances. This stock is for investors who buy stocks of cigarette and alcohol companies. One needs a blunt conscience to buy this stock.

    But who cares about conscience these days when talking about investing!

  • Report this Comment On June 28, 2013, at 11:03 AM, spinindog wrote:

    McDonalds is like cigarettes and water.

    If you drink 20 gallons of water a day, it will kill you.

    If you smoke 20 cigarettes a day, it will kill you.

    If you eat fries every day, it will kill you.

    However, a gallon of water each day, the occasional cigarette after dinner, and the occasional pile of hot greasy fries will not harm anyone.

    Speaking of which, I haven't had any fries lately, and it is almost lunch time. Thank God I live in a free country where I can satisfy that urge in an adult manner without the government mandating baked fries only.

  • Report this Comment On June 28, 2013, at 11:09 AM, maninatl wrote:

    My above comment seems like I am parroting what many others are saying. I don't want to single out a company. Fast foods are generally not good for you. If you have some time to prepare food at home, you are making a good investment in yourself for the future.

  • Report this Comment On June 28, 2013, at 11:35 AM, CatchTwentyTwo wrote:

    Logistics is what is all about, and it sounds like McDonalds has it down to a science. I agree about the potential risk of no contract, hand shake agreements, but I think the opportunity to do business with the top fast food chain in the world (not the largest mind you, Subway wins for total number of stores but McDonalds crushes them in profit per store) is an extremely lucrative arrangement.

  • Report this Comment On June 28, 2013, at 12:21 PM, TMFfinosus wrote:

    To all commenting on the nutritional value of McDonald's fries, thanks for weighing in. But I would encourage everyone to take a step back, and understand that McDonald's is in the first phases of a multi-year initiative to improve the nutritional value of its menu: http://fastfood.ocregister.com/2011/07/26/mcdonalds-health-p...

    Also, in zeroing in on the menu, it's easy to overlook the positive economic impact the company has around the world. In the article I mention how McDonald's enables McCain to invest in India. The 8,000 acres that McCain owns in a single location in a single state in India employs local potato farmers, and this type of development means opportunity for many who are on the margins of the global economy. I think that in some ways McDonald's is a more socially conscious investment than most people realize. I'm not trying to excuse the company for its contribution to health problems around the globe, but I do think that the truth is more complex than most of us see at first blush.

    The sheer numbers of people employed by McDonald's restaurants (both directly and indirectly through the supply chain) is staggering, and in developed countries we often miss how important such a global employer can be to those who have aspirations to be able to buy a pack of fries just like you or me with their discretionary income.

    So yes, by all means let's discuss the health impacts of MCD's product. But -- just sayin' -- let's also be impartial enough to recognize both MCD's effort to improve, and the real benefit it brings to the world's economy.

  • Report this Comment On June 28, 2013, at 12:50 PM, daveandrae wrote:

    Great article!

    I'm going into my 11th consecutive year as a McDonald's shareholder.

    As for MCD being a "sin" stock...please.

    When a share price goes up EIGHT FOLD over ten years AND yields 24% cash on your cost basis every investor on the planet wishes he been buying this stock at 13 in 2003 like I was.

  • Report this Comment On June 28, 2013, at 1:58 PM, RRobertsmith wrote:

    no mention of how the margins WILL SUFFER after the minimum wage is reset upwards....this stock is very overextended on hopes of expansion into china...(what happens if they get their a$$ests kicked there)?

  • Report this Comment On June 28, 2013, at 3:08 PM, jimwnorton wrote:

    The real secret to McDonald's financial success is their international operations. In the USA, they have a lot of competition. However, in most international markets, they have very little competition.

    McDonald's invested in international markets way before their US competitors began to enter foreign markets. Take a look at how much of their profit comes from international (over 60% I think).

  • Report this Comment On June 28, 2013, at 7:53 PM, TMFfinosus wrote:

    RRobertsmith,

    The minimum wage reset will effect many companies, not just MCD. I've seen long-term data on both the positive and negative effects of minimum wage hikes; personally I believe that wage hikes get absorbed into economies that are growing, as it looks like the U.S. economy is poised to do.

    On your second point, please take a look at another article I wrote on this very topic (MCD in China). Not so sure that the stock is overextended based on China. http://www.fool.com/investing/general/2013/06/10/mcdonalds-a...

    Thanks for commenting!

    Asit

  • Report this Comment On June 28, 2013, at 9:03 PM, Fracguy wrote:

    Everyone should already know that fries and soft drinks is where fast food companies make their profit. Why do you think the want you to supersize? It goes straight to the bottom line.

  • Report this Comment On June 29, 2013, at 11:36 AM, swiver wrote:

    I had some 2 days ago on a cross-country drive in the US. Too thin, too much salt, very little taste, and what there was was starchy. Really miserable, and they hadn't any malt vinegar.

    Give me the good old English chip anyday!

  • Report this Comment On June 29, 2013, at 1:51 PM, TMFfinosus wrote:

    Pub chips and malt vinegar are hard to beat, I agree...

    Asit

  • Report this Comment On July 02, 2013, at 11:43 AM, dsciola wrote:

    Perhaps dumb questions...

    but why cant YUM or any other comp do what MCD is doing here, via its supply chain and possibly meet or beat MCD's Op Margin and/or its overall global growth?

    Feel free to enlighten me.

    Dom

  • Report this Comment On July 05, 2013, at 11:47 AM, TMFfinosus wrote:

    Hi Dom,

    Here's my 2 cents: I think that in the case of YUM, their model calls for very fast and aggressive expansion into China. So they are almost compelled to own some of the supply chain themselves. They want to conquer the market as quickly as they can, and that contradicts the idea of taking your time to work with local suppliers (or have your multinational suppliers of choice build out their operations). This grabs more revenue off the bat, but it comes at the expense of those long-term margins. It's a trap that most of MCD's competitors have fallen into since the 1960s! It's hard to be patient in new markets, but I believe MCD is going to follow the strategy that has always worked for them.

    Just my opinion on your question -- thanks for asking.

    Asit

  • Report this Comment On July 05, 2013, at 1:35 PM, Superball wrote:

    I have not eaten at a McD's in 2 years, but I do occasionally go in for a coffee (which is quite good and inexpensive). I do appreciate, however, that if I am on a road trip with friends and they insist in McDs, I know they have some reasonably healthy options like their oatmeal (skip the sugar) and yogurt/fruit meals. I like how McDs recognizes that their food is not healthy and provides options for those that are more health conscious.

    So while I will not buy an oil stock or cigarette stock, I did buy stock in McDs. I am very happy to hear about their suppliers using local food producers. I hope others will agree that there is more to like at McDs than just the heart attack fries.

  • Report this Comment On July 05, 2013, at 4:07 PM, klausmager wrote:

    I see enormous risk in this stock. The kitchen operations in a McDonald's restaurant are so specialized, there isn't a knife to be found. They would be unable to adjust and adapt to a truly local, organic supply.

    The impact McD has on agriculture is toxic. Imagine thousands of restaurants, all with the same menu, looking for the same ingredients on a year round basis, no room for seasonality.

    This is the primary driver of industrial farming and GMO crop development. It requires massive amounts of oil based fertilizers, causes massive pollution, and basically turns precious top soil into sand. Then ee are taking out rainforest in South America to increase land to raise cattle.

    Climate change is happening, just look at the news. Agriculture will have to go local, work with seeds specialized to local soil and weather, restore organic soil to capture carbon and raise nutritionally sound foods. That is in direct conflict with McD business model.

    Another even greater risk factor is related to GMO's. Coke is full of GMO high fructose corn syrup. McD products everything is GMO. Once the public catches on to that, you could see a reaction similar to "pink slime", the health implications of consuming GMO products are quite clear, even the US medical association has come out with an announcement already.

    Ethics or not, this is a high risk business.

  • Report this Comment On July 05, 2013, at 4:17 PM, anonymous13 wrote:

    I don't know how much of McD's profit margin comes from paying most of their employees a below-poverty line wage, but I am sure it is a substantial component. That puts them in company with most large corporations. And the excuse is always the same: we need to keep salaries down, so we can stay in business. Same does not apply to executive salaries and bonuses. Just because everyone is doing it doesn't make it right. It is one reason why I rarely patronize their franchises.

  • Report this Comment On July 07, 2013, at 10:41 AM, twb311 wrote:

    Thanks TMFfinosus for a great article. I hope everyone takes a moment to examine the facts about McDonald’s and it’s food. I should state up front that I am an employee of McDonald’s, but I am not a spokesperson and these views are mine FWIW.

    McDonald’s was my first job and now 20 years later I am still working for this great company. I strongly disagree that McDonald’s is the cause of most health related problems in this country. McDonald’s does not make money by damaging people’s health. I’ve eaten McDonald’s nearly all my life, but I also exercise, watch what I eat and try to maintain a balanced lifestyle. I just received the results of my most recent physical and have a clean bill of health. I’m living proof that one can eat McDonald’s and still live a healthy life.

    McDonald’s removed the supersize fries and drinks from it’s menu nearly 10 years ago and IMO that was a good move towards limiting caloric intake.

    http://www.nbcnews.com/id/4433307/ns/business-us_business/t/...

    McDonald’s USA has always used 100% USDA-inspected beef. McDonald’s USA does not use ammonia-treated beef (aka pink slime) in our hamburgers and it has been out of the system since 2011.

    http://abcnews.go.com/blogs/health/2012/02/01/mcdonalds-anno...

    McDonald’s uses a Canola blend cooking oil. All fried menu items in McDonald’s U.S. restaurants are now 0 grams trans fat per serving. This includes French Fries, Hash Browns, all non-grilled chicken choices and the Filet-O-Fish.

    http://www.mcdonalds.com/us/en/food/food_quality/see_what_we...

    I’d invite everyone to visit McDonald’s What We Are Made Of website which gives more facts about McDonald’s food and shares some true stories about the suppliers mentioned in this article.

    http://www.mcdonalds.com/us/en/food/food_quality/see_what_we...

    Finally, McDonald’s is not a dead-end job. Nearly 50% of our corporate restaurant managers started as crew and so did more than 60% of our owner/operators. McDonald’s offer flexible schedules; provides training and education and many other additional benefits.

    http://www.mcdonalds.com/us/en/careers/working_here.html

    In the end, McDonald’s is not a perfect company, but I believe they are committed to being a socially responsible partner in this world we all love.

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