With 37,000 locations across 120 countries, McDonald's (MCD 2.14%) is easily the biggest restaurant chain in the world. The fast food titan is also among the most profitable companies on the market. Despite a weak operating year in 2016, its 20% profit margin places it 9th from the top among the 30 members of the Dow.
It might surprise you to learn that most of those earnings weren't produced directly through the sales of trademark menu products like Quarter Pounders, Chicken McNuggets, or Big Macs. Instead, Mickey D's market-thumping profitability is thanks to the rent, royalty income, and fees it collects from its army of franchisees.
Selling franchises, not burgers
McDonald's runs a franchising business model under which it trades access to its brand, its operating infrastructure, and its resources to restaurant operators -- for a hefty price. These entrepreneurs pay an initial fee at the start of their franchise. They also send in an ongoing royalty that's based on a percentage of their sales. Finally, franchisees pay McDonald's rent for the property that, by the way, can't drop below a certain rate and is set on 20-year terms.
This approach is an incredibly efficient way to run -- and expand -- a fast food empire. Since the franchisee puts up all the capital, McDonald's can quickly scale up its market footprint with almost no financial risk. It also benefits from the fact that rent and royalty fees carry much higher margins than do direct markups on fast food sales. That's how its profitability stays around 20% of sales, or roughly double the best that Chipotle (CMG 1.70%) could manage before its food-safety scare problems pushed results lower last year. The burrito specialist doesn't franchise at all, opting instead to own all its locations.
There are significant trade-offs to a franchising setup. Among the biggest is the fact that McDonald's has little control over the employees who serve as the main point of contact between the corporation and its customers. While Chipotle places significant emphasis on attracting and grooming the best crew that it can with an eye toward developing them into management positions, McDonald's leaves those kinds of decisions up to each individual franchise owner. The corporation also has little say in how the franchisee chooses to market and price its menu, or whether it is taking all the right steps to protect the brand.
Opting for higher profits
Yet this setup is extremely profitable. Most of McDonald's revenue comes from the 15% subset of its restaurant base that it directly owns and operates. Last year, those locations generated $15.3 billion of sales, compared to the $9.3 billion the company booked in revenue that came directly from franchisees who run the remaining 85% of its fast food restaurants.
However, the picture changes dramatically when you look at the bottom line. McDonald's only generated $2.6 billion of raw profits from its company-owned stores last year but collected $7.6 billion -- almost three times as much -- in rent, royalties, and fees from franchisees.
Given the impressive financial benefits, it's no wonder that McDonald's has decided to double down on this business model. It plans to sell 4,000 of its company owned locations to franchisees this year on the way toward reaching a 95% franchised business over the long term. What the company gives up in fast food sales through this move is likely to be far offset by increased earnings.
McDonald's still needs to find answers (like mobile ordering and delivery) to the market share problem that has sent customer traffic down for the past few years. But whether it quickly achieves an operating rebound or not, the company is likely to see its profit margin increase as it commits even deeper to its franchising business model.