With nothing more than a passing glance, it doesn't seem like that big of a deal. Fast food chain McDonald's (MCD 0.51%) hasn't raised its franchise royalty rates in nearly three decades, after all, despite bolstering its powerful brand name during that time stretch.
Besides, the royalty increase from 4% of sales to 5% of sales only applies to new (or newly acquired) stores, and the company isn't actually opening a lot of new restaurants these days. It only established 266 new units last quarter, which is a drop in the bucket compared to its total of 40,801. Those already-established locales will continue paying their current franchise royalty rate of 4% -- at least, for now.
Given all the other fee increases the company has imposed just within the past few years, however, this latest move underscores the idea that McDonald's is struggling to drive new, meaningful growth. That should be a concern for any current and would-be shareholder.
McDonald's unique business model
Don't misread the message. McDonald's is anything but doomed. Its name and logo rank among the world's most recognized and most loved. Plenty of new franchisees will willingly pay the higher royalty rate for the right to use one of the most marketable brand names in the world.
The company isn't making it easy though. It's slowly nickel-and-diming prospective and even current franchisees to the point of revolt. Note that most McDonald's stores aren't actually owned by the company. The bulk of them (38,674 of the aforementioned 40,801, to be precise) are owned and operated by franchisees. The company itself only owns 2,127 of its own locations.
And that is no small matter. This model puts the bulk of the financial risk on the franchisee, as the royalties in question are based on sales rather than profits. It's conceivable that an operator whose business is beneficial for the parent company could still lose money if their costs are greater than that store's revenue.
Then there are the costs above and beyond royalties. McDonald's operators must purchase their supplies from the parent company or an approved supplier, regularly spend money on remodeling, and participate in promotional efforts.
Perhaps most noteworthy, however, is that franchisees don't actually own the real estate on which their stores operate. McDonald's does, charging them market-based rent based on a percentage of a particular store's (hopefully growing) sales. That's dramatically different from most other restaurant franchise models.
The nickels and dimes add up
If the nuances of McDonald's franchise agreement seemingly establish ways for the parent company to financially squeeze restaurant operators, most of its franchisees would probably agree.
Take the late-2020 surprise increase in so-called "technology fees" as an example. Already struggling with the impact of the COVID-19 pandemic, the franchisor announced it would be implementing its long-looming but never-enacted $423 increase in monthly technology fees in March of the following year. That's also when McDonald's Corporation decided to stop sending out $300 monthly subsidies to help support the sale of Happy Meals.
After a third-party review of them, the parent opted to reduce these technology fees to the tune of 62%. But it required a contentious review process to make it happen.
And that was hardly the only instance where the parent has wound up increasing payments from owners/operators. In 2017, the company began a sweeping and costly remodeling program of most of its U.S. locations. Although McDonald's itself was willing to cover a little over half of these costs, this assistance came with conditions that required other outlays.
The irony? Shortly thereafter, McDonald's raised rent payments on many of these newly improved locations. These higher costs are making it more difficult for restaurant operators to afford higher wages required to attract and retain workers now.
This single statistic sums up the impact of all these measures: While McDonald's 2022 revenue was roughly even with 2021's top line, and same-store sales were up to the tune of 11%, the independently run National Owners Organization (of McDonald's franchisees) reports the average restaurant's overall cash flow actually declined by $100,000 last year thanks to these continued cost increases.
That's not a recipe for long-term success. That's also why prospective as well as current franchisees are now having second thoughts about working with the chain or sticking with it.
McDonald's stock isn't for everyone
Don't panic if you own a stake in McDonald's. The franchisor usually works things out with its franchisees. The two parties know they need each other. If nothing else, the parent company's cash flow and subsequent dividend will be fine for the foreseeable future.
Do connect the dots, though. Neither ongoing price increases (driven by ordinary inflation) nor the continued opening of new restaurants at previously established royalty rates seems to be a satisfactory growth driver any longer. The company is now repeatedly seeking out small, subtle, and contractual ways to rekindle its waning top- and bottom-line growth.
If that's the best option McDonald's can come up with, it may be a hint that it's exhausting all other known options. Indeed, given how saturated the fast food restaurant business now is -- IBIS World says there are over 200,000 of them in the United States alone -- there may be few other options left. (At the same time, it's never been more expensive to run and own a fast food business.)
If all you care about is the dividend, you'll be fine for at least a few more years. If you also need a bit of sustained growth, however, there may be better options out there than this one.
