After news broke on May 28, 2014 that McDonald's (NYSE:MCD), the largest restaurant chain in the world, was initiating a bold three-year plan to return as much as $20 billion to shareholders, the stock inched up 1%. While the company's ambition may seem like good news, this change in corporate strategy represents a major change for the business. Fortunately, the information released by the company can allow us to get a grasp on what this means for the business and its shareholders moving forward, but in order to do so, it's imperative to look at the fallout of refranchising on another big restaurant player; DineEquity (NYSE:DIN).
McDonald's has high hopes
In spite of recent fears that its growth is slowing, McDonald's is confident enough in its core business to increase how much it is distributing to shareholders in the years ahead. In the past three years, the restaurant giant has handed shareholders a whopping $16.4 billion in the form of buybacks and dividends. From the start of 2014 through the end of 2016, the company hopes to increase this distribution to between $18 billion and $20 billion.
Also included in its plan, is the company's goal to refranchise 1,500 of its existing stores. What this means is that the company hopes to sell at least that many of its company-owned restaurants to franchisees. At first glance, this move may raise some eyebrows but the fact is that McDonald's will see both positive and negative side effects from this decision.
Refranchising might make sense but downside exists
One of the biggest players in the refranchising business happens to be DineEquity, the parent company of Applebee's and IHOP. In exchange for forgoing future revenue from those locations, the company has been pledged a percentage of each restaurant's sales into perpetuity. This approach typically reduces the parent's revenue but has the upside of bringing in higher margins. That's because the payments it's entitled to are like royalties, which carry little associated costs.
Today, approximately 99% of DineEquity's operations are franchised locations, up from 88% in 2009. As a result, the company's revenue has dropped 55% over the past five years from $1.4 billion to $640.5 million, but its net income has soared 129% from $31.4 million to $72 million.
As of its most recent annual report, McDonald's also has a sizable portion of its restaurants, approximately 81% of its total locations, under this type of arrangement. This represents an increase over the 80.7% of locations franchised five years earlier. Despite this massive exposure however, McDonald's generated just 32.8% of all revenue from these chains while the remaining 67.2% of sales came from the business's company-owned operations.
If McDonald's can achieve its goal of refranchising an extra 1,500 locations while continuing to add 1,100 locations globally each year (its goal for 2014 projected into 2015 and 2016), then the number of restaurants franchised will fall to about 78% of all locations. Unlike DineEquity, whose focus has been to maximize its exposure at the cost of revenue, McDonald's will see its top-line rise but its margins will likely contract using this strategy.
Right now, McDonald's is placing a lot of emphasis on rewarding its shareholders, but it's also important to remember that the business hasn't given up on growth. While management might be better off focusing on growing the business more than increasing buybacks and dividends, its goal of refranchising at least 1,500 locations is a start.
The upside to this objective is that sales will grow, but management does appear to be making a conscious decision to accept smaller margins if the business can grow its total number of locations in operation at the rate forecasted. In the near-term this will probably make a lot of investors happy, but the high margins of McDonald's won't be quite as high as they are today.