McDonald's(NYSE:MCD)arches are looking golden once again. The company just posted its strongest quarter in four years, led by a 5.7% jump in U.S comparable sales. Its all-day breakfast launch was the key driver in domestic growth.
New CEO Steve Easterbrook has rolled out a number of changes, including new Pick 2 for $2 offerings to replace the Dollar Menu, the Buttermilk Crispy Chicken sandwich, and a pledge to remove antibiotics from all chicken it serves and to eventually switch to cage-free eggs.
While the all-day breakfast launch and other menu changes are pushing sales in the right direction, Easterbrook's biggest decision may be to refranchise 4,000 restaurants in order to free up capital to return to shareholders. Easterbrook's long-term goal is for 95% of McDonald's restaurants to be owned by franchisees, up from 81% today. The strategy follows in the footsteps of its fast-food brethren, Restaurant Brands International's(NYSE:QSR)Burger King and Wendy's(NASDAQ:WEN), which have seen strong earnings growth as a result of refranchising. Here are some of the benefits to this strategy.
It's an asset-light model
McDonald's plans to trim $500 million in annual general and administrative costs over the coming years. Relieving itself of the capital expenditures required to rebuild and maintain restaurants is its primary tactic for cutting those costs.
Selling restaurants back to franchisees is also a way of putting the burden of upgrading restaurants, as McDonald's has been doing, onto its franchise partners. Not surprisingly, Wendy's and Burger King's refranchising efforts have come as they're rolling out major upgrades to their stores. Wendy's plans to revamp 60% of its North American stores by 2020, adding features like lounge seating, fireplaces, and Wi-Fi. At the same time, it's selling hundreds of stores back to franchisees.
McDonald's, meanwhile, has been in the midst of its own store improvement program, adding wooden tables, faux leather chairs, and other features to make its stores more comfortable. Chances are the stores being sold back to franchisees are still in need of upgrades.
Immediate cash inflow
McDonald's Founder Ray Kroc famously said, "We are in the real estate business; not the hamburger business." The fast food entrepreneur saw franchising as the company's main business, not food service. The beauty of the franchise model is that McDonald's can cash in on the real estate it has developed and collect rent and royalty checks.
Selling those properties is another way for the company to cash in on its real estate. Though McDonald's rejected the idea of a REIT spinoff, it has begun unloading valuable real estate. In the third quarter, it sold two properties worth nearly $30 million and netted a gain of $135 million for the full year.
It's unclear how much McDonald's would receive by selling its restaurants back to franchisees, but the sum total would likely be substantial. For franchisees to open a restaurant, the per-store fee is $45,000.
If it works . . .
Burger King was able to double its net income from 2012 to 2013 when it unloaded nearly all of its remaining 418 company-owned restaurants. That move sacrificed $105 million in restaurant-level operating profit but resulted in an $85 million increase in franchise-level profit and helped the company cut $105 million in general and administrative expenses.
McDonald's is hoping for some similar magic. Based on its 2015 results and per-restaurant averages, the company would lose $388 million in operating profit by refranchising 4,000 restaurants -- but that difference would be more than compensated by the $500 million in general and administrative costs the company plans to cut.
There are, of course, risks to the strategy. McDonald's relationship with its franchisees reached all-time lows recently, though that may have changed with last quarter's upbeat results. The refranchising strategy will increase the company's dependence on franchisees and their cooperation. McDonald's is also planning to take on more debt to buy back shares, which brings its own risks of weighing down the balance sheet. However, refranchising will ensure a more stable cash flow, and if McDonald's can fulfill its promise of cutting $500 million in expenses, the company should emerge more profitable.