Congrats to McDonald’s Corporation (NYSE:MCD) and to any investors with the fortitude to hold onto their MCD stock headed into McDonald’s earnings report on Tuesday morning. Shares were up 33% since the end of last year, setting the stage for a sizable pullback had the company not delivered good news. The fast food chain’s third quarter was a good one though, and McDonald’s stock managed to edge its way a little higher following the news.
With the dust settling now, longer-term-oriented investors are starting to ask key questions that could still affect the restaurant’s future in a big way. Namely, they want to know if the move away from company-owned restaurants and toward more franchisee-owned units is paying off.
The jury is still out.
McDonald’s Earnings Under the Microscope
Depending on who you ask, McDonald’s either met, slightly beat, or just missed last quarter’s expectations. The MCD stock earned $1.76 per share on sales of $5.755 billion, as same-store sales grew 6% on a year-over-year basis.
The lack of a strong consensus estimate is forgivable this time around.
The organization has been shifting some of its owned and operated restaurants to franchisees in Hong Kong and China, changing the business model altogether. Owning its restaurants means the company aims to turn a profit by directly serving customers. A year ago, McDonald’s operated 6,056 of its own stores, but that number’s been pared back to 3,230. At the same time, the number of franchised stores has grown from 30,559 to 33,746. All told, it’s trying to shed 4,000 of its corporate-owned units, hoping the maneuver will improve margins.
The franchise model shifts the profitability burden to the franchisee, and the parent organization simply collects higher-margin but ultimately smaller royalty revenue. The $64,000 question is, has it paid off? It’s not yet clear.
Last quarter’s net income of $1,883.7 billion is impressive to be sure, up 47% from the Q3 2016 bottom line of 1,275.4 billion despite the 10% decline in revenue, which is one of the side effects of shedding company-owned units for franchised stores. Take the figures with a grain of salt, though. The company gained a $828.9-million benefit for “the gain on the Company’s sale of its businesses in China and Hong Kong of approximately $850 million, partly offset by $111 million of unrelated non-cash impairment charges.” Take that amount out of the picture, and McDonald’s only earned $2,250.5 billion in operating income last quarter. That’s better than the year-ago tally of $2,137.3 billion, though not by very much.
Still, broadly speaking, the shifted business model appears to be paying off in terms of better margins, except for one important arena. Profit margins for the U.S.-based units the parent company still owns fell and by more than a little bit. All told, margins for corporate-operated United States units fell from 16.9% in the third quarter of 2016 to 15.5% this time around. Margins from all other sources improved YOY.
A fluke? Maybe. Perhaps the consistent promotional activity like $1 drinks and value-oriented offers that kept a steadier stream of customers coming in the doors ultimately cost the company more than it was forced to spend in the comparable quarter a year earlier.
Or, maybe it’s a microcosm of the increasingly difficult restaurant market environment that’s made even tougher by the higher wages and benefits workers can now command in the marketplace.
Whatever it is, it’s something working against the company in a small way in its owned restaurants right now, and it will eventually work against its franchisees should the trend not change. And it’s not like the parent company has the best of relationship with its franchisees to begin with, with many of them lamenting misguided decisions from the chain’s corporate chiefs.
Bottom Line for MCD Stock
The shift toward more franchisees and fewer corporate-owned units is neither a reason to buy or sell MCD stock. But it is a reason to scrutinize McDonald’s going forward. The shift more or less looked like it worked last quarter, though not decidedly so. And, while franchisees were willing to absorb the few thousand stores the company wanted to shed, the costly reality of ownership could dampen demand for new franchises going forward.
It’s still ultimately about pulling people into its restaurants and extracting more revenue from them without having to spend more money to do so, whether it’s the franchisee or the franchiser that does it. Last quarter’s results don’t exactly paint a clear picture either way.
As of this writing, James Brumley did not hold a position in any of the aforementioned securities. You can follow him on Twitter.