McDonald’s (NYSE: MCD) is the largest and best-known fast food brand in the world. The company has been incredibly successful: by 2015 it operated 36,258 locations in 119 countries and claimed to serve 69 million customers every day.
McDonald’s business model is a simple one. It offers a consistent dining experience, quality food and fast service in its locations. Around 80% of the restaurants are franchised—which means that they are owned by an entrepreneur that purchases the right to use McDonald’s brand and sell its products. Franchise owners also gain access to McDonald’s system of cooking and selling food and its extensive advertising and marketing resources.
Even though it operates globally, McDonald’s is heavily dependent upon the American market. Around 40% of its operating income is generated by its locations in the United States. Another 40% comes from a few other countries, including Australia, Canada, the United Kingdom, Germany and France.
McDonald’s greatest strength is its highly recognizable brand name. Most people equate McDonald’s with fast food and a few specific entrees such as hamburgers and French fries. Some observers credit McDonald’s with changing the world’s eating habits by introducing fast food to the world.
Despite its fame, McDonald’s has been struggling with declining market share and revenues in recent years. McDonald’s reported revenues of $26.02 billion in June 2015, a drop of $2.28 billion from June 2014, when the chain reported revenues of $28.3 billion. Falling revenue indicates that McDonald’s sales are declining sharply, which means it is having a difficult time maintaining market share.
Shrinking market share does not seem to have hurt profitability at McDonalds; it reported a profit margin of 18.5% and a net income of $4.18 billion on June 30, 2015. McDonald’s is also very popular with investors because of the high returns and dividends it delivered. It was still able to reward shareholders with a dividend yield of 3.31% and a return on equity of 32.35% on June 30, 2015.
One of McDonald’s greatest strengths is the number of countries it operates in. The company generates around 60% of its revenue outside the United States. That means it can survive declining business in the U.S. market, unlike some of its rivals, such as Burger King, which gets 98% of its income from U.S. sources.
The Crowded Fast Food Market
The biggest problem that McDonald’s faces is the increasingly crowded and competitive fast food market in the United States. Challenges in the industry include the changing tastes of customers and a growing variety of direct competitors. McDonald’s biggest competitors in the United States include the privately-held Burger King, Starbucks (NYSE: SBUX), the privately-held Subway and Yum Brands (NYSE: YUM)—owner of Pizza Hut, Taco Bell and Kentucky Fried Chicken.
Observers think the biggest threat to McDonald’s business comes from next generation quick service restaurants such as Chipotle Mexican Grill (NYSE: CMG). On June 30, 2015, Chipotle reported revenues of $4.441 billion, or nearly four times those of the well-known fast food chain Jack in the Box (NASDAQ: JACK), which reported revenues of $1.531 billion on the same day. Chipotle’s revenue has more than doubled in recent years, rising from $2.04 billion in 2011 to $4.441 billion in 2015.
The biggest potential threat to McDonald’s business comes from quality burger chains like Shake Shack (NYSE: SHAK) and the privately held In-N-Out Burger. These restaurants employ Chipotle’s business model of selling high-quality food at a reasonable price in a quick-service setting, but they compete directly against McDonald’s by offering higher-quality versions of its main products: hamburgers and French fries.
One problem facing McDonalds is that many consumers view its food as a lower-quality product than that served at restaurants like Shake Shack and Chipotle. Some customers also see McDonald’s food as less healthy than competitors or the brand itself as a lower-class establishment that caters to the poor.
The real danger for McDonald’s is that these quality chains could move into the chain’s other large markets, such as Canada, the United Kingdom, Australia, France and Germany, which account for 40% of its revenues. That could cut the foreign revenue, which has offset McDonald’s recent losses in the U.S. It could also force the company to make expensive changes to its menu and restaurants in those markets simply to survive.
The increased competition in the U.S. has forced McDonald’s to begin making drastic changes to its operations. In 2015 the company announced salary increases at its company-owned stores, plans to serve breakfast items all day and the elimination of eight items from its iconic menu. Management also dropped hints that other innovations, such as higher-quality items on the menu, would be forthcoming.
The nature of these changes was unclear, but they could lead to higher operations costs, which could further cut revenues. Other potential problems that could arise from these changes include the possibility of a franchisee revolt; news stories indicate that some franchise operators are not happy with the proposed innovations and loss of loyal customers that value the consistency of McDonald’s traditional menu.
The Bottom Line
The bottom line is that McDonald’s is still a very good company that generates a lot of revenue. It still has a strong brand that can attract large numbers of loyal customers.
If it can successfully reform its menu and business to adapt to changing times, McDonald’s should survive as the dominant fast-food brand for decades to come. Even though its business will continue to shrink for the foreseeable future, McDonald’s should remain a very profitable company and a solid investment.