Operating margin for a quick-service-restaurant franchisee in the US

Quick-service-restaurant (QSR) brands such as McDonald’s, Domino’s Pizza are franchisors that allow qualified individual investors to operate stores using their brand names and operational formula in general. These investors become franchisees. So, roughly in the US, how much is the margin for franchisees?

I looked at Domino’s Pizza’s latest annual report and came up with some estimations.

Besides franchising out stores, Domino’s Pizza also runs some owned restaurants by themselves. Self-owned restaurants provide a great reference to pitch future investors and test out new technologies and operational practices. How big is operating margin for the brand’s self-owned stores?

Source: Domino’s Pizza

Cost of sales for US company-owned stores in 2019 was about $346 million while revenue was $454 million. That put operating margin at around 24%. Even though each franchised store will have a different cost structure, it’s reasonable to assume that is a good starting point to look at this issue. However, 24% is just operating margin for the brand without any cost related to the franchise agreement. Here is how Domino’s Pizza describes its franchise agreement:

We enter into franchise agreements with U.S. franchisees under which the franchisee is generally granted the right to operate a store in a particular location for a term of ten years, with an ability to renew for an additional term of ten years. We have a franchise agreement renewal rate of approximately 99%. Under the current standard franchise agreement, we assign an exclusive area of primary responsibility to each franchised store. Each franchisee is generally required to pay a 5.5% royalty fee on sales as well as certain technology fees. In certain instances, we will collect lower rates based on certain incentives.

Our stores in the contiguous United States currently contribute 6% of their sales to fund national marketing and advertising campaigns (subject, in certain instances, to lower rates based on certain incentives and waivers). These funds are administered by Domino’s National Advertising Fund Inc. (“DNAF”), our consolidated not-for-profit advertising subsidiary. The funds are primarily used to purchase media for advertising, and also to support market research, field communications, public relations, commercial production, talent payments and other activities to promote the Domino’s brand. In addition to the national and market-level advertising contributions, U.S. stores generally spend additional funds on local store marketing activities.

Source: Domino’s Pizza

Essentially, there are three main expenses from a franchise agreement: a fixed upfront fee, a monthly royalty fee of 5.5% of sale and a contribution of 6% to the national marketing and advertising campaigns. First of all, a fixed upfront fee which can easily be more than $20,000 is a significant sum that can generate interest in another investment opportunity. However, for the sake of simplicity, let’s ignore that. Second, a franchisee will have to pay a 5.5% haircut every month to the brand, which lowers the margin from 24% to 18.5%. Additionally, there is also a required contribution of 6% of sale to the fund for marketing and advertising purposes. Now, there are two ways to look at this: whether Domino’s Pizza’s definition of “cost of sales” already consists of marketing and advertising expenses that are on top of the fund.

If it does, then franchisees’ operating margin, after the royalty fee, may stay at 18.5%, even though it’s entirely possible that each store may run additional activities on their own dimes. However, it’s worth noting a couple of more things:

  • Some franchisors lease lands/buildings to franchisees with margin on top of their own expenses. It means that franchisees’ operating margin will take another small hit
  • Franchisors like Domino’s Pizza also sell supplies and ingredients to franchisees at profit. Even though there is a profit-sharing scheme, Domino’s Pizza still stands to make around 6-11% margin, implying another hit to the margin of franchisees

We believe our franchisees voluntarily choose to obtain food, supplies and equipment from us because we offer the most efficient, convenient and cost-effective alternative, while also offering both quality and consistency. Our supply chain segment offers profit-sharing arrangements to franchisees who purchase all of their food for their stores from our centers. These profit-sharing arrangements generally offer participating franchisees and Company-owned stores with 50% (or a higher percentage in the case of Company-owned stores and certain franchisees who operate a larger number of stores) of their regional supply chain center’s pre-tax profits. We believe these arrangements strengthen our ties to and provide aligned benefits with franchisees.

Source: Domino’s Pizza

In sum, I used only Domino’s Pizza as an example in this post, but it’s the standard formula across QSR brands. Read any publicly available annual reports and you’ll see that. Some franchisors have higher operating margin for their owned stores (Domino’s Pizza is among the ones with the highest margin) than others. Some may require a lower royalty fee rate than others. However, I don’t think QSR franchisees have a great operating margin. It’s true that they can raise prices to make up for additional expenses compared to the expenses of franchisors’ owned stores. Nonetheless, given a cut-throat competition in the QSR industry and Food & Beverage in general, they can only increase prices so much before losing customers.

Understanding YUM! (Owner of Taco Bell, KFC and Pizza Hut brands)

Yum! was founded in 1997 as Tricon Global Restaurants under Pepsi and spun off in the same year. Headquartered in Kentucky, the company was rebranded as YUM! in 2002. As of 31st December 2019, YUM! “franchises or operates a worldwide system of over 50,000 restaurants in more than 150 countries and territories, primarily under the concepts of KFC, Pizza Hut and Taco Bell”, according to its latest annual report. Let’s get to know a little bit about the business that owns and operates three brands that are well-known among Americans and thousands around the world.

Business Description

YUM! revenue comes from two primary sources: Company Sales and Franchise Revenue. Company Sales refers to the sale of food items at company-owned restaurants which make up about 2% of YUM’s total restaurants. Franchise revenue includes upfront fees in order to be a franchisee, continuous percentage of monthly revenue (typically around 4-6%) and contribution to advertising. In terms of expenses, YUM! is responsible for all expenses at their own stores. For franchised stores, YUM!’s costs consist of lease, depreciation of the buildings/lands that YUM! owns and leases to franchisees, direct marketing support and others.

Over the past 5 years, the new unit growth rate is pretty steady at the mid single-digit while the franchise segment makes up an increasing part of the whole business

The shift towards franchise is understandable, if you look at the margin of company sales and franchise revenue. In 2019, YUM’s own restaurants’ margin stood at 20% while margin of the franchise segment was almost 93%.

The company sales decreased by over 50% in 2019 compared to 2017 level. Franchise and property revenue continued to the biggest revenue generator for YUM!. The company-wide operating margin stood at a respectable 34% in 2019, even though it is down from 46% in 2017.

KFC Division

As of the end of 2019, there were about 24,000 KFC restaurants under YUM!, of which 83% were outside the US and 99% were operated by franchisees. Revenue has been declining since 2019 due to the drop in company sales and shift towards more profitable franchise model which helped push operating margin

Franchise revenue rose to 56% of KFC’s total revenue in 2019, up from 38% in 2017. While restaurant margin largely remained at 15%, franchise margin rose by 400 basis points in 2019, compared to 2017.

Pizza Hut

As of the end of 2019, there were around 18,700 Pizza Hut stores, of which 61% were outside the US and 99% were operated by franchisees. Revenue for Pizza Hut has been on the rise since 2017, albeit the fact that its operating margin slightly dipped

While restaurant margin fluctuated as the company didn’t even make money at its own stores in 2018, franchise margin has been on the rise, reaching 93% in 2019. As in the case of KFC, YUM! shifted Pizza Hut’s model towards franchise model which made up 56% of the chain’s total revenue in 2019

Taco Bell

Taco Bell has much smaller footprint than its siblings under YUM!. As of the end of 2019, there were around 7,300 units of which 92% were in the US and 94% were operated by franchisees. Revenue has been on the rise while operating margin remains steady at around 30-35%

Franchise revenue made up a smaller chunk of total revenue for Taco Bell than it did for Pizza Hut or KFC. While franchise margin is in the same ballpark as that of the other two brands, restaurant margin is much higher for Taco Bell

The difference in restaurant margin, overall operating margin and the number of stores explained why KFC led the way at YUM! in terms of franchise sale contribution and operating profit contribution while Taco Bell was the leader with regard to restaurant sales

Even though these fast food chains share the same high franchise margin, they differ from one another in terms of restaurant margin. I am curious about what factors result in such a difference. Is it because of the competition in each vertical? Is it due to specifically how each product line is made as in pizzas carry more expenses than chicken wings/fries or Mexican tacos? I’ll try to dig deeper in the near future, but that’s it for today. Hope that it is helpful to you guys. Have a safe and pleasant weekend!

Which business segment is the most profitable for McDonald’s?

Overall business

McDonald’s main business segments include the company operated and franchised outlets. At the moment, franchised restaurants make up 93% of the total store count, not so far off the company target of 95%. Under the franchise segment, there are conventional franchise, developmental and foreign affiliate agreements, each of which comes with a different revenue and expense structure. Below is a diagram I quickly drew to summarize McDonald’s business structure

Getting into the weed

Between the company-operated restaurants and franchised counterparts, the latter have a much higher margin

Source: McDonald’s

The franchised outlets posted a 82% gross margin in 2018, compared to just about 17% by the company-operated restaurants. The three-year figures also indicated the shift of focus on being a franchisor. Revenue from franchised restaurants grew on average by 8% every year from 2016 to 2018. In the same period, the domestically run outlets recorded a decline of around 19% on average every year.

The focus on being a franchisor is also reflected on the lease agreements that the company has

Source: McDonald’s

In 2018, the company was on the hook for smaller rent expense at company-operated restaurants than at franchised outlets.

McDonald’s defines its main geographical segments as follows:

  • U.S. – the Company’s largest segment.
  • International Lead Markets – established markets including Australia, Canada, France, Germany, the U.K. and related markets.
  • High Growth Markets – markets that the Company believes have relatively higher restaurant expansion and franchising potential including China, Italy, Korea, the Netherlands, Poland, Russia, Spain, Switzerland and related markets.
  • Foundational Markets & Corporate – the remaining markets in the McDonald’s system, most of which operate under a largely franchised model. Corporate activities are also reported within this segment.
Source: McDonald’s

Systemwide revenue has been decreasing since 2016. The main reason for the decline was attributed to company-operated segment as it shrank by 21% and 17% year over year in 2018 and 2017 respectively. Additionally, the chart showed that International Lead Market was the only segment that registered revenue growth in 2018. High Growth Market delivered the biggest growth in franchised revenue, but also the biggest decline in company-operated revenue. Concerningly, the high growth market segment registered a decrease in revenue while it should have been the opposite, essentially due to the decline in company-operated revenue.

In terms of operating margin, Foundational Markets led the way in the franchise department while International Lead Markets took the top spot in the company-operated one.

Source: McDonald’s
Source: McDonald’s

Regarding restaurant counts, systemwide restaurant count went up compared to 2017, but presence in the US shrank.

Source: McDonald’s

It’s helpful when the company gave more color on the company-operated/franchise breakdown of the store count.

Approximately 93% of the restaurants at year-end 2018 were franchised, including 95% in the U.S., 88% in International Lead Markets, 83% in High Growth Markets and 98% in Foundational Markets.

Source: McDonald’s

It is very interesting that the net restaurant addition in 2018 was bigger than that in 2017, but the company added smaller initial fees in 2018 and bigger revenue from rent and royalties than in 2017.

Source: McDonald’s

The most likely explanation I could come up with is that the company gave quite a haircut on the initial fees for new restaurants in High Growth Markets (see the breakdown a few paragraphs down).

The timing of new and closed restaurants varied from one market to another and it made the calculation of average revenur or sale per restaurant tricky. Nonetheless, if we can make simple assumptions and take the revenue as well as restaurant count at year end, we can compare 2018 vs 2017 to see where the business is going

Regarding the US, compared to 2017, average sale and revenue per company-operated restaurant decreased in 2018 while both average revenue and sale per franchised restaurant increased.

For International Lead Markets, compared to 2017, average revenue and sale per restaurant increased for both company-operated and franchised outlets.

The situation in High Growth Markets is similar to that in the US. Average revenue and sale per company-operated restaurant decreased significantly.

Foundational Markets mirrored what happened with High Growth Markets.

In terms of ownership type, conventional franchise is the biggest source of revenue, followed by developmental licensed and foreign affiliate. However, foreign affiliate grew the most in 2018 compared to 2017, by 6.5%, followed by developmental licensed with 4% and conventional franchise with 1.5%.

Source: McDonald’s

When looking at the expense structure for company-operated restaurants, food and paper is the biggest piece of the pie, even though personnel registered the biggest growth YoY compared to 2017.

Above is just my analysis for the operating side of McDonald’s based on its last two annual reports. There is a lot more to look at such as the cash flow, the financing and investing activities. I hope that you found something useful in this entry.