We have often shared that we a franchise is a great way to scale a business. This is because franchises follow a simple, easily replicable business model. A successful concept (like a restaurant) is replicated quickly, usually without much cash outlay from the original business owners.
The scale of a successful franchise brings about supply chain efficiencies (i.e., one supply chain can serve more than one restaurant) and incremental earnings drop to the bottom line as free cash flow since the original business does not incur the added costs of running its franchises.
But are all franchise businesses made equal?
The obvious answer is no.
The usual rules apply. One of them being capital intensity.
Yes. Capital intensity.
In other words, how much extra money does it cost to open a franchise?
Capital intensity is like gravity. The more money you need to expand, the heavier and harder it gets to do so. Franchises are not immune to this, even if many franchises are capital light businesses.
McDonald’s is a franchise. Domino’s Pizza is a franchise. Yet the share price returns for investors between the two are vastly different. Domino’s Pizza listed in July 2004, and since then has returned a staggering 4,080% for investors as of end-2021. McDonald’s using a similar time frame has only returned 911%.
But why? Both businesses are fast food franchises. Both have similar operating environments and serve cheap, ‘tasty’ food. So why did the investor of one enjoy 40 times returns whilst the other enjoyed only 9 times?
The answer, as you might guess, lies in capital intensity.
A Domino’s franchise costs approximately $100k. It can go up to $500k if we’re talking about rent in a more expensive part of town and renovations. But most of the time, you can have a rough gauge between $100k to $500k.
In comparison, a McDonald’s franchise store can cost between $1.5m to $2.5m easily. Most of this information is publicly available on a variety of sources or via reports, so feel free to check the numbers.
Now via publicly disclosed numbers, each Domino’s store does about $158,000 in EBITDA. Pretty high returns on capital given a maxed out $500k outlay. That translates to 30% returns in a single year. By Year 4, you’d own the store ‘free and clear’ and every penny after post-royalty fees and operation expenses would be pure profit. Domino’s themselves like to advertise that fact…
What about McDonalds? Bloomberg estimates that most owners can make about $153,000 of profit a year. Out of a $2 million investment, that’s about 7.7% returns in a year. Not to mention the time and energy required to run a restaurant full-time.
The fifth perspective
But what really drives the difference here?
To me, at the core, it’s the business model. McDonalds functions as a property business masquerading as an F&B business. It’s stated right there in their annual report:
‘We have significant real estate operations, primarily in connection with our restaurant business. We generally own or secure a longterm lease on the land and building for conventional franchised and Company-operated restaurant sites. We seek to identify and develop restaurant locations that offer convenience to customers and long-term sales and profit potential. As we generally secure long-term real estate interests for our restaurants, we have limited flexibility to quickly alter our real estate portfolio.’
Or similarly, you can reference this video. While dramatized, the facts bear out. McDonald’s is an incredibly high capital intensity business. Business slowed because expansion is just so expensive; how many millionaires want to fork out $2 million to own a McDonald’s franchise and earn single-digit returns running a restaurant every year?
I guess, in a way, my long-winded point is to look at the business model. Who owns the land? What is the return for each store in the franchise? How fast can franchisees make back their money? Is it capital light?
Remember, capital is like gravity. The more you need. The heavier it gets.
Take care investing.
Some points in this article don’t make any sense. The point of the article is to compare two business, a Domino’s franchise and a McDonald’s franchise, but you reference their stock performance. Investing in McDonald’s or Domino’s stock is a completely different investment than investing in a franchise. It’s investing in a different business. For example, McDonald’s stock could have a way higher ROI than a competitor’s stock due to McDonald’s keeping a much larger portion of each location’s profit for itself. This would mean that the stock itself is a better investment than its competitor but the franchise itself is a worse investment than the competitor. ROI on stock has no bearing from ROI on owning a franchise.
To compare which franchise is a better investment, one needs to simply compare the ROI of investing in a franchise of each, and completely ignore the ROI on the stock.
Hi Joe, thanks for sharing! The main gist of the article is that it requires much more capital to start a McDonald’s outlet compared to Domino’s. So even though it is the franchisee that is fronting that investment, the higher amount of capital needed for a McDonald’s outlet means that expansion (total number of stores) is naturally slower. Couple this with McDonald’s requirement of also owning the land and the capital intensity further increases. At the same time, McDonald’s is still a great business and a more stable one than Domino’s.