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Financing

McDonald’s operators say remodels are a financial risk

Franchisees say that as much as 40% of the system would not qualify for lease renewal if sales don’t grow as projected.
Photograph courtesy of McDonald's Corp.

As many as 40% of McDonald’s franchisees are in danger of not having their leases renewed if expected sales increases from newly remodeled locations don’t materialize, according to figures presented to a group of franchisees in October.

The figures help explain the rapidly growing momentum behind the formation of the National Owners Association (NOA), the first independent franchise association in the company's storied history.

Operators, required to make hundreds of thousands of dollars in investments they don’t see paying off quickly enough, are increasingly worried about their finances and are banding together to push for changes. Sources tell Restaurant Business that as many as 1,300 operators—three-quarters of the system’s franchisees—are expected to attend the group’s second meeting this week.

“The game has changed,” John Kujawa, a former U.S. vice president of franchising with the company, told attendees at the first meeting. “We’re playing by different rules.”

McDonald’s takes issue with the 40% figure that was presented and insists that its franchisees’ finances are strong enough to withstand the remodels.

A senior McDonald’s official, who asked not to be named, said that the company looks at a lot of different, comprehensive data on its operators’ finances, saying that, “The vast majority of owner-operators are in strong financial health.”

Franchisees’ financial strength has long been considered a hallmark of the chain, which generates strong unit volumes despite its omnipresent nature.

Still, sources have told RB that the company has assured its franchisees that good operators would still have their restaurants renewed, even if they don’t meet some of the company’s financial requirements. McDonald’s controls the franchisees’ leases and bases their renewals on many criteria, including finances.

The growing momentum behind the association helps explain why McDonald’s recently agreed to back off its aggressive timeline for remodels. The company said earlier this month that it would allow some operators to complete the move to McDonald’s Experience of the Future design in 2021 or 2022—in exchange for a lower company contribution to the cost.

McDonald’s typically pays 55% of the cost of remodels but would pay 40% for stores completed after the 2020 deadline.

“It’s all about cash flow,” said Richard Adams, a former franchisee-turned-consultant who works with McDonald’s operators. “They’re spending vast amounts of money and are not getting sales increases.”

Officials with NOA did not respond to requests for comment.

The formation of the association is perhaps unsurprising, given the level of changes for the Chicago-based chain in recent years, coming at a time of intense industry competition and rising labor costs.

Under CEO Steve Easterbrook, McDonald’s has overhauled its corporate structure and cut a lot of its corporate staff and moved its headquarters downtown, from its longtime home in suburban Oak Brook, Ill.

The company has also refranchised most of its remaining locations, and in the U.S. now operates just 700 of its 14,000 restaurants.

At the same time, McDonald’s has made an aggressive series of changes that upended years of how the company did business and changed norms. The company started selling breakfast items in the afternoon. It started making Quarter Pounders with fresh beef. It quickly added delivery at half of its locations. It added new breakfast products and changed the way it made some chicken products.

Executives acknowledged in October that the changes were significant. “Our franchisees are taking on a lot all at once,” Easterbrook said on the company’s third quarter earnings call in October.

But operators say many of these efforts haven’t worked and only made the system more complex while slowing service and hurting profits.

Blake Casper, whose email to franchisees ultimately helped spur the creation of the association, said during the Tampa meeting that all-day breakfast was “change, masked as innovation” that did little to help the overall business but added complexity to an already complex operation.

The remodel requirements are only hurting finances more. The company is pushing franchisees to remodel the entire system by 2020, a huge order considering McDonald’s is the country’s largest chain.

Though McDonald’s is paying more than half of the cost of remodels, franchisees still have to pay hundreds of thousands of dollars. And so far, the sales haven’t quite met expectations.

Kevin Ozan, McDonald’s chief financial officer, said in October that the sales and guest count recovery period following a remodel’s completion has been “a little inconsistent.”

In his presentation at the first meeting, Kujawa said he got a call from an operator of a low-volume restaurant who recently spent $250,000 to fix up the lobby, a remodel that “didn’t do a lot.”

That operator was then asked to put $1 million into that restaurant, of which the franchisee’s contribution was about $500,000—an investment that would have made that store’s cash flow turn “significantly negative,” Kujawa said. When told of the problem, he added, a development person told the operator, “Basically, ‘We don’t care, do it.’”

The 40% figure is being used to highlight the financial strain operators are under amid all of these changes.

Unlike many of its competitors, McDonald’s controls its operators’ real estate and charges them rent. And the company has numerous requirements if it is to renew franchisees’ leases.

Adams said that McDonald’s requires franchisees to have the financial capability to expand if it is to renew their leases—even if the operator has no intention of adding units.

Few believe the company would not renew 40% of its franchisees, and Adams noted that the remodels have reduced the number of operators who could potentially take over restaurants that don’t get renewed.

The issue also highlights the impact of years of cost cuts at the company. At its peak, Kujawa noted, regional managers oversaw an average of 50 operators. After a reorganization in 2002, that number went up to 100. Now, he said, it’s up to 190 operators and an average of 1,300 restaurants.

That has turned the company’s support and oversight functions from one that was relationship-based to one that is more “numbers” based.

“No one, no matter how hard they work, can develop a relationship with 190 operators,” Kujawa said. “They’ve taken the relationship and they’ve isolated the operators.”

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