The Logic Behind McDonald's Asia Strategy

By Markets Fool.com

McDonald's "McDelivery" in Osaka, Japan. Image source:Flickr user Tjeerd Wiersma.

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As part of a turnaround still very much in progress, McDonald's Corporation recently publicized a key decision to seek out strategic partners "who will add value and unlock growth potential in key markets throughout Asia."

The company aims to refranchise, or sell, its corporate-owned stores in China, Hong Kong, and South Korea, which make up about 70%of the 2,800 McDonald's-branded locations in these countries. The global burger chain also thinks local franchise investors can help it reach an aggressive target of 1,500 new openings in these three markets over the next five years.

The initiative was reaffirmed by CEO Steve Easterbrook during the company's earnings call with analysts last week, and it's consistent with a broader McDonald's strategy to transition the entire Asian continent to a primarily franchised model.

Of course, McDonald's as a whole is evolving into a business that, per management, will be 95% franchised in the coming years. The quick-service giant appears eager to make Asian store refranchising the vanguard of this model shift.According to a recent Reuters news article, McDonald's is currently holding parleys with a number of potential partners, from state-backed China Resources Holdingsto private equity firms.

As executives pointed out in McDonald's April 22nd earnings call, there are three tangible benefits to selling to, and developing through, local partners. By franchising, the company will be able to open restaurants at a faster pace than it can through launching corporate locations.

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The shift will also reduce McDonald's capital requirements. The less McDonald's invests in its wholly owned locations in the future, the more capital it will have available to subsidize the equipment and technology investments franchisees need to fulfill CEO Steve Easterbrook's vision of a "modern, progressive burger company."

Finally, McDonald's will incur less in the way of general and administrative expenses if well-capitalized, experienced restaurant groups run most or all locations throughout Asia, which will benefit corporate operating income margin.

Other, more subtle reasons for the shift
While the company may not tout the following, there's certainly an advantage to this model when things go wrong. China, Hong Kong, and South Korea are designated "High Growth Markets" by McDonald's, and they hold higher potential returns for the corporation, but they're also fraught with more risk.

For an example of this dynamic, we can look to the chicken supplier issues that hit McDonald's in China in 2014. This food safety scandal generated harmful, though temporary, negative publicity.But it also stung McDonald's' bottom line: The company absorbed a negative earnings impact of $0.23 per diluted share that year -- about 5% of final EPS.

Under a fully franchised operation, the same event would have resulted in smaller royalty checks from local franchisees since licensing payments are based on a percentage of sales revenue. While such an arrangement would have also trimmed McDonald's profit and loss statement, the effect would have been muted versus the operational losses the company incurred on its owned Chinese restaurants.

Other benefits exist, though they remain theoretical until proven on the ground. Local partners have a firmer grasp on regional tastes and trends than a remote parent company, and they should be better equipped to develop menu innovations that can wrest market share from home-grown dining competitors.

Additionally, when franchisees predominate in a market, there are simply more eyes on the supply chain as well as an additional, vested interest in ensuring the integrity of suppliers, which tends to go a long way toward protecting the brand image.

McDonald's doesn't see a plethora of pitfalls associated with even a 100% franchised model in Asia.Yet the company may emerge against local chains as the pre-eminent fast-food label in the bulk of Asian markets over time, and ironically, this may be to its detriment.

Why is this the case? It's true that continuing to run restaurants in Asia would be an arduous and capital-intensive endeavor. But let's dust off our crystal ball and peer ten to 20 years into the future -- not a long time for a legacy business like McDonald's. We may then see a company that's raking in handsome royalty revenue but plagued nonetheless by an awareness that by hanging up its apron, it left enormous profits on the table.

The article The Logic Behind McDonald's Asia Strategy originally appeared on Fool.com.

Asit Sharma has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.