When it comes to the global restaurant industry, McDonald's stands at the top. With over 40,000 locations worldwide, McDonald's boasts the largest chain of restaurants on the planet. Its market capitalization has at times exceeded $200 billion, positioning it as a clear leader in the industry.

However, McDonald's takes an unconventional approach. Despite being a giant in the restaurant sector, its primary revenue source is real estate, earning from property rentals. Moreover, despite being the company with the highest market value in the industry, it paradoxically has negative shareholder equity.

This seemingly "unorthodox" strategy hasn't hindered McDonald's stock performance, which has kept pace with the rise of the S&P 500 index.

On July 29, McDonald's will release its latest earnings report. Each earnings release may signal a potential investment opportunity, but before diving in, investors need to understand how to interpret their financial statements.

So, how should we analyze the financial statements of a company like this? We can examine it through three common lenses: revenue growth, profitability, and shareholder returns.

1. Revenue Growth

For a chain restaurant like McDonald's, revenue growth is driven primarily by two factors.

1. Increase in the Number of Restaurants: Rapid expansion in the number of locations often correlates with periods of fast growth for the chain. Conversely, a continuous decline in store count usually spells trouble for revenue growth.

2. Growth in Comparable Sales: When the number of restaurants remains constant, growth in comparable sales (same-store sales) can still drive revenue. Conversely, a decline in same-store sales can pressure overall revenue growth.

Among these two metrics, comparable sales growth is particularly crucial. Sustained growth in comparable sales indicates a strong brand momentum and suggests that there is ample room for market penetration and regional coverage. Even with a dense network of stores, strong same-store sales growth implies minimal competition for customer traffic among existing stores. Conversely, declining same-store sales suggest that further expansion might dilute the customer base of current locations. Therefore, only with robust growth in same-store sales can a chain accelerate store openings and drive revenue growth.

How does McDonald's perform in these metrics?

From 2014 to 2023, McDonald's saw growth in comparable sales for most years. Although there was a significant drop of about 7.7% in 2020 due to the pandemic, the company rebounded strongly over the next three years. However, the growth rate has been slowing, with comparable sales increasing by only about 1.9% in Q1 of the 2024 fiscal year.

The total number of McDonald's locations worldwide grew from 36,258 in 2014 to 41,822 by the end of 2023, an increase of over 5,000 stores. This equates to an average annual growth rate of about 1.6%, indicating a steady expansion pace.

Despite the positive trends in both comparable sales and store count, McDonald's revenue has declined from $27.44 billion in 2014 to $25.49 billion in 2023. This paradox can be attributed to a shift in McDonald's business model, which is not necessarily a negative development.

McDonald's operates two types of restaurants: company-operated and franchised. Company-operated stores contribute all their revenue to the company, while franchised stores provide McDonald's with initial fees, royalties, and rental income, which represent only a small portion of the total revenue.

In 2014, company-operated stores, though less than 20% of all locations, contributed the bulk of the revenue—about $18.2 billion, or roughly two-thirds of the total revenue.

Starting in 2014, McDonald's began selling company-operated stores to franchisees, reducing their proportion. By 2023, only 2,142 company-operated stores remained, comprising just about 5% of the total, and their revenue contribution dropped to less than 40%.

Thus, despite the increasing total number of stores, the substantial reduction in company-operated stores (which were the main revenue contributors) resulted in overall revenue shrinkage.

In future financial reports, we may continue to monitor whether McDonald's gross and net margins maintain their upward trajectory, thereby driving sustained net income growth.

2. Profitability

The ultimate goal of any business is to generate profit. McDonald's willingness to risk declining revenues by reducing company-operated stores and expanding franchised locations underscores its focus on enhancing profitability and net income.

Company-operated stores, though contributing significant revenue, come with substantial costs such as food supplies, rent, utilities, and labor, resulting in limited profit margins. Conversely, each franchised store contributes less to total revenue, but the franchise fees, royalties, and rental income McDonald's collect incur minimal costs. Notably, rental income, which makes up nearly two-thirds of revenue from franchised stores, is highly profitable. McDonald's leverages its brand influence and long-term lease commitments to secure locations at lower rents, which it then subleases to franchisees at higher rates.

For instance, in 2023, the gross margin for McDonald's company-operated stores was only 15.6%, whereas the gross margin for franchised stores was a staggering 83.9%. The franchising business accounted for nearly 90% of the company's overall gross profit.

As the proportion of franchised stores increased, McDonald's profitability also soared. Since beginning to reduce company-operated stores in 2014, McDonald's gross margin has climbed from 38.1% to 57.1%, an increase of 19 percentage points. During the same period, the net margin rose from 17.3% to 33.2%, an impressive increase of about 16 percentage points.

Consequently, despite some revenue decline, McDonald's net income grew from $4.76 billion in 2014 to $8.47 billion in 2023—an approximate 78% increase over ten years, reflecting steady growth.

In future financial reports, we can continue to monitor whether McDonald's gross and net margins maintain their upward trajectory, thereby driving sustained net income growth.

3. Shareholder Returns

In the U.S. stock market, many companies use excess cash to return value to shareholders, primarily through buybacks and dividends once their growth stabilizes. However, few companies have taken shareholder returns to the extreme, such as McDonald's.

Since 2014, when McDonald's began reducing its company-owned stores, it has aggressively returned cash to shareholders. For six consecutive years, its dividend and buyback amounts significantly exceeded its net income. For example, in 2017, McDonald's net income was $4.69 billion, but it paid out a staggering $14.23 billion in dividends and buybacks.

From 2014 to 2023, McDonald's cumulative net income was $58.01 billion, while total dividends and buybacks reached $79.85 billion, far exceeding its net income during this period.

Due to this aggressive return of capital, McDonald's net assets turned negative in 2016 and were approximately -$4.7 billion by 2023.

A negative net asset value might seem alarming, suggesting the company is insolvent, but there maybe no immediate need for concern.

Firstly, McDonald's insolvency isn't due to poor management but is a strategic choice. Most McDonald's locations are franchised, making the company relatively insulated from operational risks and ensuring a steady income stream. This reduces the need for large cash reserves to mitigate economic downturns.

Secondly, companies typically go bankrupt not because of insolvency but due to cash flow issues. McDonald's free cash flow remains positive each year, indicating healthy cash management.

In future financial reports, we should continue to monitor the sustainability of McDonald's high dividends and buybacks, as well as the health of its free cash flow.

Having read this far, you may now have a deeper understanding of how to interpret McDonald's financial reports. It's noteworthy that the release of earnings reports from prominent companies may present unique trading opportunities for different types of investors.

For instance, if an investor, after analyzing past reports and considering recent developments, believes a company's latest earnings will send positive signals and boost the short-term stock price, they might consider taking a long position. This could involve buying the underlying stock or purchasing call options.

Conversely, if the investor expects the earnings to be unfavorable and potentially pressure the stock price, they might consider taking a short position, either through short selling or buying put options.

If the report's outcome is unclear but volatility is expected, they might use a straddle strategy, buying both calls and puts.

However, investors should carefully assess their risk tolerance, particularly when considering high-risk trades like short selling or options, before making any trading decisions.

In summary:

For McDonald’s financial reports, key areas to focus on include:

• Revenue Growth: Monitor same-store sales growth and store expansion.

• Profitability: Track improvements in gross and net margins, and subsequent net income growth.

• Shareholder Returns: Observe the stability of dividends and buybacks, as well as the level of free cash flow.

Each financial report release can offer potential trading opportunities. Investors should consider their risk tolerance to choose appropriate trading strategies.