McDonald's Lagging Competitors But Looks Ready For Turnaround

| About: McDonald's Corporation (MCD)

Ticker: McDonald's Corp. (NYSE:MCD)

Rating: Maintain at Hold


McDonald's would likely prefer to forget 2012. After a solid two-year run from 2010-2011, which saw the company rise 40%, MCD looked unstoppable. The company had reinvented its image, added new looks to its establishments, and reinvented the company's coffee lineup. 2012, however, has seen the stock drop over 10% amidst weakness in Europe, rising competition, and strength in the dollar. Heading into 2013, is MCD ready to get back on track or will it be another so-so-so year for the company?

We have a $109 price target for 2013 (which is discussed further below) and believe that MCD should return 10-15% in gains in 2013. We believe the weakness in 2012 will not sustain through next year due to a number of reasons that will be discussed. At the same time, the company's upside seems limited past $110.

The first major issue for MCD to deal with in 2013 is competition rising and stealing market share. In 2012, Burger King Worldwide (BKW), Wendy's (NYSE:WEN), and Yum Brands (NYSE:YUM) have all done a great job of increasing menu offerings significantly to attract customers. BKW has introduced snack wraps and new shake offerings that have obviously been successful given the weakness in McDonald's US sales. YUM continuously updates its menu at Taco Bell locations, and it has seen a lot of success from its Cantina Bowls and Doritos-inspired taco shells. MCD has been slow to introduce new menu offerings this year. The company's food items need updating to attract new customers. McDonald's has been working on expanding its beverage offerings, which offer higher margins, but it has left the rest of the menu stagnant.

The company's response has been to comment that it wants to ramp up marketing for the dollar menu. Yet, these items provide lower margins as well. Why buy a Big Mac for $4 when you can get a single burger for $1. We believe that MCD needs a big-ticket item to get things turned around, and while we believe that is going to happen, it may not ramp up until at least Q1-Q2 of 2013, as there are no major plans in the works right now. One benefit of the doubt we will give MCD is that the company has a history of renovating its menu amidst any weakness, and we believe we will see some big changes in 2013 that should kick start the company's US demand.

In the company's October update, US same-store sales saw a 2.2% drop, which was the first drop for the company in nine years. The economic moat of MCD is still strong, but the company is not helping themselves by lagging competition in offering reasons for people to choose them over some of its competitors. Marketing, alone, is not the key. A facelift to the menu is needed. We'll leave what that means to the experts, but the stock cannot move until that happens.

At the same time that we are critical of MCD, we are talking about perhaps the greatest American franchise ever. The company has a strong yield over 3% and has increased its dividend every year since 1976, so there is value here for income investors. For value investors, there is also reason to buy. MCD is operating with a 15 future PE, which is a buy signal for us. We are still cautious that some more downside may not occur first, but starting to take a look at MCD is not a bad idea here.

Another reason to like this company is that MCD is entering the ground coffee market. The company has started offering ground coffee at stores in Canada. Results are not in yet, but MCD's coffee business is one of the biggest reasons for its breakfast success. If the company can leverage that success into ground coffee, it will definitely provide a catalyst for upside for the company. Margins are high on bagged coffee as well.

MCD is in a lull as the shares reflect. 2013 should see a return to demand in China, which will help MCD increase sales there. In the USA, it needs to address key issues we have discussed. We believe the company will, but we are keeping our expectations in check. The strength in the dollar that has hurt them this year can be overlooked if the global market is stronger. All in all, the value the company is currently offering is close to a Buy for us. It's a great place to add if you are an income investor and value investors should buy on any weakness. Growth investors will want to wait to see what 2013 has in store before parking any money here.

Price Target:


New Price Target

Old Price Target

New Rating

Old Rating

New Buy/Sell Range







The following price target was configured through a 5-year projected discounted cash flow analysis. The model projects operating income, taxes, depreciation, capital expenditures, and changes in working capital. Using that information, we can project what the company is worth. We can then use that projection and compare it to current prices.

Here is how to calculate price targets using discounted cash flow analysis:

(all figures in millions)

Step 1.

Project operating income, taxes, depreciation, capex, and working capital for five years. Calculate cash flow available by taking operating income - taxes + depreciation - capital expenditures - working capital.

2012 Projections

2013 Projections

2014 Projections

2015 Projections

2016 Projections

Operating Income


















Capital Expendit.






Working Capital






Available Cash Flow






Here are our calculations for our PT. We are expecting a surge higher each year for operating income. We dropped our 2016 expectations slightly due to recent results, but the drop was limited. We used a 32% tax rate.

Step 2.

Calculate present value of available cash flow (PV factor of WACC * available cash flow). You can calculate WACC, but we have given this number to you. The PV factor of WACC is calculated by taking 1 / [(1 + WACC)^# of FY years away from current]. For example, 2016 would be 1 / [(1 + WACC)^4 (2016-2012).

WACC for MCD: 6.00%






PV Factor of WACC






PV of Available Cash Flow






* For 2016, we are going to calculate a residual calculation, as we believe that the market tends to value companies with around a five-year projection of where business will be. This is the common projection for discounted cash flow analyses.

Step 3.

For the fifth year, we calculate a residual calculation. This number is calculated by taking the fifth year available cash flow and dividing by the cap rate, which is calculated by taking WACC and subtracting out the residual growth rate. Residual growth rate is typically between 2-6%. 4% is average growth for the industry. Companies with high levels of growth have higher residual growth, while companies with lower growth levels have lower residual growth. This is why higher growth companies tend to have higher PE ratios. We will give you cap rate.

Cap Rate for MCD: 4.0%


Available Cash Flow


Divided by Cap Rate


Residual Value


Multiply by 2016 PV Factor


PV of Residual Value


Step 4.

Calculate Equity Value - add PV of residual value, available cash flow PVs, current cash, and subtract debt:

Sum of Available Cash Flows


PV of Residual Value


Cash/Cash Equivalents


Interest Bearing Debt


Equity Value


We have added in current cash/cash equivalents as of the latest fiscal quarter along with debt levels.

Step 5.

Divide equity value by shares outstanding:

Equity Value


Shares Outstanding


Price Target


In the end, we have found that KO is worth around $109, which we believe accurately reflects the company's five-year projections.


Q1-Q3 2012

Q1 - Q3 2011

Operating Margin



Gross Margin



Return on Equity



Profitability has been a big issue for MCD this year. Currency issues mixed with lower sales have hurt the company. Things do not look ready to turn around as it is preparing to launch a marketing campaign for its dollar menu. We would look for profitability to remain flat in 2013. How do these levels compare to the competition?

Sonic (NASDAQ:SONC) is operating with a 16% operating margin, 79% gross margin, and 61% ROE. Chipotle (NYSE:CMG) is operating with an 18% operating margin, 67% gross margin, and 18% ROE. YUM has a 22% operating margin and 71% gross margin. Yum Brands is offering 55% ROE. WEN has a 5% operating margin, 24% gross margin, and -1% ROE.

MCD's operating margins are top of the line, but the company's declining ROE is concerning. The diminishing profitability is affecting shares. This issue needs to be resolved to help the confidence of investors.



Industry Average




Future P/E



MCD is lagging its industry average for PE and it is below the 18-benchmark for PE and at the 15-benchmark for future PE that we like to see for value. Some concern over 2013 has kept our expectations a bit lower and Hold rating. How do these levels compare to competition?

SONC has a 17 PE and 13 future PE. CMG is working with a 31 PE and 25 future PE. YUM is operating with 20 PE and 18 future PE, and WEN is operating with no PE due to its current losses. MCD is sitting below much of its competition, which could mean an opportunity is there if you like the company.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Business relationship disclosure: The Oxen Group is a team of analysts. This article was written by David Ristau, one of our writers. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.