McDonald's Continues To Be A Worthwhile Investment

Jul.10.13 | About: McDonald's Corporation (MCD)

Whenever you look at the numbers around McDonald's (NYSE:MCD) it is difficult not to be impressed by the sheer size and success of the operation. It is the largest chain of restaurants in the world by revenues and serves 69 million people every day in over 14,000 restaurants in the U.S. and more than 34,000 all over the world. More Americans visit them than any chain store of any kind including giants like Wal-Mart (NYSE:WMT). With a single-minded focus on value for money, it has survived the worst of the recession. It is also the classic example of the successful business that has continued to grow despite its size.

The supply chain advantage

You may not fully realize that one of the key elements in maintaining growth and profits is the role of the company's supply chain. Take the example of arguably its most famous product, french fries. The company sells more than 3 billion lbs. annually and has three major suppliers. As McDonald's has expanded overseas, its suppliers have followed to help the company source its fries locally. For global restaurant chains, the biggest advantage of sourcing ingredients locally is the reduction in transportation and import costs and this advantage is enhanced by the innovative processes that McDonald's has established. The company essentially receives a product that is almost ready. The fries simply need to be fried for a little while in order to be ready for sale. Similarly, in the case of beverages, concentrate is procured in large quantities from Coca-Cola (NYSE:KO) and water is added at the point of service resulting in a large cost savings. Multiple orders of fries can then be processed in a single batch and then separated for delivery and soft drinks orders process from an automated dispenser. In contrast, much more time and work is required to assemble and prepare a Big Mac without generating significantly higher margins.

As you can imagine, establishing and maintaining these supply chain initiatives takes a lot of planning and effort and can often take years to establish in new markets. For instance, in the case of India, the establishment of the supply chain took six years. Most of the cost and the effort are often expended by suppliers who have established long-term relationships over many years. McCain Foods has set up a potato processing facility in the Indian state of Gujarat on 4000 acres and buys from local contract farmers who farm its land. As McDonald's expands, McCain will expand its contract farming area to 8,000 acres. Because of the nonexclusive relationship, McCain is free to sell frozen potato products under its own brand domestically and to service customers in China and the Middle East. This is a win-win situation for McDonald's as well as McCain.

As an increasing share of revenues comes from expansion into Europe, Asia and the Middle East, the supply chain advantage has enabled McDonald's to maintain or even increase its operating margins and the cost burden of localized supply has largely fallen on suppliers. It also gains the advantage of continuing to deal with trusted suppliers with whom it has had a long-standing working relationship.

A look at some competitors

Wendy's (NYSE:WEN) is making aggressive moves to improve margins. The "Image Activation" initiative is reported to have produced an average of a 25% increase in revenue at stores that have already been renovated. This would indicate that there could be further growth in sales as the company continues to implement the program in all of its current restaurants by 2015, which is the objective. However, the increase in revenues will be offset by the loss of revenues from stores that are closed during renovation. The "Right Price, Right Size" initiative has resulted in the company adding a value menu for the first time. This should go some way to protect revenues in times of recession. I would advise postponing an investment in the stock until the expenses associated with the renovation have actually been in incurred.

Burger King Worldwide (BKW) has a P/E ratio, which is relatively high at around 51. Though it has announced a $200 million stock buyback, which would bring down the P/E ratio, it is still an expensive stock considering the limited growth expectations. Furthermore, the company has high levels of debt with $3 billion being long term, equating to a debt-to-equity ratio of almost 2.5, leaving limited opportunities to raise further debt to finance future growth.

The bottom line

McDonald's has performed impressively by growing profits at 12% compounded annually for the last decade while nearly tripling a return on investment. It has also enhanced shareholder value by growing economic earnings at 35% compounded annually for the same period. By comparison, competitor YUM! Brands (NYSE:YUM) only managed earnings growth of 15% compounded annually over the same period. I believe that the company will continue to grow revenues and profits and should be considered as an investment in the consumer sector.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.