Due to its vast global presence, McDonald's (MCD) is exposed to sluggish global macro growth, particularly in the US and Europe. The recovery in the US has been painfully long. However, the company has been doing well to cope with the situation. Let's what are the pros and cons of investing in McDonald's given the changing informal eating out trends.
McDonald's is a leading global foodservice retailer with nearly 33,000 system-wide restaurants in over 100 countries, serving about 60 million people each day. McDonald's generates nearly two-thirds of its revenue and roughly half of its operating income outside the US.
Slow US economic growth, coupled with continued weakness in Europe, has been creating headwinds for multinational corporations. However, apart from the situation in Germany, McDonald's seems to be coping well with these headwinds.
Painfully long recovery
The current year has been pressured from the start with the payroll tax increase, and more recently with volatility within the labor and housing markets while consumer confidence further slows down. However, since the start of the year, McDonald's has grown its market share compared to the Quick Servicing Restaurant (QSR) sandwich category. This is despite the challenges presented by the macro economy.
Weakness to prevail in Europe
The company's July comparable sales slowed materially though interestingly were in-line with internal expectations. While UK remains the strongest market in the region, Germany can be ranked as the weakest. Russia also remains relatively strong while pressure prevails in France with informal eating out trends on the decline. Despite the decline in eating out trends in France, McDonald's is still growing its market share there.
Among the big four European economies, Germany remains the weakest link despite being the strongest economy of the region. Like France, Germany is also witnessing declines in Informal Eating Markets (IEO), compounding McDonald's headwinds as it is losing share in the declining market. In Germany, McDonald's holds 70% share of the QSR segment and 9.5% share in the IEO market. While unemployment remains at a relative low of 7%, Germans are more focused on savings. Besides, McDonald's weakness in the country can be attributed to a move away from the Euro value focus along with lack of menu innovation.
Strong fundamentals, opportunities stemming from extended hours and additional rental income are some of the positive stock price drivers that will benefit McDonald's in the coming future.
The financial discipline demonstrated by McDonald's made it possible for the company to earn an "A" rating from Moody's. This discipline is also preached to the company's franchisees regularly. This is why the franchisees require the company to re-invest in the business rather than return excess cash to shareholders. For Moody's, retained cash flow over adjusted debt remains a strong rating determinant, which means the company's leverage is limited by Moody's rating. That's because as the business grows, McDonald's will be required to increase its leverage to remain at target levels.
However, the company has a strong track record of generating solid cash flows over the past few years. This growth in cash flows is particularly important because it will help the company to meet the changing needs of its customers. Fitch expects these cash flows to remain strong during the second half of the current year.
Largest opportunity in extended hours
Currently, nearly 45% of US outlets of the company are open 24/7. Interestingly, this percentage is as high as 90% in China. The company is targeting a percentage of 60% for US over the next 2-3 years. I believe this could be the single most profitable move that will benefit the company. The most recent decision to combine the dinner and breakfast menu after midnight has been well received, supporting greater 24/7 operations. One challenge in this regard is the zoning of local markets.
Large real estate
Over the past few quarters, the company's earnings have been partially supported by real estate margins. According to the latest annual SEC filings, McDonald's owns nearly 45% of the land and 70% of the restaurant buildings. According to one source, its rent margins are nearly 84%. While the ownership of these properties might be a drag on return on equity, they offer additional returns in the form of a stable rental income stream.
I'm bullish on McDonald's as I believe the positive stock price drivers will overshadow its headwinds. The company has a strong financial position and solid long-term growth opportunities overseas. Additional rental income and extended hours at its outlets will provide future support to the company.
Additional disclosure: Equity Whisper is a team of analysts. This article was written by our Services analyst. 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.