The global population is becoming more health conscious which has caused suffering for the fast food and restaurant industry. The industry was hit by the effects of the recession in the US and Europe. A decline in the disposable incomes of Western consumers as well as declines in consumer sentiment and spending also posed a challenge to the industry. Although economic recovery has been witnessed the restaurant industry was still struggles because consumers still plan to spend less and eat healthier in 2014. This will likely hurt both the top and bottom lines of the players in the industry. Despite the feeble future outlook of the industry, McDonalds's Corp. (NYSE:MCD) has received a "BUY" rating from TheStreet. With an "A" rating score analysts based this decision on the company's financial strengths and indicated that the target price of the stock will be up to $110 per share.
Attracting more and more customers has always been the company's focus and forms the base of its top line. The company earned 2.4% more revenue in Q3 2013 compared to revenue earned in Q2 2012.
The major drivers of the company's top line, in terms of geography, are shown in the table below. The US, Europe and APMEA are the company's major geographic segments. Established markets of the company include the US, France, Germany and Australia while emerging markets include China, Brazil, India and Russia. The percentages of revenue generated from the three geographic segments are also shown in the table below which indicates that Europe is the major contributor to company's revenue followed by US.
Source: MCD 10K Reports
In Europe, the UK, France and Germany contributed around 51% of the total revenue generated by the segment in 2012. The table also shows a slightly increasing revenue share by APMEA. China, Australia and Japan are the major contributors to the total revenues generated by this geographic segment and contributed 56% of revenues reported in 2012.
The US only contributes around 30% to total revenue earned by the company. The downfall in the restaurant industry in the US is likely to have a limited effect on the company as it is not totally dependent on the US for revenue generation. Since 30% of revenue is still a material figure, let us examine how the company has been able to achieve its revenue growth in the US till now considering changes in consumer demand.
US Restaurant Industry
Accessibility and Customer Experience
The company's strategy is focused on menu innovation but accessibility and improving customer experience is also relevant to this. In a survey conducted by AlixPartners, 70% of the people heading to grocery and convenience stores in the US to buy ready meals stated that accessibility to stores was the main reason for buying food from those locations. The table below shows a measure of the company's accessibility in terms of square miles of urban area covered by each restaurant in the US. Similar calculations for YUM's (NYSE:YUM) KFC brand were also made in order to better understand the companies' positions in the industry.
The table above states that McDonald's has one restaurant present for every 7.58 square miles in the US on a generalized basis and further additions to the restaurant count have been made so the figure reached 7.51 in 2012. Additionally, the company has plans to continue opening more restaurants in the US which was reflected by the company's $3 billion spending plan. A KFC restaurant can be found every 21.05 square miles compared to McDonald's. Moreover, the closure of KFC restaurants from 2010 to 2012 has had further increased the distance between KFC restaurants and indicate a decrease in the restaurant's accessibility.
The number of restaurants isn't the only important factor. The company has also been striving to enhance the quality of its restaurants through the remodeling and renovation of already operating restaurants and has also set aside its cash flows to continue investing in this endeavor. This strategy plays a role in refining customer experience through the company's image. A neat, clean and well-maintained restaurant also should reflect an image of quality and hygienic food offered by the company.
Health concerns addressed
As far as health is concerned, the company has abandoned some of its less nutritional menu choices and intends to add offerings of fruits and vegetables in many of its adult menu combinations. These changes are slated to take effect in 20 of the company's largest markets that represent 85% of the company's total sales.
By addressing some of the major concerns of customers which are adversely affecting the US restaurant industry the company will likely continue to see expansion in its US operations.
Now, let us examine the company's prospects in Europe and APMEA mainly concentrating upon major revenue generating regions.
European Restaurant Industry
The chart above shows a recovery in the sector related to food service and drinking places. The sales of food service and drinking places turned from a negative growth of 3.1% in 2008 to -0.2% in 2013 while a prediction of 0.1% and 0.2% expansion has been made for 2014 and 2015 respectively.
Europeans have also been categorized as an emerging wealthy nation as a result of higher salaries and disposable incomes by 2020 but this trend mainly relates to Eastern Europe. Overall, an increase in consumer spending can be seen in the chart below. This is relevant to the restaurant industry in those countries. As a result of increases in consumer spending, brands such as McDonald's can earn their share in the industry.
Source: Trading Economics
APMEA Restaurant Industry
China, Australia and Japan are the main drivers for revenue generation in this area. The following is a brief look at what the restaurant industry holds for McDonald's in this region.
In China, the main growth drivers for this industry are the sector's comparative confrontation to variations in economic cycles and the government's backing for food and drinks trade. Total revenue from China's dining industry was 2.3 trillion Yuan ($375.8 billion) in 2012 which is 14% higher than last year's reports. The number is still expected to increase but at a slower pace until the economy recovers.
The Australian restaurant industry currently earns revenues of $14 billion and an annual growth of 3.4% has been estimated from 2009 until 2014. Consumer demand for healthy, quality food and fine-dining experiences are the key drivers of this growth. Upon achieving a 3.1% growth the industry is forecasted to reach a figure of $14.3 billion by 2014.
Large chain restaurants are only 11% of the Japanese market, revenue-wise, and have constantly been achieving a larger share since 2008. The trend is expected to continue. These companies are able to take more shares due to their brand power and resources. The table below shows that McDonald's is among the top restaurants operating in Japan and currently holds a 1% market share. Clearly there is room for the company to expand.
Margins and Earnings
The company has been able to keep its net margins around 20% over the years. A strain on the margin may come in the future as the company intends to switch to healthier ingredients for its products. At a 20% net margin level the company has been earning double in comparison to the industry average of 10.1%. A greater difference in these figures would mean that even if the company experiences a decline in its margins there would still be room to remain above the industry average.
Maintenance of margins with improvement in the top line will ultimately improve the company's earnings position in the future. The company is currently earning a return on equity of 38.5% which is again above the industry average of 30%.
Since the company has been paying handsome dividends to its stock holders and has stated the intention to pay increasing dividends in the future as well. The dividends growth model has been used to value the company's stock. The table below shows historic dividend growth well above what has been assumed for the future in order to remain conservative.
After applying inputs for the expected market return and risk-free rate of 29.87% an upside potential in company's stock price has been estimated and is shown below.
The multiples-based valuation has also been undertaken to assess the company's stock price potential. The stock is currently undervalued with a fair value of $109.38 as shown.
Cash flows have been given more weight since they are true indicators of the company's position while earnings are subject to manipulation so they have been allotted a relatively lesser weight. Combining the results from both methods has caused the company's stock to reach a 21.28% upside potential as shown below.
From the analysis above, the company's strengths, which have saved it from being affected by industry trends, have been identified. These include the company adopting strategies to counter consumer concerns and address changing consumer preferences. Additionally the company's sales and expansion opportunities in regions outside the US are also satisfactory. As a result of these factors analysts are optimistic about the company's share price. Their opinion was also supported by the valuation techniques utilized in the analysis above. The analysis also showed that the stock is undervalued at its present price.
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 article has been written by a Blackstone Equity Research research analyst. Blackstone Equity Research is not receiving compensation for it (other than from Seeking Alpha). Blackstone Equity Research has no business relationship with any company whose stock is mentioned in this article.