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Summary

  • Valuation models can be very useful in determining if a particular security is undervalued.
  • The model must use conservative assumptions, or it will be proven to be wildly inaccurate.
  • McDonald's is, in my view, undervalued by at least 20%, offering the conservative investor above-average gains with below-average risk.

Valuation models can be very helpful in evaluating different industries for companies that are mispriced by the market. Oftentimes, an individual investor will allow personal feelings cloud their judgment when investing in securities. If a stock has been performing well, we tend to "give it" the benefit of the doubt and assume the good times will continue. The best values are seldom to be found in companies that are performing well, for it's very easy to be a cheerleader. The far larger gains are to be had by the intrepid investor who goes against the grain and invests in unloved industries ripe for a turnaround. Such is the current investment opportunity in McDonald's (NYSE:MCD).

MCD operates in the restaurant industry, which has had a particular rough go of it over the last few years. The economic meltdown of 2008 has caused a lack of meaningful wage growth, which has caused many to cut back on expenditures. One of the easiest expenditures to limit is restaurant usage, as more are preparing food at home. This recent phenomenon has led to weak revenue growth throughout the industry, with MCD as no exception. The weak revenue growth has caused the shares to lag the overall return of the S&P 500 since 2009, as evidenced by the charts below. The underperformance has no doubt caused many to shun the shares in a quest for higher returns elsewhere.

The negative sentiment attached to the shares currently has caused the shares to trade down to what I believe to be a very attractive valuation level. As we can see from the table below, using a DCF analysis, MCD is trading at a 49.4% percent discount to its implied fair value. The first thing I do when I see such a wide disparity in value is examine the assumptions made to arrive at such a calculation. I am particularly interested in the assumptions made to determine if they are realistic.

The first set of data points I would like to point out is the sales growth data used to compute a fair value for the shares. The model is forecasting sub-2% sales growth, which I would hardly term as wildly optimistic. Conversely, the sub-2% growth over the next 5 years, in my opinion, will be proven to be wildly pessimistic, as the company is taking positive steps to drive sales higher. One of the main complaints bedeviling MCD currently is the lack of speed in processing a customer's order. MCD has taken positive steps to address these issues by simplifying the amount of products it serves. Last year, MCD would promote a new product that had multiple steps to produce. By making the offerings more complicated, it slowed down the overall speed in the kitchen, which led to longer wait times and slower sales. Invariably, many would see a long line at the drive-thru and move on to a local competitor, depriving MCD of additional revenue. This particular issue was most pronounced during lunch service, where the vast majority of consumers are time-compressed.

MCD is certainly not simply resting on its laurels; instead, it is aggressively trying to address the speed of service issue with an innovative test pilot in the Florida market. The company is guaranteeing your order will be ready 60 seconds after you pay for it at the drive-thru window, or your next sandwich is on them. By simplifying the menu and making serve it is well-staffed for the noon to 1 pm lunch hour during weekdays, the plan should drastically improve on wait times at the drive-thru.

I found an interesting comment from a competitor Panera Bread (NASDAQ:PNRA) discussing the speed of service during the lunch hour. As we can see from the quote below, a few additional customers served during the lunch portion can have a huge impact on sales growth.

"Walk into our cafes at 12:30 p.m. during the lunch rush, and you'll see the lines. It's clear that the demand for our product is not the issue. Our problem is keeping up within meeting that demand with an in-cafe experience that delivers something truly differentiated. Roughly 6 customers per cafe per day equates to approximately 1% transaction growth. Indeed, the difference between the successful or unsuccessful transaction growth at Panera, at least as we hold it, is just 6 to 12 customers per cafe per day. And yet, anyone of us can visit a Panera and see that - and see that many customers walk out of our cafes every day when they can't or won't wait in the line."

I included this quote to illustrate the essence in speed to not only MCD but its competitors in the field. The weekday lunch hour is extremely time-constrained, with speed of service, in my opinion, the overriding factor in increasing sales.

The second point I would like to mention with regards to the models forecast for sales growth is a macroeconomic issue that is starting to shift from a headwind to a tailwind. The world economy has begun to exhibit sustained growth coming off the disaster of the 2008/2009 financial meltdown. In the US, the Federal Reserve has pushed interest rates to absurdly low numbers in an effort to buy time for the financial system to heal from the self-inflicted wounds.

(click to enlarge)

(Charts taken from this recent Forbes article)

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As we can see from the charts above, job growth has begun to pick up and the unemployment rate has begun to trend down to a more acceptable level. The naysayers in the audience will mention that the U-6 unemployment is considerably higher, and it should be used as the real gauge of unemployment. Fair enough, the chart below speaks to that. Notice how the trend is undeniably pointing lower. The Fed, in my opinion, is consciously aware of this reality, and is more than willing to allow interest rates to remain low in an effort to combat this issue. The same situation can be seen overseas in Europe as well, with Mario Draghi following a similar path. I expect the trend to continue, which will aid MCD growth its rather anemic sales.

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(Image taken from this recent Forbes article)

The Discount Rate analysis can be seen above, which shows a WACC of 7% is used to determine MCD fair value. I would like to discuss the risk-free rate used in the model. I choose a risk-free rate of 3%, which is higher than the 10-year US Treasury bond, yet a bit lower than the corresponding 30-year US Treasury bond. I am extremely hard-pressed for anyone to show me a risk-free rate of return greater than 3% in the current low interest rate environment. Furthermore, MCD currently pays out a dividend of greater than 3.5%, which is more than covered by earnings.

The second set of data points I would like to highlight is the cost of debt. The low interest rate environment here is an absolute boon for well-established strong companies such as MCD. The cost of debt figures used is 4% and 5%, which is the current market rate for MCD debt instruments. If we look at the after-tax cost of debt, we can see just how favorable the low rate environment is for well-established companies with a proven business model.

The final question becomes what sort of discount we should apply to the model's projections. I will use a 20% discount, which will net out a fair value of roughly $113 per share which I will use for my target price by the conclusion of 2015. At its current rate of $94.45 per share, a current investor in MCD can reasonably expect a total return of $18.55 per share in capital gains, along with an additional $3.43 worth of dividends. The total overall gain I am targeting is 23.27%, which is highly satisfactory for such a low-risk play as MCD. I would like to mention the valuation model uses a stagnant share count in figuring its model price, which will be proven to be on the conservative side.

Management of MCD recently announced a new 3-year cash return proposal, which I found to be quite interesting. The proposal will return $20 billion to shareholders over the next three years through a combination of share reductions and dividends. The plan would therefore return roughly 21% of MCD current market cap to investors. The following are some key excerpts from the press release that I thought were particularly appealing.

  1. Return $18 to $20 billion to shareholders between 2014 and 2016 through a combination of dividends and share repurchases, representing a 10% to 20% increase over the amount of cash returned between 2011 and 2013;
  2. Refranchise at least 1,500 restaurants by the end of 2016, primarily in Asia-Pacific, Middle East and Africa (APMEA) and Europe, reflecting a more-than-50% increase in refranchising activity compared with the prior three-year period; and
  3. Analyze G&A spending with the primary intent of reallocating resources to higher return initiatives and growth areas, including development of the Company's global digital capabilities.

"The actions we are taking to enhance long-term shareholder value fit squarely within our proven business model," said Senior Executive Vice President and Chief Financial Officer Pete Bensen. "Our 3-year cash return target is based on several activities including the significant free cash flow generated from our operations, as well as the use of cash proceeds from our debt additions and refranchising activity. Financial discipline has always been a cornerstone of McDonald's strategic plan, and we will pursue these activities while maintaining appropriate levels of financial flexibility, liquidity and access to capital for the Company and the System. Our commitment to this discipline continues to fortify our long-standing financial strength and our ability to deliver sustained profitable growth."

MCD's focus on aggressively reducing its share count will have a positive impact on its share price. The aggressive reduction in share count will provide an additional tailwind that will help lift the shares higher over the next three years. While my target price is quite satisfactory in the short term, the real value will be attained by those who hold and simply reinvest the dividend over the course of the rest of the decade. Sometimes, the best move an investor can do is to do nothing. Such is the case with MCD.

MCD Chart

MCD data by YCharts

I personally invest in companies that offer above-average returns with below-average risk. Granted, the overall gains may not be as satisfactory as, say some of the social media plays have returned this year, but I look to sleep well at night. I am more of a Warren Buffett follower who believes in investing in high-quality companies with a proven business model that are trading at a discount to their true worth. As a side note, for those who are more inclined to trade shares, MCD is entering into its weakest point of the year. Over the past three years, the summer/early fall period has proven to be an opportune time to invest in MCD, with the current year repeating the same pattern. I would like to offer a special thanks to Matt Hogan at Levered Returns for offering the wonderful charts we see in the article. I would also like to thank the audience for taking the time to read the article, and I look forward to your comments.

Source: Illustrating Why McDonald's Is Underpriced At Its Current Price

Additional disclosure: Investors are always reminded that before making any investment, you should do your own proper due diligence on any name directly or indirectly mentioned in this article. Investors should also consider seeking advice from a broker or financial adviser before making any investment decisions. Any material in this article should be considered general information, and not relied on as a formal investment recommendation.