McDonald's Shows Clear Vision For Efficient Growth

Dec.20.11 | About: McDonald's Corporation (MCD)

Management

One of the most overlooked and undervalued aspects of a company by casual investors is management. It tends to take a back seat to valuations and multiples, but I believe it is absolutely critical to appreciation of capital. Companies from different industries require certain responsibilities from its CEO. Technology firms need innovation, sin companies (tobacco, casinos, alcohol) need lobbying, and restaurants need efficiency. Think about it. At the heart of its business, McDonald's (NYSE:MCD) is just one restaurant duplicated thousands of times. Their business model needs to be so efficient, so transparent to its workforce, that each branch embodies the same efficient characteristics. There can be no room for interpretation by store managers, lest McDonald's begin to warp the strength of its cookie cutter brand.

As investors looking for capital appreciation in the restaurant industry, we need a leader who stresses those pertinent efficient themes.

McDonald's CEO Jim Skinner who has 10 years logged in the United States Navy, began his working career as a McDonald's restaurant manager and slowly worked his way through the corporate hierarchy. The intricacies and nuances of day to day operations are not lost on Skinner, which in turn leads to higher efficiency at the restaurant level.

An example of Skinner’s alterations includes a next-generation point-of-sale system implemented in mid 2010. The new system allows registers in McDonald’s chains to have images on the keyboard to designate items in their various forms. Hourly employees now hit a single key bearing a depiction of that precise order. Skinner's decision cut service time, boosted order accuracy, and allowed stores to handle more customers during heavy traffic periods. Instead of making the process variable through interpretation by hourly cash register employees, Skinner streamlined the process and increased chain level efficiency.

With a business model that is just one restaurant duplicated thousands of times, driven solely by efficiency, what more can you ask from your CEO?

Business Model

Fiscal 2010 Data

YUM

WEN

MCD

Company Operated Rev

86%

88%

68%

Franchise Rev

14%

13%

33%

Click to enlarge

The franchise model is something I love as a potential investor. It becomes in a sense a deleveraging tool to the overall economy. With a higher percentage of revenue dollars coming in from capital-intensive company-operated restaurants, firms like Yum! Brands (NYSE:YUM) and Wendy’s (NASDAQ:WEN) may be more profitable than McDonald's on a per store basis, but would fluctuate more during uncertainty. Also, in order to finance expansion into new emerging markets, Yum! Brands and Wendy's might have to raise more capital at unfavorable interest rates to compete with McDonald's expansion through its franchising model. McDonald's has built a brand so strong that they can afford such a highly aggressive franchising campaign.

In return for using the McDonald's name, franchisors take on the heavy costs associated with running individual restaurants. A few key points below about McDonald's franchising agreement:

  • For franchise licensing rights to a new McDonald's, the company charges its standard $45,000 initial franchise fee.
  • The second cost category associated with establishing a new McDonald's franchise is "Equipment and Pre-Opening Costs." According to McDonald's, the total costs range from $995,000 to $1,842,700. MCD leads it peers in this category.
  • Last, you have the yearly costs associated with running day to day operations. Labor and electricity are just two examples.This speaks to risk associated with overall economy growth. With franchisors kicking up a percentage of revenue back to corporate, McDonald's is bringing in revenue at minuscule costs. Think about a beta relative not to any individual index, but to the overall economy. McDonald's theoretical economic beta is lower compared to its peers due to its revenue leverage. With a higher percentage of revenues coming in through franchises, McDonald's lowers its fixed costs and overhead per revenue dollar and in turn lowers it risk associated with subpar macro economic conditions. McDonald's had been so efficient with the franchising model that it allows them to expand into new markets with less capital infusion.

Margins

Year over Year Comparison

A major ratio I look at in equities is margins, both operating and net. What I scan for is efficiency, and the ability of management to become more efficient as the years progress. Constant year over year margin growth is preferred, but not always necessary to paint a picture of increased efficiency. McDonald's, however, has posted margin gains in each fiscal year since 2007. This falls back to the first paragraph on quality management. If you have a CEO who clearly understands the business, preferably on a micro scale, he can then properly put measures in place to increase margins. Obviously with increased margins come increased earnings.

McDonald's

2010

2009

2008

2007

Operating Margin

31%

30%

27%

17%

Net Margin

21%

20%

18%

11%

Click to enlarge

Fluctuation in food prices

Some argue that higher food prices hurt any restaurant, particularly the fast food industry . Rightfully so as they do exhibit strain on margins, but I argue that rising food prices aren’t the negative catalyst that could derail a company like McDonald's. In fact, I would go as far to say that higher costs of food commodities help a business like McDonald's grow. Sure it might lower operating margins, but at higher revenue volume. With a 20% rise in certain groceries, a lower cost meal alternative becomes attractive to consumers. That substitute good becomes a necessity to keep your food budget at reasonable limits.

If McDonald's, which has such strong relationships with its suppliers, can somewhat control the inflation in prices and maintain critical price points, then they will exhibit near term as well as long term top line growth. A flight to lower cost food choices by consumers brings McDonald's in contact with a new stream of eaters looking to try its product. Hamstrung by rising prices elsewhere, new consumers who wouldn’t normally be McDonald's customers, are forced to give McDonald's an opportunity to win their consumer dollars.

Expansion

Expansion is always essential when investing. After all, you are investing based on the calculations of future cash flows. You want to invest in firms that can pinpoint expansion points and deliver. There are two key areas of growth I want to illustrate that makes McDonald's a viable investment going forward.

Menu Items

Innovation is vital, and ignoring changing consumer habits is a death warrant. See Blockbuster, AOL, Borders etc. With consumers pushing for more flexible and healthy menu items, McDonald's has shown its ability to adapt. With salads, fruit, low carb snack wraps, and fruit smoothies, McDonald's now appeals to a broader audience, and in turn rakes in more revenue. The thinking is this, for too long McDonald's has not catered to the needs of the health conscious individual. When one member of a food-seeking group rejects a fast food option due to healthy eating habits, it alienates the rest of the group from making their purchase at McDonald's. Management saw this as a wasted opportunity for revenue. With these new healthy items on their menu, McDonald's is now more attractive to a more universal group of consumers and allows for more overall revenue.

Emerging Markets

Expansion is also vital to the future health of the company. Take McDonald's systemwide restaurant numbers below. Brazil and China, two of the fastest growing economies, have been a focal point of expansion in recent years, with restaurant numbers growing by 14% and 75% respectively since 2005. The emerging middle class in China has shown a desire for more McDonald's products. Betty Tian, a McDonald's spokesperson, stated that by 2013, the company plans to have 2,000 stores in the Chinese market. While McDonald's has been seeing promising growth out of its domestic stores, the growth associated with expansion into China could be immense. Sure the lack of strength of the USD will have a negative effect on foreign expansion, but getting exposure to a huge population like China will be vital to long term growth.

McDonald's Systemwide Restaurants (2010 Annual Report)

(at year-end 2010 and 2005)

2010

2005

5 Year Growth

United States

14,016

13,727

2%

Japan

3,302

3,802

-13%

England

2,203

2,323

-5%

Canada

1,434

1,378

4%

Germany

1,386

1,264

10%

China

1,287

735

75%

France

1,193

1,060

13%

Australia

831

739

12%

Brazil

616

542

14%

Click to enlarge

Performance

At its current valuation of 17x forward earnings I see McDonald's as a solid buy at these levels. If you would like to wait out the mess in Europe before jumping all in, then feel free to buy in small doses on the market dips. My opinions over the course of this reading are clearly bullish on McDonald's.

Is McDonald's going to outperform a cyclical casino stock in a huge bull market? Probably not. Is it going to have outlandish revenue growth like the next hot tech stock in a bull market? Nope. But look at yourself as an investor. Are you trying to play the market swings or invest in a solid company that has proven growth, both during recessions and booms? Some have made a profession out of timing the market, and in turn play the market through 3x price movement ETFs and margin accounts. That’s trading, not investing. Works for some, not for the masses. McDonald's is a proven company with a proven track record. A track record that shows efficiency as well as expansion initiatives to grow both company and investor dollars.

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