As a new CEO, Don Thompson, is set to take over for Jim Skinner at McDonald's (MCD), a review of the company's fundamentals is in order. Skinner has done a terrific job at the helm, and I believe the absence of his deep industry knowledge will be missed. With the S&P 500 currently trading above its historical multiple, bears are likely to be eyeing overpriced stocks.
In this article, I will run you through my DCF model on McDonald's and then triangulate the results with an exit multiple calculation and a review of the fundamentals compared to Wendy's (WEN) and Yum Brands (YUM). I find that these restaurant businesses are currently priced more on the aggressive side. While I wouldn't advise selling shares like the bears, I advise merely a "hold" for all of the securities.
First, let's begin with an assumption about the top line. McDonald's finished FY2011 with $27 billion in revenue, which represented a 12.2% gain off of the preceding year: acceleration. I model 9.9% per annum growth over the next half decade or so.
Moving on to the cost side of the equation, there are several items to consider: operating expenses, capital expenditures, and taxes. I model cost of goods sold as 60% of revenue vs. 9.5% for SG&A and 8.8% for capex. Taxes are estimated at 30% of adjusted EBIT (i.e., excluding non-cash depreciation charges, in order to keep this a pure operating model).
Taking a perpetual growth rate of 2.5% and discounting backwards by a WACC of 7% yields a fair value figure of $93.61. Basically, the market has fairly priced the stock.
All of this falls within the context of impressive operating performance, as noted by the company:
I'm pleased to report a strong fourth quarter and another strong year for McDonald's in 2011. System-wide sales increased 7% in constant currencies, with global comparable sales up 5.6%, marking our eighth consecutive year of positive comp sales growth in every area of the world.
We closed the year on a high note with fourth quarter comp sales up 7.5%, the highest quarter in over seven years, and December comp sales at 9.6%, reflecting positive momentum and a weather benefit in Europe and the U.S. This momentum continues as we begin 2012, with global comparable sales for January expected to be up 5.5% to 6.5%.
Indeed, from a multiples perspective, McDonald's has room for upside. It trades at a respective 18.1 times and 15.1 times past and forward earnings, vs. 120 times and 20.8 times, respectively, for Wendy's and 26.1 times and 18.9 times, respectively, for Yum. For a company with such a strong retail name, it strikes me as odd that its multiples are this low. Sure, growth expectations may be lower, but this does not explain why forward multiples are at a discount to those of its peers.
Consensus estimates for Wendy's EPS forecast that it will grow by 20% to $0.18 in 2012 and then by 27.8% and 8.7% in the following two years. Assuming a multiple of 17 times and a conservative 2013 EPS of $0.21, the stock would fall to $3.57 for 25.5% downside. In light of this risk, I expect restaurant investors to consider safer stocks like McDonald's. While I would normally argue that this allows for a silver lining (i.e., higher risk-adjusted returns), Wendy's 0.94 beta limits the high reward case.
Consensus estimates for Yum's EPS forecast that it will grow by 14.3% to $3.28 in 2012 and then by 15.2% and 15.9% in the following two years. Assuming a multiple of 17 times and a conservative 2013 EPS of $3.73, the stock would fall to $63.41 for 11.2% downside. Again, in light of this risk, McDonald's may very well be the outperformer as macro trends improve.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.