Despite the disappointing May sales data and the stock taking a downturn recently because of the eurozone uncertainty, we are bullish on McDonald's Corporation (MCD). We believe that the current levels provide a good entry point for the stock. The following reasons make us bullish on the stock:
- World's largest restaurant chain and diversification in product offerings.
- Impressive growth in its Asian pacific segment, with expansion plans in China underway.
- Higher operating margins compared to its peers, Wendy's and Burger King.
- An impressive earnings growth rate of almost 20% over five years.
- Strong balance sheet.
- Sufficient cash flows from operations to meet liquidity and capital needs.
- Attractive dividend yield of 3.1% and a dividend growth rate.
- Consistent share repurchase plan.
Investors can shortsell the Consumer Discretionary Select Sector SPDR ETF (XLY) to hedge a long position in MCD.
McDonald's Corporation franchises and operates McDonald's restaurants primarily in the United States, Europe, Asia Pacific, Middle East, and Africa. As of December 31, 2011, it operated 33,510 restaurants in 119 countries, including 27,075 franchised restaurants and 6,435 company operated restaurants.
Key drivers
- Guest count drives sales of the company.
As depicted in the chart above, the guest count for MCD has increased over the past few years, with improvements visible in comparable sales as well. The company is seeing a rise in traffic despite the economic slowdown, and the fact that consumers are now more cautious than before regarding their spending. Since MCD operates in the defensive industry (beta of 0.26), it has enjoyed a more or less constant demand for its burgers and other products.
- Diversified product offerings have helped the company in many ways. Not only has the move away from the traditional "burger/fries" attracted more customers, but spending per customer has also increased. MCD has separate lines for breakfast now, with products like pancakes and yogurts gaining popularity. Other items include various juices and coffee drinks.
Catalysts
- The company plans to open another 250 restaurants in China in the current year. With the saturation of markets in the U.S., growth in China can be a major catalyst going forward. MCD is already enjoying impressive growth in the Asian pacific markets.
McDonald's Corporation has various franchise arrangements, including the main conventional franchisees arrangements, developmental license arrangement, and licensed foreign affiliates. Under the conventional franchisees arrangements, the company funds only a portion of the investment, with the franchisee providing the rest of the capital. Under the developmental arrangement, the licensee provides the entire capital and the company makes no investment.
MCD's business is divided into segments on a geographical basis, with a majority of its revenues coming from the U.S., Europe, and Asia Pacific and the Middle Eastern region (32%, 39% and 24% of total revenues respectively). MCD derives its revenues from the sales in its company-run restaurants and the fees from its various franchise arrangements. The chart below shows the performance of its various segments and compares it to the performance in the first quarter of the previous year. 
The table emphasizes the fact that MCD derives the majority of its revenues from its 6,435 company-operated restaurants. However, its APMEA segment has been the most impressive one when it comes to growth, overall revenues from this segment increasing by 11% in 1Q2012 compared to 1Q2011, which is also the highest growth shown by any segment.
Growth in sales for the company in the first quarter was primarily driven by factors like menu innovation (the new chicken Mcbites), favorable weather, and expansion in China and Russia. Comparable sales data also showed improvement in the first quarter, with the U.S. outperforming other segments in terms of growth. Comparable sales include all the sales, whether by the company or the franchises.
If we look at the margins for various segments of the company-operated stores, they improved by 6% for the quarter, however, the offsetting factors at play were high commodity and labor costs. According to quarterly results, net income improved by 5%, with earnings per share growing by 7% to $1.23. The company's operating margins of 31% are impressive relative to its peers, YUM! Brands, Inc. (YUM) (16%) and Wendy's (WEN) (7%).
However, second quarter results have been disappointing for MCD, wherein the company missed its sales guidance, mainly due to tough austerity measures in Europe and a slowing economy in China. According to a report presented by MCD, continued costs in preparation for the summer Olympics are going to continue to weigh on the most recent quarter's results (Reuters).
Dividend Yield
The company has historically returned money to its shareholders in the form of dividends. It has an attractive dividend yield of 3.1%, which is higher than most of its peers (Wendy's dividend yield, 1.80%). It also has an impressive historic dividend growth. The company has paid dividends on its stock for 36 consecutive years and the amount of dividends paid each year has also gone up. The figure below illustrates growth in dividends over a three-year period (growth of almost 12%).
McDonald's Corporation has also maintained consistency in its share purchase program, which is a part of its goals to return shareholders' money. Moreover, this share repurchase has helped its bottom line and is likely to do so going forward.
Source: Company website
The company has a total debt of around $13 billion, with no substantial exposure to a single counterparty. Major credit rating agencies have a stable outlook for the company's debt with no indication of a future downgrade and with an interest coverage ratio of 27%, substantially higher than its peers. It is not likely to run into any debt servicing problems. The company has total cash of around $2.5 billion as of the most recent quarter, and operating cash flows of $7 billion, which should be sufficient to meet its liquidity and capital needs going forward.
Market Performance
The stock has outperformed the market and competitors like WEN and YUM over a period of five years, indicating the value in holding the stock long term.
Risks
The company faces various challenges going forward in the form of increased competition from its peers, a slowing economy and the resulting unemployment. From a company-specific perspective, rising costs of commodity, labor and occupancy provide challenges for the company, which it needs to address. On top of that, the company has an additional challenge of somehow ensuring that its franchises and licenses have the proper experience and financial resources to operate in their respective regions.
Recommendation
The company's P/E (16x) is currently at a discount to the industry average (88x), as well as its five-year historic average (30x), indicating that it is a cheap stock at current levels. When compared to the said multiple of WEN, the stock is trading at a discount as well (WEN's multiple, 60x and YUM's 21x). Moreover, since the stock is currently trading close to its 52-week lows and is down almost 15% from its 52-week high of $10, we believe it is a good entry point to long the stock.
Comp. Table:
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
