McDonald's Corporation (MCD) has performed very well as a stock over the past few years, having almost doubled the returns of its shareholders since 2009. However, it has taken a little dip since early 2012, and is currently trading at around $89. So the question becomes, 'Is it worth buying now, or was the decline justified?' I will try to answer these questions by estimating the future profitability of each segment that McDonald's operates in, and putting those numbers into a discounted cash flow model that calculates the intrinsic value of the company.
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McDonald's in the United States
- Revenue grew 1% from 2009 to 2012 (TTM). Both franchise revenue and company revenue have increased.
- Guest count increased by 0.5% in 2009, 5.3% in 2010 and 3.4% in 2011.
- McDonald's is constantly adding new products to its lineup. In 2010, the Angus Snack Wrap was launched, and in 2011, Fruit & Maple Oatmeal was added to the menu. New additions to the McCafé product line have been introduced through the years as well.
- Higher commodity costs have had a negative effect on the bottom line in 2012, though this effect was offset by the increased sales.
Years ago, one could have thought that McDonald's growth opportunities were limited, as it was already the market leader in the US burger market (see below diagram); however, it has showed the incredible ability to constantly innovative its product line and at the same time increase its market share in the burger market.
McDonald's has proven to be a timeless brand throughout its history, which has given it a significant advantage over its competitors. So while I would normally assume a much steeper decline in growth and margins for such a market leader, I only estimate that McDonald's will lose a couple of percentage points in market share and operating margin over the next 10-plus years.
However, I believe that McDonald's has room to grow through its McCafé brand, as the market for coffee is expected to grow at a moderate rate over the coming years (see the below diagram). It would definitely help if MCD could gain a few percentage points in market share as well. I also believe that it will continue to innovate and add a few new successful products to its portfolio.
Therefore, I believe that McDonald's will grow its revenues by 5% y/y, and maintain an operating margin of 50% until 2022. In the terminal period, I assume a growth rate of 2% and an operating margin of 45%.
The European market
- Revenues grew by 18% from 2009 to 2012, primarily due to an increase in same-store sales in Russia, France, Germany and the UK, and an expansion in Russia.
- Europe McDonald's relies more on income from the company's own stores, which is unlike US McDonald's, where most of the income comes from franchises. As there are fewer costs related with franchise operations, margins are lower in Europe than in the US.
- Franchise margins are lower in Europe than in the US. Despite increased same-store sales, no significant rise in margins has been made, as occupancy expenses have risen as well.
- Commodity costs and higher labor costs were other factors negatively impacting the operating margin in Europe.
- Similar to most other US-based companies operating in Europe, McDonald's has been impacted by the strength of the dollar in the USD/EUR exchange rate in 2012. Revenues would have a risen by a couple of percentage points had it not been for currency adjustments.
McDonald's Europe has actually done reasonable well (before currency adjustments), given the macroeconomic problems in Europe. The fact that McDonald's has been able to maintain its margins is especially impressive, considering the rise in commodity costs. I do not expect the EUR/USD exchange rate to change significantly in the future. Hence, I predict that operating profit will increase again. I don't predict significant revenue growth because a lot of the growth over the past few years has come from expansion in Russia, where stores have so far have been company operated. However, McDonald's has recently partnered with the Russian company Rosinter, and plans to open 40-45 franchises a year in Russia. This will have a significant positive effect on margins. One could also argue that the McCafé brand could win market share over Starbucks Corporation (SBUX), as the economic crisis may drive consumers towards McCafé's lower prices. I expect revenue to grow by 4% y/y and total operating margin to be 38% until 2022.
Asia-Pacific, Middle East and Africa
- Revenues have risen by 43% since 2009 due to high growth (especially in China, and to some extent Australia).
- Franchise margins are higher than what they are in the US and Europe due to the larger proportion of developmental licensed restaurants. The company receives royalty income from these restaurants with no corresponding occupancy costs.
- Company operating margin is slightly lower in APMEA than in the US and Europe, which can be explained by the fact that new stores have lower margins than old stores. And since a large part of the growth in revenue has been from new store sales, these margins are somewhat expected.
China seems to be slowing down, which has hurt same-store sales in 2012, which fell by 1.7% last quarter. However, I believe we should take this decline with a grain of salt, as a lot of new stores have opened in China, and the numbers could reflect the cannibalism effect at work. McDonald's is planning to double the amount of stores in India over the next three years, and I believe that could India could be decent growth driver for McDonald's. South Africa is another market where McDonald's plans to expand its operations.
I estimate that revenues will grow by 7% y/y, and operating margin will increase to 32% until 2022.
In the table below, you can see my combined expectations for growth rate, profitability, discount rate and reinvestment's.
As I expect FCF of 3905 in 2013, the 1-year forward Price/FCF is 22, which is pretty expensive for a current market-leader (as the market-leader usually has limited growth opportunities). However, I expect MCD to obtain a decent growth rate and a high operating margin through the budget period. McDonald's is also a very safe investment, and therefore I use a low discount rate, which means that the present value of the forecasted free cash flow is relatively high.
The value of income over the next 10 years is $33 billion, which is around 36% of the current market value of the company. But I also expect MCD to continue to be very profitable after 2022, and the present value of the terminal period is $70 billion - around 77% of the market value. Subtracting the net debt ($11.7 billion) from the combined market value of the budget and terminal period, I end up with a fair share price of $89. This means that I believe that the company is fairly valued.
Does this mean McDonald's is a bad investment? Not necessarily, as there can be a few reasons why you should but this stock:
- You want a relatively safe place to invest your money, and you are not satisfied with a 1.6% yield on treasuries.
- You disagree with some of my assumptions on growth rate or profitability. You may think APMEA will grow by more than 7% or that margins will be higher.
- You disagree with assumptions on the discount rate. To calculate the discount rate I used a beta of 0.55, which is above the historical beta (of around 0.45). I chose this because I don't feel completely certain that McDonald's will continue to launch successful innovations. I think it's likely, but not 100%, and I believe the historical numbers underestimate the risk. But if you are more confident than me, then you will probably find McDonald's to be undervalued.