Too Cautious On Mickey D's? What Do You Think?

| About: McDonald's Corporation (MCD)
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We love McDonald's, but we've been the word of caution on the shares the past year or so. Have we been too cautious?

Fundamentals are great at the Golden Arches, but its valuation is quite stretched - and competition is only getting more aggressive.

Let's take a look at shares of Mickey D's. We'll derive a fair value estimate and margin of safety, too!

By The Valuentum Team

Quick Valuation Take: We think McDonald's is worth $94 per share with a fair value range of $75.00-113.00.

Ugh, talk about a company that everyone knows about that we didn't nail the call on. We're somewhat disappointed that we have been cautious on McDonald's (NYSE:MCD), and frankly, we're surprised not only by the company's turnaround, but also how aggressively the market is buying into shares on the basis of a view that such improvements will be sustainable. Here's where we went wrong on the shares.

We were getting word several months ago that McDonald's franchises were livid about the company's recent transformation efforts, and that there were all sorts of problems with rolling out all-day breakfast and the like - labor problems, the threat of minimum wage hikes, no strategic direction by management, competition from Starbucks (NASDAQ:SBUX) coffee and others aggressively entering into breakfast and issuing lunch promotions, and the list goes on and on. Then... poof. All of a sudden, McDonald's gives people access to breakfast all day and then same-store sales performance surges?

One might say: "What was management thinking all these years holding back this initiative... until now?" Whoops, right? That is neither here nor there anymore. The reality is, things are going really well right now, and we really haven't heard a peep from those previously complaining franchisees. We were head-faked, and not only has McDonald's become a fan favorite among breakfast-goers, but dividend-hungry investors have been eating up shares, too. A lofty dividend yield, and refranchising efforts that are transforming its margin economics have really brought some new investors to shares.

Now that said - and maybe we're being too hard on ourselves - we could have envisioned a scenario where the fundamentals would improve. But the stock price action is rather peculiar. We're viewing the transformation plan as a step change, not sustainable dynamics that can be repeated each and every year. Is this where we differ than the market? Once all-day breakfast initiatives reset sales trends, and refranchising efforts are complete, what next? Not much, in our view. What does that then mean?

It means that investors are paying nearly 20 times fiscal 2017 earnings for a company that may plateau yet again toward the latter part of this decade. Okay, you're thinking - but what are we really saying? Well, let's imagine McDonald's reverts to 15 times fiscal 2017 earnings - this is quite a reasonable valuation (certainly not unreasonable). What does this then imply? We'd be looking at a stock trading at ~$90, a far cry from the $120+ price tag today. From our perspective, there's some froth in the shares, but we've been way too cautious, it seems, to this point.

McDonald's Investment Considerations

McDonald's Investment Highlights

  • Home of the Big Mac, McDonald's is the world's largest quick-service restaurant brand. The firm's management is extremely shareholder-friendly, returning billions to shareholders annually. It serves ~70 million customers on a daily basis in over 110 countries. The company was founded in 1940 and is based in Oak Brook, Illinois.
  • McDonald's comeback may have legs, but we think the shares won't be truly tested until 2017, when step-change initiatives wear off. The company could be benefiting more from falling gas prices (and higher consumer discretionary income in its target demographic) than really anything else at the moment.
  • Though it will be hard for the firm to pull another gem out of its hat to the same success as McCafe, "all-day breakfast" has been a needle-mover, and its refranchising efforts are moving the operating line nicely. The company is presently engaged in a massive breakfast war with Yum! Brands (NYSE:YUM), Taco Bell and Burger King (NYSE:QSR) and a coffee war with Starbucks and Dunkin' Brands (NASDAQ:DNKN), however.
  • McDonald's turnaround plan, released May 2015, was met with much skepticism. Though the initial read is positive, we're not convinced the firm will be able to completely fix its menu issues while improving service speeds, two major areas of concern. Increasing competition from fast-casual and healthier menus is a permanent, structural change.
  • All-day breakfast and other menu initiatives have investors excited, and the initial read is that the "buzz" it has created has worked. Franchises aren't that happy, though, and we wonder whether these catalysts are merely a one-time step-up in nature. Developments in the labor/wage market are worth keeping an eye on.

Business Quality

McDonald's Economic Profit Analysis

The best measure of a firm's ability to create value for shareholders is expressed by comparing its return on invested capital with its weighted average cost of capital. The gap or difference between ROIC and WACC is called the firm's economic profit spread. McDonald's 3-year historical return on invested capital (without goodwill) is 23.6%, which is above the estimate of its cost of capital of 9%. As such, we assign the firm a ValueCreation™ rating of EXCELLENT. In the chart below, we show the probable path of ROIC in the years ahead, based on the estimated volatility of key drivers behind the measure. The solid grey line reflects the most likely outcome, in our opinion, and represents the scenario that results in our fair value estimate.

McDonald's Cash Flow Analysis

Firms that generate a free cash flow margin (free cash flow divided by total revenue) above 5% are usually considered cash cows. McDonald's free cash flow margin has averaged about 16.3% during the past 3 years. As such, we think the firm's cash flow generation is relatively STRONG. The free cash flow measure shown above is derived by taking cash flow from operations less capital expenditures, and differs from enterprise free cash flow (FCFF), which we use in deriving our fair value estimate for the company. At McDonald's, cash flow from operations decreased about 8% from levels registered two years ago, while capital expenditures fell about 36% over the same time period.

McDonald's Valuation Analysis

We think McDonald's is worth $94 per share with a fair value range of $75.00-113.00.

The margin of safety around our fair value estimate is driven by the firm's LOW ValueRisk™ rating, which is derived from an evaluation of the historical volatility of key valuation drivers and a future assessment of these. Our near-term operating forecasts, including revenue and earnings, do not differ much from consensus estimates or management guidance. Our model reflects a compound annual revenue growth rate of -1.1% during the next five years, a pace that is higher than the firm's 3-year historical compound annual growth rate of -2.7%.

Our model reflects a 5-year projected average operating margin of 39.2%, which is above the company's trailing 3-year average. Beyond year 5, we assume free cash flow will grow at an annual rate of 2.9% for the next 15 years and 3% in perpetuity. For McDonald's, we use a 9% weighted average cost of capital to discount future free cash flows.

Margin of Safety Analysis

Our discounted cash flow process values each firm on the basis of the present value of all future free cash flows. Although we estimate the firm's fair value at about $94 per share, every company has a range of probable fair values that's created by the uncertainty of key valuation drivers (like future revenue or earnings, for example). After all, if the future were known with certainty, we wouldn't see much volatility in the markets, as stocks would trade precisely at their known fair values. Our ValueRisk™ rating sets the margin of safety or the fair value range we assign to each stock. In the graph above, we show this probable range of fair values for McDonald's. We think the firm is attractive below $75 per share (the green line), but quite expensive above $113 per share (the red line). The prices that fall along the yellow line, which includes our fair value estimate, represent a reasonable valuation for the firm, in our opinion.

Future Path of Fair Value

We estimate McDonald's fair value at this point in time to be about $94 per share. As time passes, however, companies generate cash flow and pay out cash to shareholders in the form of dividends. The chart above compares the firm's current share price with the path of McDonald's expected equity value per share over the next three years, assuming our long-term projections prove accurate. The range between the resulting downside fair value and upside fair value in Year 3 represents our best estimate of the value of the firm's shares three years hence. This range of potential outcomes is also subject to change over time, should our views on the firm's future cash flow potential change. The expected fair value of $115 per share in Year 3 represents our existing fair value per share of $94 increased at an annual rate of the firm's cost of equity less its dividend yield. The upside and downside ranges are derived in the same way, but from the upper and lower bounds of our fair value estimate range.

This article or report and any links within are for information purposes only and should not be considered a solicitation to buy or sell any security. Valuentum is not responsible for any errors or omissions or for results obtained from the use of this article and accepts no liability for how readers may choose to utilize the content. Assumptions, opinions, and estimates are based on our judgment as of the date of the article and are subject to change without notice.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.