Upcoming Earnings Release and Our Conclusion
MCDONALD'S CORP (NYSE:MCD) is scheduled to report its16Q3 earnings Friday, October 21 th before the market opens with a conference call at 11AM EST. Per Bloomberg: Of the 29 sell side analysts providing estimates, the consensus projections of revenue and EPS of $6,285M (range $5,963M-$6,428M and $1.49 (range $1.44-$1.54), respectively, are substantially unchanged since they were lowered slightly following the Q2 report, although comps at 1.8% (range +0.8% to +2.8%) have been reduced by about 50bps in that time. Similarly, 16Q4 revenue and EPS estimates are substantially unchanged, while comps were only modestly lowered, and FY17 estimates, including comps, are substantially unchanged. Meanwhile, the mean target price is $128 (range $110-$140) which is lower by nearly $3 since the Q2 report). On October 13 th the company announced $130M or $0.12 in charges taken in conjunction with its G&A and refranchising initiatives.
While short term investors try to "play" quarter to quarter same store sales results, with the stock down over 10% from its recent high we view MCD as one of the most attractive large capitalization long term situations, and would purchase it as current levels.
MCD: Company Overview:
McDonald operates and franchises a global quick service restaurant chain universally known for its value-priced hamburgers and fries. At the end of its 16Q2 (6/30/16), its global system consisted of 36,504 units of which 6,137 were company operated and 30,367 were franchised. About 40% of the units are in the US. Of the franchised units, MCD owns or leases the land and building on about 70%, which it leases (or subleases) to the franchisees, earning percentage rents in addition to royalties and fees. The remaining franchised units are operated as either joint ventures or via the more asset light arrangement typical in franchising today whereby the franchisee is directly responsible for the real estate investment.
The company has gone through periodic declines and recoveries in its 60 year history. The most recent cycle started with its 2004-2011 recovery from the stagnation in the early 2000's. In those 8 years global comps averaged nearly 6% and its operating margins expanded over 1500 basis points to over 31%. Since then comps weakened and margins retreated as the company foundered in the face of new consumer preferences (healthier and fresher food), new competitors (fast casual, better hamburger entrants), macro trends and events (strengthening of the dollar, wage pressure, regulation, tainted supply in Asia) and missteps (overly complex menu, a poor product pipeline, poor marketing, supply chain issues).
In early 2015 new CEO Steve Easterbrook outlined a turnaround. The plan included grouping global operations into 4 segments (US, International Lead Markets, International High Growth Markets and Foundational/Corporate Markets) that combine markets with similar characteristics and opportunities for growth rather than by geography. In addition by the end of 2018 he targeted refranchising 4,000, the majority in the High Growth and Foundational markets. When achieved, franchisee ownership will have increased to 93%, and the company expects it to exceed 95% long term. The plan also targets reductions in SGA expense by $500 million, a decrease of about 25%, which, if achieved, implies an EBIT margin boost of 200bp. With regard to menu, the plan is committed to streamlining the menu while still allowing for personalization and adoption of consumer-facing technologies, such as mobile ordering apps. While MCD has lagged the industry in employing technology to streamline service and enhance the customer experience, its scale and global reach provide a significant edge in catching up and perhaps surpassing its competitors. Notably, it views the 120 countries where it operates-many already with more sophisticated digital and mobile traditions than the US-as test labs for best practices.
MCD has traditionally been one of the least leveraged restaurant operators. The company's ratios of Debt to TTM EBITDA and lease adjusted Debt to TTM EBITDAR of 2.8X and 3.6X, respectively are about a turn below the average of peers with 70% or more of system units franchised. But Mr. Easterbrook intends to increase debt by $10 billion to step up stock buybacks and capex which would lift its leverage measures to about peer average. On the other hand he has rejected a sale-leaseback of the company's real estate holdings or spinning them off into a REIT, and has expressed consideration of selling its equity holding in its JV in Japan. In the TTM through 16Q2 Cash from Operations was $6,294M, which net of capex of $1,750M, provided free cash flow of $4,544M, or a FCF margin of 18.1% of sales.
MCD: Recent Developments
MCD reported 2Q GAAP EPS of $1.25 which included $0.20 of previously announced charges related to its turnaround strategy (non-cash refranchising expense, G&A initiatives and moving its HQ) partially offset by unspecified gains from refranchising. Global same store sales were up 3.1%, including international lead markets up 2.6%, high growth markets up 1.6% including China up 2.1%, and foundational markets up 7.7% led by pre-Pokemon recovery in Japan. Those results were largely in line, however, all the attention is on the exception-U.S. comps, which slowed to 1.8% vs expectations of 3.0%. Company-operated margins were up 150 bps YOY to 17.1% (U.S. was up to 16.8% versus 16.5%, with the expansion driven largely by 190bps lower food costs) and margins on franchised revenues were up 10 bps to 81.7%.
MCD's slowing rate of U.S. same store sales growth in 2Q does raise concerns about lapping positive second half comps, especially in 4Q when the rollout of all-day breakfast drove U.S. comps up 5.7%. In explaining its US comp performance, management noted, as have others, macro factors, such as general consumer uncertainty, but also the unfavorable gap opening between the pricing of meals-away-from-home pricing and meals-at-home, exacerbated by labor pressures in the food service business vs the grocery business, though both sectors are benefiting from lower commodity costs. Still MCD notes its comps are over 100 bps better than its competitors in the QSR sandwich bu siness. In response, the company plans to tweak its all-day breakfast menu to include muffins, biscuits and McGriddles in all markets and will continue cycling items in and out of its McPick 2 value menu offering. Additionally, management reported U.S. gross pricing, which had been 3% higher for 2Q YOY would not be fully replaced as last year's increases run off. Separately, the company is slightly ahead of its SGA reduction target for the year on its way to $150M this year and $500M annually by 2017. It also refranchised 160 restaurants in Q2, which brings the total to 850 in the last 6 quarters and over 20% of the way to its target of 4,000 by 2018.Going forward, the challenges will be to sustain the progress of 2015 despite the headwinds from the macro environment (both domestically and globally), and higher labor costs, among others. Aside from sustaining positive comps, the company is challenged with restoring its traditional healthy balance of price and traffic. In the recent down cycle, the company has been able to take price but traffic has been consistently negative until 15Q4 when traffic was just barely positive.
Disclosure: I am/we are long MCD.
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.