McDonald's: Shifting Business Model Creates Opportunity For Investors
Summary
- McDonald’s has always been a favorite in the dividend community. Today, it is riding high on strong earnings driven by solid comparable sales growth and the benefits of re-franchising.
- In our view, McDonald’s Experience of the Future initiative is the natural progression of its re-franchising strategy as it shifts from a Restaurant Operator to an Intellectual Property Licensor.
- We believe that McDonald’s earnings will continue to grow strongly for the foreseeable future and present the case for how the stock could appreciate 15-22% above the current level.
Analysis
McDonald’s Enters the 21st Century
The typical consumer experience at McDonald’s (NYSE:MCD) involves either waiting in a queue or going for a drive-thru at one of its many outlets. However, in an era where companies like Amazon (AMZN) are looking to delivering goods to customers using drones and when payments can be made through services like Apple’s (AAPL) Apple Pay, McDonald’s methods of bringing its All-Day Breakfast and French fries to its customers seems increasingly ‘last century'.
Enter CEO Steve Easterbrook’s Experience of the Future initiative (or “Experience” for short), which adds technological flair to the Golden Arches’ fast-food staples through touch screen ordering kiosks, app-based mobile ordering, partnerships with third party delivery services.
The idea behind these initiatives is to adjust to customers’ lifestyles today – with customers increasingly focused on convenience and frictionless interaction – while bringing McDonald’s classic menu to people more quickly (and perhaps more frequently).
McDonald’s hasn’t limited its initiative to the United States – it has rolled out its Experience initiative to markets as far away as Hong Kong – so the intent is clearly to make Experience its new standard of service.
The Experience initiative isn’t all about optics either – this was clearly intended to help drive future earnings growth. Wells Fargo has estimated that it could drive a 1% bump in comparable sales next year based on the mid-single digit growth in same-store sales at the Canadian and UK outlets where Experience has been rolled out.
Dividend and Recent Stock Performance
This is music to the ears of investors who are currently enjoying McDonald’s $3.76 annual dividend – which works out to a 2.5% dividend yield. Among restaurant stocks, McDonald’s has the distinction of being the only blue chip with a yield that is 70-basis points better than the industry average. This yield is also attractive in relation to other S&P500 stocks – as well as the average Dow Jones Industrial Average constituent.
McDonald’s shares have risen by 29% in the year-to-date on the back of a 19% surge in its first-quarter earnings that were driven by a 4% rise in global comparable sales. Investors should also note that while overall retail sales have been soft in the United States, consumers have persisted in their patronage of restaurants and bars, which delivered 2.7% growth in the first five months of the year, compared to the same period a year earlier. This is reflected in the solid performance of the Dow Jones Restaurants & Bars Index, which has risen by over 15% since the end of 2016.
Re-franchising and Experience of the Future are Two Sides of the Same Coin
Re-franchising, or McDonald’s practice of franchising out its own stores to franchisees in exchange for rents and royalties, has generally been met with approval from shareholders since it effectively allows it to cash flow its fixed assets, thus freeing up capital to be returned to shareholders.
Of course, this initiative has a limit: McDonald’s aim is to bring the share of the franchisee-owned store to 95% and the current count is somewhere in the mid-80% range. This suggests that McDonald’s re-franchising efforts could be over in the next 3 years (assuming it makes progress on re-franchising an average of 4% of its stores each year).
So, what’s next after that?
In our view, Experience is merely the pre-cursor to McDonald’s generating cash flow from its intellectual property. Consider how Experience of the Future plays to its asset-light model – the ordering Kiosks could remain the property of McDonald’s Inc. even as the franchisees pay a mandatory license fee for their use, with the pricing attractively below the cost employing store front-liners to man the cashiering stations. It could even simply license the machines to third parties in exchange for an attractive fee.
Meanwhile, partnering with third-party delivery services could eventually lead to a future where strategically-located commissaries prepare food for pick-up by the services and delivered to customers in key locations in McDonald’s major markets. The commissaries themselves wouldn’t even need to be owned by McDonald’s. Instead, they could make the initial investments to bring the standards forward – then re-franchise the commissaries to willing operators.
All of this is possible, of course, because McDonald’s will effectively bring its store-front to customers at little cost beyond app development – people tend to think of apps as everyday conveniences when they’re actually distribution vectors – for good, services, ideas and the like. In this case, McDonald’s customers would effectively be building a store for McDonald’s wherever they may be – at virtually zero cost to the Golden Arches.
What does this mean? That, as Wall Street already knows, McDonald’s should probably not be judged by its aggregate revenues so much as its margins and profits. A look at McDonald’s EBITDA margin shows that it’s trending in the right direction – in Q1-17, the company’s EBITDA margin was a solid 41.4% -- nearly or 2,000-basis points better than its average of the last 5 years.
This reading compares favorably (by a similar margin of difference) to the 21.3% EBITDA margin for its industry peer group. A similarly sizable difference may also be seen in McDonald’s Net Margin, which is a full eleven percentage points higher than its competition’s. All this is only possible because McDonald’s has slowly but surely been making the transition from Restaurant Operator to Intellectual Property Licensor. We just haven’t noticed it as we’ve enjoyed that extra order of French fries.
Conclusion
We agree with Wells Fargo’s assessment that comparable sales could lead to a 1% pickup in comparable sales and anticipate that McDonald’s will earn $6.70 per share this year – up from $5.71 per share last year. We further expect that McDonald’s earnings will rise to $6.95 per share in 2018, meaning that its current forward earnings ratio is around 22x. While this might seem high, it’s actually below the 31.5x forward multiple of its industry.
In our view, considering that McDonald’s profits aren’t constrained so much by store traffic as they are by the speed of which they can refranchise and reap the benefits of their intellectual property, the valuation gap should actually be far less and that McDonald’s should be trading at 26x the consensus forward earnings estimate – or anywhere from $176 to $188 per share. This would work out to a capital gains of anywhere from 15.5% to 22.2% – for a total return of between 18% to nearly 25%. Not bad for a company that’s only recently entered the 21st Century.
This article was written by
Analyst’s Disclosure: I/we have no positions in any stocks mentioned, but may initiate a long position in MCD over 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.
Black Coral Research, Inc. is a team of writers who provide unique perspective to help inform dividend investors. This article was written by Jonathan Lara, one of our Senior Analysts. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article. Black Coral Research, Inc. is not a registered investment advisor or broker/dealer. Readers are advised that the material contained herein should be used solely for informational purposes. Investing involves risk, including the loss of principal. Readers are solely responsible for their own investment decisions.
Seeking Alpha's Disclosure: Past performance is no guarantee of future results. No recommendation or advice is being given as to whether any investment is suitable for a particular investor. Any views or opinions expressed above may not reflect those of Seeking Alpha as a whole. Seeking Alpha is not a licensed securities dealer, broker or US investment adviser or investment bank. Our analysts are third party authors that include both professional investors and individual investors who may not be licensed or certified by any institute or regulatory body.
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