McDonald's - You'll Continue Lovin' It

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About: McDonald's Corporation (MCD)
by: Aisha Rahman
Summary

Q2 2017 was a stellar quarter for the fast food chain as we witnessed double digit growth in earnings and improvement in comp sales.

The refranchising initiative lowers expenses, increases royalty and rent income and also hedges against poor sales performance. Ultimately, it's a great move for cash flows.

Revamping the stores and the menu has been a good move, although at the expense of debt accumulation on the balance sheet.

The stock trades at a high PE which may suggest that returns might slow down in the future - but I wouldn't bet on that.

As I sit here devouring my Big Mac and fries, it occurred to me how McDonald's (NYSE:MCD) as a company and as an investment has come a long way. There have been several SA contributors who have been haste in writing the stocks obituary – or at least remarking that the company has its best days behind itself. I am of a different point of view and here is why.

Q2 roundup

Q2 2017 was a quarter where McDonald's managed to turn itself around and showcase how much exactly the company’s re-franchising efforts are actually worth. You can read more about the quarter here. There is no denying that revenues shrunk by about 3% during the quarter, but that impact definitely did not trickle down to the company’s bottom lines, which witnessed a 28% increase Y-o-Y. This increase can be credited greatly to the company’s re-franchising efforts which are allowing the company to not only reduce its General and Administrative Expenses, but are also allowing the company to gain from rental and royalty income. These re-franchising efforts are likely to scale up by the end of next year, where McDonald's is aiming at re-franchising 95% of its outlets while owning only 5% of them. Moreover, in my opinion, the re-franchising move is definitely a smart one, considering the ‘healthy eating’ debate that takes place every time a topic related to fast food is touched. Whether or not all fast food franchises are doomed because people will eventually begin eating healthy is another story, but I think that the franchising move acts like a perfect hedge against this phenomenon (should it occur) because McDonald’s will still have its revenues guaranteed from these outlets regardless of whether or not they make sales. That offers the company a great deal of stability should eating habits change, or should the company do poor for a couple of quarters. And in the end since it’s all about stability, I foresee that earnings will continue to do well on the back of progress taking place due to re-franchising.

There is no denying that this will reflect badly on the company’s top lines as these plans materialize, but if earnings seem to be reflecting increases (a 36% jump in diluted earnings for Q2), many investors won’t be too skeptical about these plans. As far as revenues are concerned, Q2 showed how comp sales remained strong locally and internationally. The way I see it, it doesn’t just reflect that the same number of people are shopping more; I see this as a sign of more guests coming to McDonald's, which takes me to my next point.

Redesigning the way McDonald’s is doing business

I believe there are a lot of reasons to which McDonald’s owes its second quarter stellar results to. The first on the list would be a transformation (or more like new additions) to the menu that they serve and second would be focusing on improving the brand image of their outlets.

Apart from the promotions that the fast food chain has been renowned to host, there are some additions to the menu which are welcomed by several, including the substituting fries for salad, and some innovative sandwiches and wraps to the menu. This change to the menu seems to have done a lot of good for the company, and although the move was a bit delayed as it could have helped McDonald's up its game a long time ago, it has ensured that this family-oriented fast food chain makes customers want to come out and dine with them just for the variety and the taste.

The redesigning of McDonald’s outlets has been taking place for a while, and I think it’s safe to say that they’ve done it for the better. Their stores now match up with some of the good cafes in the country, allowing customers to enjoy a better dining experience. And it doesn’t just stop there. There are a few interesting things that the company is on its way to doing, that will shake up the way people order from McDonald’s. The introduction of ordering kiosks is one of them, and will certainly leave the younger generations amused with this age old name.

How is McDonald’s looking as an investment?

I’ve talked a lot about the good things that McDonald's has been up to recently, and while these have panned out pretty well for the fast food chain, they do have certain costs attached to them as well. While re-franchising and revamping the menu have certainly proved to be good moves for the company, they have come at the expense of debt and interest expenses for the giant. In the current quarter we witnessed interest expenses increase to 3% Y-o-Y, which doesn’t seem to be much of an increase, but considering that at the end of Q1 the company had accumulated a debt level of $27 billion makes me a little hesitant. While I do admit that it makes me a bit shaky, I believe that at the end of the day, McDonald’s has a solid and reliable cash generating model, which will continue to do better with the re-franchising efforts and eventually pay out the dividends that most investors of the company have been interested in since they jumped on the bandwagon with this one.

Talking more about the dividends – the stock has been a consistent dividend paying investment as it has managed to increase its dividend since. As it offers a 2.40% yield to its investors, the dividend remains intact since McDonald’s seems like it will to very well when it comes to maintain a healthy cash flow.

The stock is pricey with a PE of 27.31. Many are doubtful about investing in the stock as it apparently is quite overvalued. However, after taking into account more factors that seem to be going in McDonald’s favor than against it, I believe that being overvalued just makes it difficult for interested parties to jump in on the investment. If I may act as a skeptic for a little while, I’d say that the stock isn’t going to head south simply because it is overpriced right now. But I will say this – perhaps future returns in terms of capital gain may experience a slowdown since the stock seems to have priced in a lot of the company’s growth already – but I wouldn’t bet on this.

The way I see it, McDonald’s has managed to do a pretty good job when it comes to listening to its customers. It has come a long way from revamping its menu to now include a lot of healthy options while ensuring that its original menu continues to live on. The evolution of the menu to add healthier options could go a long way for the company even if many graduate from unhealthy eating to having healthy foods.

All of its moves combined have played out as a good strategy for the fast food chain that is now keeping investors happy with its impressive earnings and store sales growth. To top that off, the re-franchising initiative is slated to do well for the company and be accretive to its free cash flow position, which is amazing for future dividend payouts. Considering all of the above, I think that McDonald’s seems to be your best bet for a buy and hold stock right now- more of a hold, keeping in mind the escalated price levels, but nonetheless.

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.