McDonald's Has A Powerful Diversified Portfolio

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Includes: MCD
by: Vinayak Maheswaran

Summary

An attractive net unit growth of 3%.

MCD is more willing to change than investors anticipated.

Downside is the market share loss in recent times.

McDonald’s Corporation (NYSE: MCD) franchises and operates McDonald’s quick-service restaurants. Founded in 1948, the company currently has more than 35,000 locations in more than 100 countries. More than 80% of McDonald’s restaurants worldwide are franchised, and approximately 60% of the units are located outside the U.S. McDonald’s generates more than 50% of operating profit internationally.

Investment Case

MCD has a powerful diversified portfolio (>55% operating profit internationally and >65% operating profit from rents/loyalties) whose breadth of product and value leadership remain very relevant globally, and that generates an often overlooked net unit growth of 3%. Considering my upside to consensus EPS estimates, a low relative multiple, MCD’s historical stability of results, and a dividend yield of ~3%, I view the risk-adjusted return as favorable and would recommend buying the shares. When putting the dividend yield in context, it must be stated that it is higher than the market with ~1.4% being the standard for companies under coverage and ~2% for the S&P 500.

Nonetheless, I expect limited multiple expansion for the rest of 2018 based on continued restaurant-level margin pressure and ongoing FX headwinds. However, uneven SSS trends will boost the stock going forward.

Valuation Methodology for McDonald’s Corp.

I derive my target price based on the EV/EBITDA multiple and my out year EBITDA multiple on McDonald’s. I analyze the company’s operating income growth rate, peer group valuations and a historical trading range to determine an appropriate multiple to apply to out year EBITDA.

Upside scenario

My upside scenario of $190 includes i) U.S. operating margins returning to 2013 levels on same-store sales (SSS) closer to 3%, ii) modest other cost control efforts including G&A, and iii) a still lower than average consumer multinationals EBITDA multiple of 12.5x.

I believe that there are multiple levers at management’s disposal to both improve fundamental performance of the business and support a higher stock price (including menu improvements, refranchising, and taking on additional leverage), and I see this as a signal that MCD’s is more willing to change than investors likely anticipated.

I think it is possible for MCD to regain its composure in the U.S., particularly as employment growth continues (and more daily breakfast/lunch routines are established). MCD is a strong multinational company and performance should improve as the year progresses as it sharpens its competitive focus domestically, and optimizes its businesses internationally.

If there is comp acceleration and multiple or margin expansion, I see potential upside too. It must be mentioned that McDonald’s operates the number one hamburger chain in the world and this gives it tremendous upside.

Downside scenario

My downside scenario of $150 is earnings driven not multiple driven and includes i) flat 2018 U.S. comps and operating margin deleverage, ii) flat Europe segment SSS, and iii) a roughly 10x EBITDA multiple.

McDonald’s opportunity to recreate the concept’s positioning/product renaissance seen in the early-2000s does not exist, in my view. McDonald’s heightened operational focus/execution, new product introductions, restaurant remodels and extended hours combined to drive a 10-year run of 5% average annual U.S. segment SSS growth from 2003 to early 2012. With the vast majority of these drivers having run their course, I believe the prospects for a near-to intermediate-term SSS recovery are modest at best.

Management’s diagnosis of the concept’s accelerating pace of U.S. market share loss strikes me as largely accurate, although it downplays the evolution of what key consumer demographics (millennials and even moderately health conscious parents) want from a restaurant experience that McDonald’s cannot offer. MCD believes the primary drivers of its market share loss include: (1) eroding value perception above the Dollar Menu – the result of too wide a gap between entry-level, core and premium offerings (Dollar Menu anchoring has resulted in core items absorbing too much pricing of commodity inflation), (2) poor food quality and freshness perception versus the fast casual segment, (3) too many menu items and excessive operational/executional complexity, (4) increased competition from convenience stores and the national coffee players, and (5) the McDonald’s concept is often the target of harsh social media criticism.

Industry Outlook

Over the next twelve months, while improving macros should drive accelerating industry comps growth, margin concerns, inconsistent top line growth and still full valuations could weigh on further restaurant outperformance. However, further gains could be driven by my outlook for modest upside to consensus’ SSS forecasts, including acceleration to ~4% in 2019 based on my discretionary purchasing power model. For margins, I am slightly more cautious than consensus given the impact of re-inflation and limited visibility into pricing intentions.

Risks

Risks include but are not limited to: deteriorating macro-economic factors that could negatively impact consumer spending (rising unemployment, low wage growth, high gas prices, falling housing market); food safety incident at MCD or another restaurant; increased competition; risks related to a franchise business model; significant commodity or labor cost inflation; changing consumer eating trends; ability to identify and secure appropriate sites for new restaurants; effect of changes to healthcare laws; failure of internal controls over financial reporting; adverse weather conditions; the negative impact on existing restaurants from opening new restaurants in existing markets; risks related to international operations; foreign exchange rate risk; and the impact from new information or attitudes regarding diet and health could result in changes in regulations or consumer preferences.

Material is sourced from McDonald’s annual reports unless mentioned.

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.