Saturday, February 15, 2014

McDonalds Analysis

The McDonald's name and brand needs no introduction. The "golden arches" company is the world's biggest quick serve restaurant operator. In many parts of the world, McDonald's is a symbol of an American way of life. In poorer areas of the world, McDonald's is also a safe bet for a clean washroom and cheap meal.

  • The world's largest quick serve restaurant
  • Over half the countries (119) in the world have a McDonald's restaurant
  • 35,000 locations world wide, serving 68 million customers each day
  • a leader in increasing the standard of service in emerging markets

Unlike Johnson & Johnson which has a myriad of subsidiaries & products, McDonald's concentrates on its core competency, serving delicious food quickly for a reasonable price! McDonald's strength is not just the corporation itself, but owner/operator franchisees. Many of its now famous products were invented by owner/operators, such as Big Mac (1968), Quarter Pounder (1971), Egg McMuffin (1975), and Canadian developed McFlurry (1997).

Past Business Performance

The past 10 years have been nothing short of stellar for McDonalds Corporation, both the business, and the stock. Dramatically outperforming the S&P 500 over the same period. Why?
  • Restructuring in 2002 after years of sluggish and declining sales, that refocused the company on gaining more sales from existing stores vs its traditional reliance on opening new stores for growth
  • Refocusing the menu on its core competency of hamburgers
  • Brand re-imaging, to appeal to younger generation, including new advertising campaigns, remodeling existing restaurants, and a healthier menu
As a result of these efforts, from 2003 to 2012:
  • Revenue growth from $17.1B to $27.6B, CAGR of 5.0%
  • Operating Income growth from $2.8B to $8.6B, a staggering CAGR of 11.9%
  • Adjusted Net Income growth from $1.5B to $5.5B, 14% CAGR
  • Adjusted EPS growth from $1.15 to $5.36, CAGR of 16.6%
  • Dividend per share from $0.40 to $2.87, a whopping 21.8% CAGR
  • ROE increased from mid teens to mid 30s
McDonald's has been a classic example of a brand and business that went through a weak period that fixed itself and boomed again. I believe it will be very hard for the company to replicate this kind "firing on all cylinders" performance over the next 10 years.

That being said, I also believe a continued strategic focus on menu innovation, restaurant improvements, operational efficiency, and moderate international growth, should deliver above average shareholder returns.

Current Valuations

A key determinant to future returns is the price paid. Overpaying for even the best company in the world will surely lead to mediocre returns.

Unlike JNJ which was overvalued a decade ago, even relative to its premium normal valuation, McDonald's was fair to undervalued during the 03-04 time period. One of many reasons for its outsized returns since then. Here is an updated F.A.S.T graph from 2013 with an updated "normal" valuation

What kind of conclusions can we make?

  • At 17x earnings, MCD is currently reasonably valued
  • Investing in MCD at or below 17x (blue line) has produced decent returns
  • Best times to invest are when stock touches orange line (15x)
  • sometimes that does not happen for years though
  • EPS completely oblivious to recession during 08 and 09
  • Trades at lower PE and higher dividend yield vs its peers (Wendy's BK, Yum!)
An interesting thought is the difference in "normal" valuation in the 2 charts. Could the overall flat market in the past decade have depressed MCD's normal PE ratio? My conclusion is that 17x is a very reasonable price to pay for MCD in any macro market condition, bull or bear. 15x would be a gift.
  • Analysts are expecting MCD to earn $5.84 in FY2014
  • Applying 17x multiple leads to a $99 fair value target, not much above its current price of $95
  • MCD currently going through a tough period of comps, revenues and earnings

Forward Business Outlook

There are a few questions I ask when looking forward:
  • Will the company be able to address its current issues
  • What reasonable dividend growth rate can I expect
Here is a quote from a Fortune magazine article on McDonald's, titled "Can McDonald's cook again? The great American icon ain't what it use to be"

"McDonald's missteps seem to have eroded its position, at least in the U.S., as an American icon. For a number of reasons--from increased fast-food competition to a lack of innovation to poor marketing-- McDonald's seems to have lost a sense of itself."

The above quote is from 2003, but it could have very well been written in 2013. Commentary from a recent analyst meeting indicates executives are well aware of the recent issues plaguing MCD, and were taking action to address them
  • Continued renovation of restaurants. Renovated restaurants show 6-7% increased sales
  • Opening new restaurants, particularly in Asia
  • dual drive-thru lanes to speed up ordering
  • a 3rd drive-thru window for larger complex orders
  • expansion of drive-thru in foreign markets
  • continued expansion of McCafe brand
  • continued promotion of breakfast items overseas, where its only 12% & 5% of sales in Asia and Europe, vs 25% in the US
  • kitchen renovations in the US, to help speed up food prep
As for the dividend, I strongly believe MCD has lots of room to grow. How much? Well that depends on a few things, all of which are within its control (which is more than what I can say about certain high flying stocks of late *cough* airlines)
  • Continued brand building: MCD remains by far the most valuable brand in the restaurants space
  • Healthy eating: MCD has traditionally been associated with unhealthy foods, and with so many consumers chasing the latest health craze these days, MCD needs its menu to remain dynamic and innovative to keep existing customers who grew up on Big Mac & Cokes, and attract the new generation of customers who may prefer a McWrap & juice. The brand strength will certainly help here too
  • Pricing Power & Cost Savings: another benefit of a strong brand & global size, even if MCD was able to squeeze an extra 5 cents out of each customer per visit, that would translate into $3.5 million per day, $1.3 billion per year. Can be done either via price hikes, or operational improvements, or a combination of both.
  • Emerging Markets: plenty of room to open new stores, particularly in Latin America and Asia. 35,000 restaurants today, opening 1500 per year in 2013, 2014, and 2015. In China alone, expects to open 300 restaurants per year for many years to come.
  • Share Buybacks: MCD consistently gobbles up shares. Shares outstanding down from 1.2 billion in 2007 to just under 1 billion in 2014, an average of 33 million shares per year, or ~3% of its float per year.
Just looking at the last 2 items, it seems like the base case for McDonald's is EPS & dividends growth of at least 5%. If it begins to fix some of its temporary issues, I believe we could see a return to 8-12% bottom line growth. It's not the past decade, but its not too shabby either.

Every once in a while, McDonalds goes thru a weak patch. I think we may be at the early or middle innings of such a period now. I do not doubt the company will eventually get out of the funk, but the question of when, will depend on strategy & execution.

Just like JNJ, McDonald's is a true blue chip that has all the properties of a core investment holding. Growing business, strong cash flow generation, consistent share buyback, and an annually increasing dividend. 

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