McDonald’s: Sustainable Value Creation (NYSE:MCD)


Investment Thesis

McDonald’s (MCD), one of the largest fast-food chains in the world, is considered by many investors a mature company, paying high dividend yields, generating significant cash flows, and a good hedge for recessions. However, due to the pandemic emergence and the uncertainties in business operations, the company has pulled its guidance for FY2020. We tried to estimate the current year’s revenue by assuming some conservative estimations for the coming years and concluded that there is room for further appreciation in the stock’s price. Our model assumptions reached a price target of $247 per share, derived from a 5-year discounted free cash flow model.

Largest Quick Service Restaurant Brand Value

Demand in the Quick Service Restaurant industry (QSR) is mainly driven by consumer’s tastes and income. However, brand value and reputation play a major role in keeping customers loyal to their preferred fast food company.

McDonald’s managed to build a huge brand name over the years, and its image is recognized globally. The below statistic shows that McDonald’s was the most valuable fast food brand in the world with an estimated value of $129.32 Billion.

Source: statista.com, chart by author

The Franchise Strategy

The profitability in this industry lies in improving profitability margins while conducting effective marketing campaigns. Since 2017, as depicted in the below chart, the company changed its expansion strategy by shifting the management of restaurants from company-operated restaurants to franchised ones. This strategy was successful in increasing the net income of McDonald’s by leveraging its products to franchisees and relying more on rent and royalty income. Thus, revenue became more stable, predictable, and the economic impact on sales was decreased.

Source: 10-K, chart by author

As stated in their latest annual report, McDonald’s had 36,059 franchised restaurants while it operated only 2,636 restaurants. This strategy supports “The Velocity Growth Plan” introduced in 2017 which focused on serving more customers more often and increasing their satisfaction.

Opportunities and Challenges

Last year, McDonald’s announced the acquisition of the tech company Dynamic Yield in order to improve customer experience and boost the innovation of their digital Drive-Thru menu which will be customized based on weather, time of day, and customers’ prior orders.

The company managed to stay ahead of its competitors in the fast food industry, however, its main challenge remains the demand for healthier food and organic menus offered by other companies. During recent years, consumers were attracted to high-quality freshly-prepared food and they were willing to pay slightly higher prices and eat healthier food. This trend might continue in the future putting more pressure on the company’s revenues.

Post COVID-19 Reopening

McDonald’s operations were highly impacted by the worldwide lockdown due to the COVID-19 pandemic. The outlets started reopening their doors during the last month of the second quarter, however, many customers may stay away from dining in restaurants for a while.

In May, U.S. comparative sales dropped by 5.1% year-over-year compared to a 19.2% drop in April. Internationally, same-store sales plunged by 66.7% in April and 40.5% in May. These figures are expected to be better in June and July as the pandemic is being contained in Europe.

Valuation

We utilized the free cash flow analysis to estimate a fair value for McDonald’s. For the remaining FY2020, we assumed a 20% year-on-year decline in revenue for the second quarter, then a 15% and a 10% y-o-y decline for the third and fourth quarter respectively. Thus, our estimation leads to a total yearly decrease of 13% in revenue for FY2020 compared to last year.

For the next years, we assumed a sales growth of 7% for FY2021 decreasing to 4% in 2024 and a perpetual growth rate of 3%. In addition, we assumed a gross profit margin of 51.50%, SG&A at 10.13% of revenue, and a tax rate of 21%.

Furthermore, we assumed a reinvestment rate of 15%, an after-tax cost of debt of 2.25% and a cost of equity of 6.57%. The current market capitalization of the company is $138,789 Million based on a stock price of $184.88 per share and 750.7 Million diluted shares while long-term debt stood at $51,311 Million as at March 2020.

Accordingly, the weighted average cost of capital is assumed to be 5.41%, which will be used as the discount rate.

The estimated operating value of McDonald’s is $231,687 Million. The company’s cash position is $5,379.8 Million, long-term debt including capital leases is $51,311.5 Million with no minority interest. As such, we can conclude that the stock is currently undervalued with a one year target price of $247 per share leading to a potential 33% capital gain.

Ratios Analysis

Numerous dividend cuts and suspension of payments were declared during the ongoing COVID-19 crisis. Even companies with strong balance sheets and high cash flows were struggling to meet their obligations. However, MCD has proved to be resilient to severe business conditions and its stock price has already shown strong recovery signs.

ChartData by YCharts

The company shows strong fundamental indicators. MCD’s free cash flow per share is steadily increasing and it managed to raise its dividend payments for 43 consecutive years.

On the profitability side, McDonald’s is operating at margins much better than the industry which gives its management more financial flexibility in responding to the current crisis. MCD’s profit margin of 27.95% which is above its sector’s margin of 2.21% and its return on assets of 11.48% versus 2.09% for the sector indicate an upward profit trend despite the financial threats.

Conclusion

The fast food industry faces many challenges related to fears of a second COVID-19 wave and higher demand for healthy food, however, McDonald’s remains a good investment. Before pulling guidance, the firm was expecting retail sales growth between 3% and 5% for FY2020. The company is constantly implementing new strategies to expand its market share and maintain its high brand value.

Despite being considered a mature stock, MCD is still profitable and might compete with younger companies. Based on our assumptions which account for the expected decline in revenues, we found that MCD is undervalued at current prices and presents a good entry point for investors.

Source: mcdonalds.com

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.

Additional disclosure: There are risks associated with investing in securities, including loss of principal. As such, before buying or selling any stock, we recommend doing your own research and reach your own conclusion or consulting a financial advisor. The information contained in this article is for informational purposes only.





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