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I last reviewed McDonald's (MCD) in this March 19, 2022 post. In that post, I disclose my March 7 purchase of an additional 100 shares at ~$226 in a 'Side' account in the FFJ Portfolio while on a ski trip.
At the time, the most recently available financial results were those for FY2021. Now that we have Q3 and YTD2022 results and FY2022 outlook, my analysis suggests MCD shares are currently overvalued.
Business Overview
MCD franchises and operates MCD restaurants, which serve a locally relevant menu of quality food and beverages in communities across 118 countries (view countries). Of the 39,980 MCD restaurants on September 30, 2022, 37,930, or 95%, were franchised.
Most investors are undoubtedly familiar with MCD to some extent. I, however, strongly encourage investors to get a good understanding of the company by, at the very least, reviewing the FY2021 Annual Report and/or the first section of the FY2021 Form 10-K. A condensed overview can be found commencing on page 15 of 48 in the Q3 2022 Form 10-Q.
Financials
Q3 and YTD2022 Results
MCD's most recent financial results are found in the Q3 2022 Form 8-K and Q3 2022 Form 10-Q (link provided above).
Free Cash Flow (FCF)
MCD's FCF in FY2012 - FY2021 is (in billions of $) $3.917, $4.296. $4.147, $4.725, $4.239, $3.698, $4.225, $5.728, $4.624, and $7.102.
MCD has a long history of generating significant cash from operations and has substantial credit capacity to fund operating and discretionary spending such as capital expenditures, debt repayments, dividends and share repurchases. Details of MCD's cash flows over the first 3 quarters of FY2022 are on page 31 of 48 in the Q3 2022 Form 10-Q.
In FY2021, overall capital spending was a little over $2B. This was slightly lower than original expectations with the timing of projects being the primary reason.
On the Q4 2021 earnings call at the end of January 2022, management anticipated CAPEX of $2.2B - $2.4B in FY2022 with about 50% slated for new unit openings. About 40% was to be allocated to MCD's US business where expectations were for net restaurant unit growth for the first time in a few years. Most of the US spending was to go towards reinvestment, including the completion of MCD's restaurant modernization efforts.
Globally, MCD planned to open over 1,800 restaurants, with more than 500 of these openings in the US and International Operated Markets (IOM); the IOM is comprised of wholly-owned markets or countries in which MCD operates restaurants (eg. Australia, Canada, France, Germany, Italy, Netherlands, Spain and the U.K). The remaining 1,300 new restaurants, including ~800 in China, were to be across the international developmental licensed markets (IDL). In IDL markets, MCD's strategic partners provide the capital for restaurant openings and there are more than 80 different markets in which MCD has licensed its franchise rights. MCD anticipated net new restaurant growth of about 3.5% for the year.
Revisions to this outlook are provided below.
FY2022 Outlook
Based on current conditions, the following reflects MCD's forecast for the remainder of FY2022:
- Excluding the closure of all restaurants in Russia, net restaurant unit expansion will contribute ~1.5% to 2022 Systemwide sales growth, in constant currencies.
- FY2022 selling, general and administrative expenses of ~2.3% - 2.4% of Systemwide sales.
- FY2022 operating margin in the 40% range as a result of charges related to the sale of the MCD's business in Russia.
- Adjusted operating margin in the mid-40% range. This excludes impairment and other charges and gains.
- Based on current interest and foreign currency exchange rates, FY2022 interest expense will likely increase ~2%. This is driven primarily by higher average interest rates.
- An effective income tax rate for FY2022 in the 21% - 22% range.
- FY2022 capital expenditures of ~$2B. About half will be directed toward new restaurant unit expansion across the US and International Operated Markets. Over 40% will be dedicated to the US business, most of which will go toward reinvestment, including the completion of restaurant modernization efforts. Globally, MCD expects to open ~1,700 restaurants. It will also open about 375 restaurants in the US and International Operated Markets segments, and developmental licensees and affiliates will contribute capital toward over 1,300 restaurant openings in their respective markets. Excluding the closure of all restaurants in Russia, the Company expects ~1,300 net restaurant additions in 2022.
- MCD continues to project FY2022's free cash flow conversion rate above 90%.
Credit Ratings
Page 57 of 95 in MCD's FY2021 10-K reflects MCD's aggregate maturities for 2021 debt balances, before fair value adjustments and deferred debt costs. In my opinion, the staggering of the debt maturities is such that I do not envision MCD will encounter challenges in meeting its scheduled debt repayments.
I have no concerns about MCD's ability to meet its debt obligations. However, the gradual deterioration in its domestic senior unsecured long-term debt credit ratings is disappointing. From mid-August 1982 to late-October 2001, for example, Moody's assigned an Aa2 rating which is the middle tier of the high-grade investment-grade category; this is 2 tiers below the coveted AAA rating.
Following late October 2001, MCD's credit rating fluctuated. In November 2015, Moody's and S&P Global eventually lowered the assigned rating to the current Baa1 and BBB+ levels, respectively. These ratings are the top tier of the lower-medium grade investment-grade level and are 5 tiers below the ratings before late October 2001.
Both ratings define MCD as having an adequate capacity to meet its financial commitments. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity for MCD to meet its financial commitments.
Dividend and Dividend Yield
MCD's dividend history is accessible here. It has increased its dividend for 46 consecutive years with an increase every year since the inception of its dividend payout policy in 1976.
On October 13, 2022, MCD declared a quarterly cash dividend of $1.52/share payable on December 15, 2022 to shareholders of record at the close of business on December 1, 2022; the prior quarterly dividend was $1.38/share.
I purchased additional shares @ ~$226 at which time the $1.38 quarterly dividend yielded ~2.44%. Shares now trade at ~$267 and with the new quarterly $1.52/share dividend, the dividend yield is ~2.28%.
Despite MCD's enviable dividend track record, investors should not fixate on dividend metrics. The bulk of any appreciation in the value of an MCD investment is likely to come from capital gains. It is, however, essential to acquire shares at a reasonable valuation. Failure to do so could lead to a sub-par long-term total investment return.
On December 31, 2019, MCD's Board of Directors approved a share repurchase program with no specified expiration date that authorized the purchase of up to $15B of MCD's outstanding common stock.
Looking at the Consolidated Statement of Cash Flows, Treasury Stock purchases in FY2012 - FY2021 amounted to $2.605, $1.810, $3.175, $6.182, $11.142, $4.651, $5.247, $4.9762, $0.9078, and $0.8455 (in billions of $).
The dramatic reduction in the number of shares repurchased in FY2020 and FY2021 is because MCD suspended its share repurchase program in early March 2020 due to the onset of the COVID-19 pandemic; the reinstatement of share repurchases was announced in September 2021.
The weighted average number of outstanding shares in FY2012 - 2021 (in millions rounded) is 1,020, 1,006, 986, 945, 861, 816, 786, 765, 750, and 752.
In Q3 2022, MCD repurchased 3.8 million shares at an average share price of $250.52 for a total of ~$0.949B. This brings MCD's total purchases for the nine months to 14.2 million shares or $3.407B. The weighted average number of outstanding shares in the first 9 months of FY2022 now sits at 743.
Valuation
Since FY2015, MCD's valuation (P/E) based on fully diluted earnings, has typically hovered in the mid-20s to low 30s.
In FY2021, MCD reported fully diluted earnings of $10.04. Based on my March 7, 2022 ~$226 purchase price, MCD's diluted P/E was ~22.5, a level not witnessed since the onset of the COVID-19 pandemic in March 2020.
Using broker earnings estimates reflected on the two online trading platforms I use and my ~$226 purchase price, the forward adjusted diluted PE ratios were:
- FY2022 - 36 brokers - mean of $10.06 and low/high of $9.25 - $10.45. Using the mean estimate, the forward adjusted diluted PE is ~22.5.
- FY2023 - 34 brokers - mean of $11.06 and low/high of $10.02 - $11.64. Using the mean estimate, the forward adjusted diluted PE is ~20.5.
- FY2024 - 10 brokers - mean of $11.84 and low/high of $10.48 - $12.80. Using the mean estimate, the forward adjusted diluted PE is ~19.1.
MCD's forward adjusted diluted PE levels based on the current ~$267 share price and broker earnings estimates reflect a noticeably higher valuation relative to when I acquired shares in March 2022.
- FY2022 - 32 brokers - mean of $9.95 and low/high of $9.72 - $10.55. Using the mean estimate, the forward adjusted diluted PE is ~27.
- FY2023 - 35 brokers - mean of $10.47 and low/high of $9.94 - $11.60. Using the mean estimate, the forward adjusted diluted PE is ~25.5.
- FY2024 - 21 brokers - mean of $11.40 and low/high of $10.72 - $12.35. Using the mean estimate, the forward adjusted diluted PE is ~23.4.
Final Thoughts
As noted earlier, I hold MCD shares in a 'Side' account within the FFJ Portfolio. I, however, hold the majority of my MCD shares in an account for which I do not disclose details.
I view MCD as an attractive long-term investment but can not justify recommending the purchase of MCD shares based on the current valuation.
On the Q3 2022 earnings call, management states there is increasing uncertainty and unease about the economic environment. In the UK, for example, MCD customers grapple with the cost of living and energy impacts and in Germany, customers deal with the highest inflation on record.
MCD's base case scenario going forward is based on expectations for a mild to moderate recession in the US and one that will be potentially a little deeper and longer in Europe. Despite these expected headwinds, MCD remains confident its customers will continue to return to its restaurants because of its value proposition.
Interestingly, senior management at several other companies I follow express a similar concern about 2023. Given the quickly deteriorating macroeconomic environment, I think we can expect a broad market pullback in 2023 at which time MCD might become more attractively valued.
I wish you much success on your journey to financial freedom!
Note: Please send any feedback, corrections, or questions to [email protected].
Disclosure: I am long MCD.
Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your own research and due diligence. Consult your financial advisor about your specific situation.
