McDonald's Corporation (MCD) released Q2 and YTD results on July 26, 2019.

I anticipate further improvements from its Growth Strategy which was launched in 2017 and am optimistic in its long-term growth prospects in China where there is ample opportunity to increase penetration in a country of 1.4 billion people.

Summary

  • MCD’s top line has declined in recent years but this is the result of a strategic decision to reduce the number of company owned outlets and to increase the number of franchised outlets to ~95%.
  • MCD intends to open more than 400 stores in China by the end of 2019 as part of its 5 year plan to nearly double its store count to 4,500 by 2022.
  • The significant reduction in the number of shares outstanding in recent years is likely to continue as management works toward improving shareholder returns.
  • MCD has taken advantage of the low interest rate environment in recent years and has increased the use of leverage as part of its strategy to improve shareholder returns.

Introduction

In my previous McDonald’s Corporation (MCD) article I indicated there is no dispute the major turnaround which commenced in 2015 was having a significant positive impact. My concern, however, was that shares were richly valued.

Unfortunately, MCD’s share price has subsequently risen in value with this increase partially fueled by current market conditions and by the increase in attractively priced long-term debt for the purpose of reducing share count.

In this article I look at MCD’s current valuation based on anticipated earnings for the remainder of the current fiscal year and provide my thoughts on MCD’s current valuation.

Business Overview

While the fast food industry is synonymous with low barriers to entry and intense competition, MCD is one of the few industry participants with a wide economic moat. Its competitive advantages include a widely recognized brand, a franchisee system aligned on driving unit-level productivity improvements, and meaningful economies of scale.

MCD is divided into the following segments based on the maturity and competitive position within different markets and this is how management reviews and evaluates operating performance.

  • U.S. - the Company's largest segment
  • International Lead Markets - established markets including Australia, Canada, France, Germany, the U.K. and related markets
  • High Growth Markets - markets the Company believes have relatively higher restaurant expansion and franchising potential including China, Italy, Korea, Poland, Russia, Spain, Switzerland, the Netherlands and related markets
  • Foundational Markets & Corporate - the remaining markets in the McDonald's system, most of which operate under a largely franchised model. Corporate activities are also reported within this segment.

MCD is primarily a franchisor, with ~93% of restaurants as at FYE2018 being owned and operated by independent franchisees. The restaurants it operates, and franchises, in more than 100 countries serve a locally-relevant menu of quality food and beverages. Franchised restaurants are owned and operated under either a conventional franchise or developmental license or affiliate.

MCD continually reviews its mix of Company-owned and franchised restaurants to help optimize overall performance. The long-term goal is to be ~95% franchised.

When the current CEO assumed his role in March 2015, reorganization was undertaken and MCD started operating under a new organizational structure beginning July 1, 2015.

The reasoning for restructuring was that the pace of change within MCD was being eclipsed by the pace of change outside the business. Market conditions and consumer dynamics were evolving and returning MCD to ‘growth’ mode required radical change.

By restructuring, MCD has been able to get closer to customers and speed up the process at the point of impact. Included in this restructuring was the decision to refranchise to drive growth and bringing greater insights at a local level; MCD refranchised more than 4,000 locations and the eliminated ~$0.5B in net annual selling, general, and administrative expenses.

MCD revamped its Growth Strategy in 2017 and details can be found here and in the 2017 CEO Letter to Shareholders.

As part of its Velocity Growth Plan (VGP), MCD is emphasizing the following "velocity growth accelerators":

  • Experience of the Future (EOTF);
  • Digital;
  • Delivery.

Further details on MCD’s VGP can be found on page 19 of 94 in the 2018 Form 10-K.

As part of its Growth Strategy, MCD sold the bulk of its China and Hong Kong business to The Carlyle Group LP (CG), a U.S. private equity firm, and Citic Limited, a Chinese state-owned investment group. By negotiating these deals MCD was able to cut costs because it no longer needs to operate those stores but it can still collect rent and royalty revenue.

In my May 2, 2018 article I wrote that investors who rely on stock screeners to identify investment opportunities could eliminate MCD as a potential investment if ‘sales growth past 5 years’ is one of the ‘screening’ metrics.

In that article I provided the 6 Year Summary of Selected Financial Data from FY2017’s 10K and I now provided the following information extracted from MCD’s FY2018 10-K.

Looking closely at the 6-Year Summary of Selected Financial Data we see that MCD has been converting its company-owned outlets into franchised-owned outlets and a few thousand new franchised outlets have also been opened.

Company-owned stores certainly add top line revenue while franchised stores only add rent and franchise fees paid to MCD. Look closely at the data and you see that a key benefit to having a higher proportion of franchised outlets is that franchised restaurants’ occupancy expenses are ~17% - ~18.50% of revenue; this compares with ~80% - 85% for company operated restaurants. An attractive feature of the franchise concept is that MCD does not need to devote as much capital to growing or maintaining stores as franchise owners now carry some of that burden.

Looking at the benefits of MCD’s strategy to be ~95% franchised, we see that the decline in MCD’s top line over the past few years does not mean MCD’s business has stopped growing. Now, the focus can be placed on assessing MCD’s credit risk (2 notch decline in MCD’s long-term credit rating within the past 4 years and 5 notch decline since the turn of the century) and whether MCD’s valuation is acceptable relative to other potential investment opportunities.

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Disclosure: I am long MCD.

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