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In my FFJ Portfolio – February 2022 Report, I list the companies in which I acquired additional shares in February. This monthly update was delayed until mid-March because I was away on a ski trip. Therefore, I also listed purchases made in the first half of March while on vacation. In this post, I explain why I acquired additional McDonald's (MCD) shares.
I last reviewed McDonald's (MCD) in this October 24, 2019 post. Subsequently, MCD's valuation has experienced wild gyrations. In hindsight, I should have 'backed up the truck' in March 2020. I, however, chose to purchase shares in other companies.
On March 7, I acquired another 100 shares at ~$226 in a 'Side' account in the FFJ Portfolio. My thought was that MCD would announce its decision to temporarily close restaurants and pause operations in Russia and Ukraine. I figured any announcement to this effect was already factored into MCD's share price. MCD announced its decision on March 8 and the share price dropped further but has since rebounded to the current ~$239.
Business Overview
Investors who are unfamiliar with MCD's global operations can quickly get 'up to speed' by reviewing the first section of the FY2021 Form 10-K.
Financials
Q4 and FY2021 Results
On January 27, 2022, MCD released Q4 and FY2021 results; a link to its FY2021 10-K released February 24, 2022 is provided above.
Q1 2022 is at the end of March 2022 which is less than half a month from now. There is, therefore, little value in reviewing FY2021 results in detail.
Although MCD has temporarily closed its Russian and Ukraine restaurants and will continue to pay salaries and benefits for those workers directly affected in both regions, operations in both countries are insignificant when viewed relative to the company's global operations.
FY2022 Outlook
When MCD released its FY2021 results, it also provided its FY2022 outlook. Based on conditions at the time of the earnings release, it forecast:
- net restaurant unit expansion to contribute ~1.5% to FY2022 systemwide sales growth, in constant currencies;
- selling, general & administrative expenses of 2.2% - 2.3% of systemwide sales;
- operating margin in the low-to-mid 40% range;
- interest expense to be relatively flat to 2021 based on current interest and foreign currency exchange rates;
- the effective income tax rate to be in the 20% - 22% range with some volatility in a quarterly tax rate outside of the annual range; and
- capital expenditures of $2.2B - $2.4B with about half to be directed toward new restaurant unit expansion across the U.S. and International Operated Markets. About 40% will be dedicated to the U.S. business, most of which will go toward reinvestment, including the completion of restaurant modernization efforts. Globally, MCD expects to open over 1,800 restaurants with over 500 restaurants in the U.S. and International Operated Markets segments. Developmental licensees and affiliates will contribute capital toward over 1,300 restaurant openings in their respective markets. MCD expects over 1,400 net restaurant additions in FY2022.
Events after the release of this outlook may require MCD to temper its growth plans. I expect management will address its FY2022 outlook when it releases Q1 2022 financial results in just over a month.
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.
FY2021 overall capital spend was a little over $2B. This was slightly lower than original expectations with the timing of projects being the primary reason.
Improvements made to MCD's business model over the last several years and the consistent strength of its global business resulted in a ~25% increase in FCF over FY2019 FCF and an FCF conversion rate of ~94% in FY2021.
A free cash flow conversion rate greater than 90% is projected for FY2022.
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 concern 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 up and down. 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 45 consecutive years with an increase every year since the inception of its dividend payout policy in 1976.
While this is an enviable track record, investors would be well-advised not to fixate on MCD's consecutive years of dividend increases and its dividend yield. The dividend has certainly contributed to MCD's historical investment return but we see that capital gains have contributed to a far greater extent to the total investment return over the long term.
Source: www.tickerteck.com
While the past does not predict the future, I think the bulk of any future appreciation in the value of an MCD investment is likely to come from capital gains as opposed to dividend income. This is why I think investors who fixate on the $1.38/share quarterly dividend (a ~2.3% dividend yield based on a ~$239 share price) are missing the 'big picture'.
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 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.
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. In FY2021, ~ 3.4 million shares were repurchased for $845.5 million bringing total purchases under the program to ~7.7 million shares or $1.7B.
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.
I think investors can expect a resurgence in the number of shares MCD will repurchase annually.
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 ~$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 on March 7, 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 current share price is ~$239 so the forward valuation levels are slightly less favourable. Nevertheless, I still consider MCD to currently be fairly valued.
Final Thoughts
I hold shares in a 'Side' account within the FFJ Portfolio and in an account for which I do not disclose details.
MCD was the 26th largest holding when I completed my Investment Holdings Review in early January 2022; it was the 30th largest holding at the time of my mid-April 2021 review and the 28th largest holding at the time of my mid-August 2020 review.
Although the closure of restaurants in Russia and Ukraine will likely put pressure on MCD's results in the short-term, I suggest investors look at the 'big picture'.
Investors should welcome periods in which a great company temporarily falls out of favour with the broad investment community. The time to consider acquiring shares is when a company's valuation becomes attractive because of:
- some company-specific negative event and the business is not permanently impaired; or
- a broad market pullback.
I view MCD as a good long-term investment and its valuation is once again reasonable. There is a very strong probability I will acquire additional MCD shares if the share price retraces close to the level of my early March 2022 purchase.
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.
