Is it time to take a bite of McDonald's?
I continue my analyses of companies that have some of the most recognizable brands in world, as that usually gives the companies a strong brand moat. This week I will be investigating McDonald's as an investment opportunity.
This is not a financial advice. I am not a financial advisor and I only do these post in order to do my own analysis and elaborate about my decisions, especially for my copiers and followers. If you consider investing in any of the ideas I present, you should do your own research or contact a professional financial advisor, as all investing comes with a risk of losing money. You are also more than welcome to copy me.
Since I have attended the workshop with Phil Town, I have decided to change the layout of my analyses a bit. I will do some more calculations and also briefly go through why the company has meaning to me. If you want to read more about how I evaluate a company, please go to "MY STRATEGY" on my website.
For full disclosure, I should start by mentioning that I don't own shares in McDonald's, and I never have. It isn't a place a frequently visits but it isn't because I have anything against the food. I'm happy to see that they to offer vegetarian alternatives, and I look forward to seeing how their roll-out of McPlant (their cooperation with Beyond Meat) will turn out. If you are interested in seeing or copying my portfolio, you can do so by following this guide.
McDonalds's was founded in California, USA in 1940, and it all started with one restaurant. They now have around 40.000 restaurants in 119 different countries. Since their foundation the business has changed, as only few (7 %) of the restaurants are owned by McDonald's, while the rest are franchised. To fully understand the business of McDonald's, you need to understand that there are two different ways that the restaurants can be franchised. The first is conventional franchise, where McDonald's owns or secures a long-term lease on the land, and builds the restaurant, while the franchise pays for equipment, signs, seating, and décor. Once the conventional franchise is running, McDonald's receive fees from the franchise that depends on various factors. The second is development license or affiliate, where McDonald's doesn't invest any capital but receive initial fees and royalties based on sales. The business structure of McDonald's mean that they are not only the largest restaurant chain in the world, but it is also among the largest real estate companies in the world. With the number of restaurants around the world and their very recognizable brand, it is obvious that McDonald's has a huge brand moat. They even got a currency comparison tool names after them, as The Economist invested The Big Mac index in 1986.
Their CEO is Chris Kempczinski. He joined McDonald's global strategy team in 2015 and was promoted to president of McDonald's USA in just one year and one month. He became CEO of McDonald's in 2019, as former CEO, Steve Easterbrook, was being removed from his position. He has a bachelor's degree from Duke University and an MBA from Harvard Business School. Prior to joining McDonald's, he had positions in Proctor & Gamble, Pepsico and Kraft Foods. He was certainly in for a rough start with the sudden departure of the prior CEO and with a pandemic hitting shorty after. The second quarter of 2020 was the worst quarter in the history of McDonald's, but it didn't shake Chris Kempczinski, as they by the fourth quarter in 2020 had fully recovered to their 2019 fourth quarter sales. Since he became CEO, he has drafted a growth strategy called MCD. M stands for Maximize our Marketing, C stands for Commit to the Core and D stands for Double Down on the Three Ds (Digital, Delivery and Drive Thru), which is a strategy that he believes will lead to long-term growth for McDonalds. He is known to be a very detailed and analytics-oriented executive, which may be a problem in such as broad leadership role. However, I read an interview with him, and I liked some the things he has learned through the pandemic, one thing he mention is that there is no such thing as overcommunicating, and in a survey in the end of 2020, 90 % of employees said they felt well supported by the leadership during the pandemic, which is great numbers. When asked if there are any companies he admire, he mentions Amazon for their Day 1 orientation, Nike for engaging their customers and keeping the brand relevant, and Walmart that is engaged with their associates to address questions about the corporate brand. All in all, I feel confident in Chris Kempczinski being the right person to drive McDonald's forward.
I believe that McDonalds has a strong brand moat. And I feel confident in Chris Kempczinski being the right person to continue McDonald's growth. Now let us investigate the big five numbers to see, if McDonald's does live up to our requirements for a strong moat. In case you want an explanation about what the big five numbers are, you can have a look at "MY STRATEGY" on the website.
The first number we will look into is the return on investment capital, also known as ROIC. We want to see 10 years of history and we want the numbers to be above 10 % in all the benchmarks, and ideally increasing from benchmark to benchmark. The numbers look very well, as they are well above the 10 % and increasing from benchmark to benchmark, except for the one-year benchmark. However, when looking at the numbers, I wouldn't put importance to the one-year benchmark, as it was during a pandemic.
The next numbers we will investigate are the Sales Growth Rates. Ideally the numbers should be above 10% in each benchmark and increasing. Yikes, it is not what you would like to see. I find it hard to find anything positive to say about the numbers. Obviously, you shouldn't discard an investment opportunity based on the sales growth rate alone, but you would like to see better than numbers than these.
The next numbers are the EPS Growth Rates. Once again, the numbers are far below of the requirements. The one-year benchmark should be ignored but it is a bit depressing to see the numbers of the other benchmarks. I honestly thought that the numbers would have been better.
The Equity Growth Rate is the most important of the four growth rates. Now the numbers look much better. In the oldest benchmark, they are still under the required 10 % but they are still positive numbers. From the five-year benchmarks and onwards the numbers are fantastic, even if you ignore the one-year benchmark.
Finally, we investigate the Cash Growth Rates. Once again, we see underwhelming numbers. The only bright side is the number from the three-year benchmark, which could indicate that we would have seen a much better future if it wasn't for a pandemic. In the three oldest benchmarks the numbers leave a lot to desire.
To sum up the five numbers. The most important number will always be the ROIC, and it is just as it should be, and as we also have some fine numbers when looking at the equity growth rate, I wouldn't completely denounce McDonald's as an investment opportunity. However, the sales growth rate, the EPS growth rate and the cash growth rate leave a lot to desire. Nevertheless, these numbers are historical and if you see a bright future for the company, you should let them scare you off investing in McDonald's, you will always need to look at the overall picture.
Another important thing to investigate is debt, and we want to see if a business has a reasonable debt that can be paid off within 3 years. We do so by dividing the total long-term debt by current cash flow. Doing the calculation on Starbucks, I can see that Starbucks has 7,44 years earnings in debt. It is more than the double of what we would like to see. We still must keep in mind though that McDonald's was significantly hit during the pandemic, and if you see them paying off debt moving forward, it would be a good sign.
Based on my findings so far, I believe that McDonald's could be an interesting company. However, no investments are without risk and McDonald's has some risks as well. One obvious risk is the ongoing pandemic. We saw the pandemic significantly influence on McDonald's numbers in 2020, as they experienced the worst quarter ever. While we see many countries reopening, we also see that more and more people get Covid-19. If this leads to new lockdowns, it could hurt McDonald's in the short-term. Other risks are supply chain pressures and labor shortages. Supply chain pressures are seen through all sectors, and it is no different for McDonalds, as the price of beef and chicken are very volatile, and they also need to buy other commodities such as paper, fuel etc. In their conference call they also mentioned that hiring enough staff is a challenge, more so in the United States than in Europe, but still a challenge all over. Because of the labor challenges we have seen a wage inflation that will, at least in the short
McDonald's also has a lot of potential to grow. I already wrote about the MCD growth strategy. In Maximizing Marketing, they mention that they want to use marketing to stay relevant, and up until Chris Kempczinski became CEO, they had been stuck in the traditional mode. Instead, they stated during campaigns with Travis Scott and J. Balvin that have paid off in a big way. While they will also start using social media more to get instant consumer feedback, meaning they are in constant iteration mode. In Committing to the Core, they mention that they want to commit to their core business as it will represent long-term growth, as they know what their customers like. They also mention that they see a significant opportunity in growing their McCafe brand. In Doubling down on the Three D's, they mention several ways they can continue to grow. They believe they can be more efficient in drive thru, as they work in more technology. Right now, drive-thru service time is 30 seconds, and they think technology can lower that, which means they can serve more people in shorter time. One of the ways to do so it through their new loyalty program called MyMcDonald's, which is a McDonald's ecosystem, where customers can order food, delivery and pay, while they receive rewards in return. It will also give McDonald's a lot of customer data for them to improve their business moving forward. They also believe that delivery will be a growth factor moving forward, and in their earnings call they mentioned that they could use their scale against their delivery providers to gain competitive advantages. They also see China as a long-term growth opportunity and expect to open 650 restaurants in China during 2021, which exceeds their original plan.
All right, we have gone through the numbers, potential and risk regarding McDonald's, and now it is time for us to calculate a price for McDonald's. In order to calculate price, we will need the numbers that I have explained in the "MY STRATEGY" section of the website, as I do not want to go through the whole calculation here. I chose to use an EPS slight lower than it is now, but slightly higher than in 2019, at 8,50. I chose an Estimated future EPS growth rate of 8 (I feel it is attainable), Estimated future PE 16 (which the double of the growth rate, as the historically PE for McDonald's has been higher) and we already have the minimum acceptable return rate on 15 %. Doing the calculations by using the formula I described in "MY STRATEGY" we come up with the sticker price (some call it fair value or intrinsic value) of $72,58, and we want to have a margin of safety on 50 % so we will divide it by 2, meaning that we want to buy McDonald's at price of $36,29 (or lower obviously), if we use the Margin of Safety price.
Our second way to calculate a buy price is the TEN CAP price, which is also explained at "MY STRATEGY". To do so, we need some numbers from their financial statements, keep in mind that all numbers are in millions. The Operating Cash Flow last year was 6.265,2 The Capital Expenditures was 1.641. Looking through their annual, I saw that 1.106 was used on existing restaurants and corporate equipment and office-related expenditures, so it is the number I will use in my calculations. The Tax Provision was 1.410,2. We have 747,25 outstanding shares. Hence, the calculation will be like this: (6.265,2 - 1.641 + 1.410,2) / 747,25 x 10 = $80,75 in TEN CAP price.
The last calculation is the PAYBACK TIME. I also described in "MY STRATEGY". With the Free Cash Flow Per Share at 7,34 and a growth rate of 8 %, if you want your purchase back in 8 years, the PAYBACK TIME price is $84,32.
McDonald's has a huge brand moat, which makes it an interesting company. I believe that the management is the right one to drive growth moving forward. However, despite McDonald's having a good return on invested capital, I believe the numbers overall leave a lot to desire, and I'm not too happy about the debt. According to my calculations, McDonald's seems a bit pricy for the time being. McDonald's is probably not a company I would add to my portfolio, but I would reconsider if it for some reason ended up trading around my calculated PAYBACK TIME price at $84,32.
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