McDonald's: Is a real estate company and not a food company.
Opdateret: 29. jan.
Former McDonald's CFO Harry J. Sonneborn is quoted saying "We are not technically in the food business. We are in the real estate business", when explaining the business of McDonald's. In my opinion, it is the strength of McDonald's as it is a higher margin business and could potentially protect the business during economic headwinds. In this analysis, I will investigate the company and if now is the time to buy the stock.
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 at the time of writing this analysis, I don't own shares in McDonald's. If you would like to see what stocks I have in my portfolio or if you would like to copy my portfolio, you can read how to do so here. I don't own any stocks in any competitors to McDonald's either. I have a tiny position in Beyond Meat that in cooperation with McDonald's make the McPlant burger, but I would hardly define it as I have any skin in the game regarding McDonald's. As always, I will keep this analysis unbiased.
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 invented 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 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 numbers are, you can have a look at "MY STRATEGY" on the website.
The first number we will investigate 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 years. These numbers are certainly encouraging. Well above the 10 % in all years and they even managed to deliver above a 10 % ROIC during 2020 where most countries had periods with lockdowns. It seems like ROIC topped in 2018 and has since decreased slightly but as the ROIC is still above the 10 %, it isn't a concern for me. However, it will be something that I would monitor moving forward, as I would like to see ROIC grow.
The next numbers are the book value + dividend. In my old format this was known as the equity growth rate. It was the most important of the four growth rates I used to use in my analyses, which is why I will continue to use it moving forward. As you are used to see the numbers in percentage, I have decided to share both the numbers and the percentage growth year over year. It is curious that McDonald's has a negative book value since 2017. The reason for that is that McDonald's has used debt to buy back shares. It might make sense if the stock is significantly undervalued, and the debt has a low interest rate. However, I personally like to see a company pay down debt, and I'm not sure that I like this strategy. Thus, it is good to see that book value is improving lately.
Finally, we investigate the free cash flow. In short, free cash flow is the cash a company generates after it has paid for operating expenses and capital expenditures. McDonald's delivers a positive free cash flow each year, which is always nice to see. It is also encouraging that they delivered a record high free cash flow in 2021. However, free cash flow yield has decreased slightly in the last five years. It would be nice to see a higher cash flow yield moving forward, as the stock seems slightly expensive that even with a record high free cash flow, the yield is lower than previously.
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 earnings. Doing the calculation on McDonald's, I can see that McDonald's has 4,72 earnings in debt. It is more than I would like to see but not surprisingly as McDonald's has bought back shares rather than paying off debt. While it won't keep me from investing in McDonalds, it is something that I don't particularly like.
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 risk is macroeconomics. In the earnings call from the first quarter in 2022, management mentioned this as a risk. They mentioned that commodity prices have gone up by 12 % to 14 % in 2022, which is higher than management expected as their expectations were 8 %. At the same time, they also experience wage inflation, as wages has risen by 10 %. Management has been able to rise prices by 8 % but it still doesn't cover the rise in commodities and wages. Management mentioned that they also experienced that inflation has affected their customers as McDonald's experience that their customers buy fewer items or make smaller orders. Covid-19. Luckily, the pandemic seems to be over in my countries, but new variants could mean new lockdowns moving forward, and McDonald's still mentions it as a risk factor in their annual report. We saw how lockdowns affected ROIC and free cash flow in 2020. Covid-19 could also affect their expansion in China, as China is having a more prudent Covid-19 policy than most other places. McDonald's results from the first quarter in 2022 were negative in China due to lockdowns. Lockdowns in China could also result in McDonald's not being able to open the 800 stores in China that they expected to open in China in 2022. China is a future growth catalyst for McDonald's and lockdowns could affect their results and affect their growth in the country. Competition. In their annual report, McDonald's mentions that they face intense competition that could hurt their business. McDonald's primarily competes in the informal eating out (IEO) segment, which highly competitive. Management believes that the segment will continue to be highly competitive for years to come, and McDonald's will need to continue to execute for not losing market share. In the first quarter, McDonald's saw a little loss in market share (only 0,3 %) in the United States, while they took market share globally. I believe that market share will be something that will need to be monitored if investing in McDonald's.
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. Management doesn't give a figure on how much potential there is in growing the McCafe brand but coffee is traditionally a high margin business. 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.
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 of 9. It is slightly lower than 2021 (10,04) but higher than 2019 (8,01). I chose an Estimated future EPS growth rate of 10 (average the last 5 years has been 15,8 % but I prefer being cautious), Estimated future PE 20 (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 $115,40, 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 $57,70 (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 9.141,5 The Capital Expenditures was 2.040. I tried to look through their annual report to see, how much of the capital expenditures were used on maintenance. I couldn't find it though, so as a rule of thumb, you expect 70 % of the capital expenditures to be used on maintenance, meaning we will use 1.428 in our further calculations. The Tax Provision was 1.582,7. We have 746,3 outstanding shares. Hence, the calculation will be like this: (9.141,5 - 1.428 + 1.582,7) / 746,3 x 10 = $124,56 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 7,92and a growth rate of 10 %, if you want your purchase back in 8 years, the PAYBACK TIME price is $85,27.
McDonald's is an interesting company with a huge brand moat. I also feel quite confident in the management. Macroeconomics will hurt McDonald's, but the question is how much and for long. Their business model should also shield themselves from some of the impact, which is nice. I like their growth strategy, which is all about committing to what they are best at, while improving the customer service, and hopefully reduce costs due to automation. I really don't like that management has prioritized buybacks instead of debt reduction, but it seems like it might has slightly changed since Chris Kempczinski took over. It is also worth noting that McDonald's has outperformed the S&P 500 over the last 5 years, as $100 dollar invested in McDonald's in 2016 would have turned into $249 compared to $233 if you had invested in the S&P 500. I think that McDonald's has the potential to continue to slightly outperform the S&P 500 but due to them prioritizing buybacks instead of debt reduction, I would need a 50 % discount to intrinsic value, if I should invest in McDonalds. It means that I will not invest in McDonald's unless it reaches the TEN CAP price of $124,56.
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