McDonald’s – I’m Buying It

McDonald’s – I’m Buying It

SUMMARY

  1. The restaurant business has been struggling to deliver returns that are comparable to the general market
  2. Steve Easterbrook has led a comeback at McDonald’s and as a result, has delivered market crushing returns for shareholders
  3. The business has all the qualities that investors should look for when buying a company; pricing power, growing dividends and a stellar balance sheet
  4. While the stock may seem expensive, it is better to pay a fair full price for a wonderful company

 

  1. Introduction

When you think of a fast-food brand, what’s the first name that comes to your mind?

I can say with an almost 100% accuracy that the brand you thought of is McDonald’s (NYSE: MCD). The fast-food kingpin operates, franchises and services a worldwide system of restaurants that prepare, assemble, package and sell value-priced foods. One of the most outstanding aspect of the business is the power of its branding. It is precisely why you would have thought of it first and not Wendy’s (NASDAQ: WEN) or even KFC (NYSE: YUM). While it continues to put pounds on its customers, investors should consider buying this company to add some weight to their wallet.

  1. A Value Meal

The fact that McDonald’s needs no business description speaks volumes about how it dominates in its own industry. The world’s No.1 restaurant chain sports a No. 1 market position almost everywhere it goes and this includes around 2,500 units in China which makes up less than 10% their global store count. On top of that, the management team has announced plans in August this year to double the number of store count in China over the next five years. It has outlined its “Vision 2022” plan to increase its store count from 2,500 to 4,500. In this plan, McDonald’s has shifted its expansion strategy to target smaller cities with 45% of newer stores opening in third or fourth-tier cities while 75% of them will offering take-out and delivery service.

It is currently the largest player in the $1.4 trillion global and formal eating out market and they operate over 36,000 restaurants in 120 countries around the world. Here’s a kicker: They owned less than 10% of the total market share. It’s pretty obvious that the opportunity for growth clearly remains for McDonald’s as it continues to spearhead new markets aggressively.

Here are the three main reasons why I would recommend investing in McDonald’s:

A.) It will super-size your dividends.

McDonald’s 2.58% yield has been on a tear lately. For a mature company like this one, investors would need to adjust their expectation with respect to the rate at which the company is able to grow its dividend. The latest dividend paid in a quarter is $0.94 per share which is a 14% increase since 2013. The company also announced a 7.4% increase in the upcoming quarterly dividend to $1.01, amounting to $3.83 per share annualised for this year. Overall, it is very impressive for a company that is selling mainly burgers and soft drinks. The business structure will continue to spin out more cash and the company is tossing it investor’s way.

B.) Numbers that will leave you drooling.

The food at McDonald’s will probably not leave anyone salivating but the numbers on its balance sheet does. Operating margin is a robust 34.89% which has been consistent since 2013 and return on asset is at 15.72%. Lastly, return on capital – essentially a more robust version of return of equity that accounts for debt – stands at a solid 24.83%, as compared to the weighted average cost of capital (WACC) of just 6.31%. For a business that makes $5.08 billion a year in net profit, that’s McMagic.

C.) Pricing Power

Warren Buffet has mentioned that when he looked back at all of his best investments, the most important factor that they all have in common was that they had pricing power. Due to its superb branding and customer loyalty, McDonald’s pricing power is key in making sure that price increments on its products will not leave a sting on the company as customers walk away. We can see the effect of this just by walking into any outlet; it’s as crowded today as it was 10 years ago.

  1. Next On The Menu

Since the market has a forward-looking mechanism built into it, the important question for investors to ask of McDonald’s would be “What’s going to make McDonald’s sizzle in the future?”

First, reaching out to new customers, whether by renovations (re-imaging of more than 600 outlets in 2017 and targets 2,500 ‘Experience of the Future’ restaurants by year end), higher-end coffee (think of McCafe’s coffee competing against Starbucks’), healthier offerings (salads and a greater variety of non-carbonated drinks) or further expanding itself into various markets (expansion mentioned earlier into China). The company’s management is focused on modernizing the customers’ experience and also broadening accessibility to deliver unparalleled convenience. For any investor, this is great news!

A second catalyst is the shifting ownership of the 20% of stores that are still company-owned into the hands of franchisees. The company is on track to refranchise 4,000 restaurants by the year end. Upon completion, the company would have successfully refranchised more than 90% of its stores. Considering that the company-owned stores deliver an 80% margin, this move means McDonald’s scores in margins and capital-weighted returns in one swoop.

Last but not least, the company has been laser-focused on cutting down cost by leveraging on its technological capabilities. Management team has lofty goals of elevating the customer experience at McDonald’s to provide a more personalized and more enjoyable visit. It leverages the convenience and technology of kiosk ordering and table service, increasing functionality of the mobile app to enhance the enjoyment of food and the outreach of distribution through other delivery services. One of the most significant disruptions in the restaurant business today is the rapid increase in delivery. Through technology, delivery has changed the way customers order, pay, track and receive food and provide feedback. Coupled with the explosive growth in third-party delivery companies, the landscape has created an exceptional opportunity for growth and McDonald’s stands to benefit enormously.

  1. Risks

McDonald’s risk comprises of mainly two components: Those that could cause volatility in the near-term and those that would impair the investment thesis. The former includes minimum wage and health-care legislation and commodity costs, as well as food regulation and marketing restrictions. As for the latter, if the populace starts eating right (think Whole Foods Market), investors might need to evaluate if customers would continue to walk through the doors. Under realistic scenarios, investors can expect this to be a buy-and-hold for long-term investment.

Another risk that might play out would be to overpay for the stock. While the company has been beating the S&P 500 index, having shot up by almost 50% since November 2016, investors might be wondering if the price is right. A reasonable assessment has to be made with regards to the business performance.

Despite softness in its revenues, the business has been delivering modest growth on its earnings per share. With a pipeline of new initiatives in its playbook, the business will continue to grow steadily and deliver stable returns to shareholders.

  1. Why I’m Still Lovin’ It

In capable managerial hands, which we have at McDonald’s, the company will continue to be a force to be reckon with. Steve Easterbrook stepped on board as the company’s CEO in 2015 and he has done a fantastic job in turning around a business that many of Wall Street’s analysts has deemed as tired and old. Overall revenue and same-store sales are picking up in single-digit percentage which is rare these days for a restaurant business. With a high-quality dividend payout, investors can expect to be rewarded handsomely over the next decade or two.

 

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Marcus Ho
Research Analyst, Mind Kinesis Value Investing Academy

Disclaimer: Please note that all information stated in this article is just for education purpose only and should not be used as any form of recommendation or advice.

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