Date of Analysis: 13 August 2020
Key Metrics
| Market Cap | $153.3b | Share Price | $206.02 | 52 Week Low | $124.23 | 52 Week High | $221.02 |
| Revenue | $21.08b | Revenue CAGR (5 yr) | -5.14% | Net Profit | $6.03b | Profit CAGR (5 yr) | 4.84% |
| P/E Ratio (TTM) | 32.7 | Current Ratio | 0.91 | Debt-to-Equity | -5.49 | Dividend Yield | 2.38% |
Business Overview
If there was ever a business that needed no introduction, it may be this one. McDonalds (MCD) is the world’s largest restaurant chain (measured by revenue) serving 69 million customers per day across 120 countries. We’re not going to spend too much time on the business basics, however, there is one quirk of the MCD operating model that needs to be understood.
Franchise v Business-Owned Stores
Like many of its fast-food peers, MCD is a franchise heavy business. Out of a total of 37,855 restaurants around the world, only 2,770 are company-owned. The remainder are franchised.
Under a company-owned store, MCD owns and operates the store and makes money by selling food to customers. A traditional restaurant business.
Under the franchise model, MCD licenses their brand and intellectual property to a franchisor. The franchisor then hires staff and runs the restaurant. MCD makes money from franchise fees and royalties based on a percentage of sales, as well as rent paid from the franchisee where MCD owns the land or building.
This distinction is important when looking at the company’s financials (below).
Other interesting business facts:
- World’s largest purchaser of beef, pork, potatoes and apples.
- Largest operator of private playgrounds in the US.
- One of the world’s largest supplier of toys
- A new McDonalds opens every 15 hours
- 1.9 million employees globally
- 32% of revenue comes from the US
Competitive Advantages
Many of MCD’s sources of long-term competitive advantage are being eroded. A few of the major sources of competitive advantage are laid out below.
Low Cost Operator
With a rationalised menu and ‘assembly line-like’ production system, MCD is able to consistently be the lowest cost operator in markets around the world. In well established markets, MCD also enjoys a scale advantage over local competitors that allows it to achieve a lower ‘per unit’ cost for many of its inputs (for many inputs – e.g. beef and potatoes – it can source directly from farmers rather than through wholesalers). This is a source of long-term strategic advantage, offering MCD flexibility in pricing, greater resilience to price shocks and the ability to engage in price wars with competitors.
The challenge: In many markets MCD is facing significant increases in its cost base. Investment in customer offer (e.g. all-day breakfast, McCafe) have required additional investment by franchisees and have increased the operating cost base of their stores. These investments also reduce efficiency (one metric that shows this – average drive-thru wait time in 2006: 167.1 seconds, by 2017 the average wait: 208.2 seconds).
MCD also faces pressure to increase wages (e.g. campaign for $15/hour in America is heavily focused on MCD, also recent strikes in UK). Important to note, a government-mandated, industry-wide minimum wage increase in a country would affect all competitors as well. However, if union and team member action forces MCD to unilaterally raise wages this will partly erode their cost advantage.
Brand
McDonalds and the ‘golden arches’ is an incredibly well-known brand. Far better known than its competitors. The benefit of a strong brand is two-fold. One, customers are more likely to frequent restaurants they know. Two, a strong brand is attractive for potential franchisees, increasing the pool of applicants that MCD can select from. In a franchise-heavy business, having the best operators as franchisees is a point of long-term competitive advantage.
Global Brand Value in 2020 (in millions)
The challenge: The MCD brand is eroding in the face of changing customer preferences around quality and health. MCD’s food is seen as quite unhealthy and made from ‘lower quality’ ingredients (at least in many established western markets).
Financials Drivers
Headline Numbers
To understand the MCD business, it is important to understand the transformation the business has been undergoing. At first look, the revenue numbers don’t look great.
| 2018 | 2017 | 2016 | 2015 | 2014 | 2013 | |
| Revenue ($m’s) | $21,025 | $22,820 | $24,622 | $25,413 | $27,441 | $28,106 |
Between 2013 and 2018, the company’s revenue has fallen 25%. Not an ideal situation, and not a business you want to invest in. However, its net income number has remained relatively stable (up 6% in the same 2013-2018 period).
| 2018 | 2017 | 2016 | 2015 | 2014 | 2013 | |
| Net Income / Profit ($m’s) | 5,924 | 5,192 | 4,687 | 4,529 | 4,758 | 5,586 |
What’s Happened Here – Changing Store Mix
How has MCD seen their revenue fall 25% in 5 years but their profit has risen 6%? The answer is in the mix of company-owned and franchise stores. In 2015, new CEO Steve Easterbrook set the company a goal of achieving 95% of stores as franchises. You can see how the company changed its store-mix in the table below.
(A quick note on Steve Easterbrook – he is no longer the CEO of McDonalds after being fired for having an affair with an employee. It remains to be seen if new CEO Chris Kempczinski continues this strategy)
| 2018 | 2017 | 2016 | 2015 | 2014 | 2013 | |
| Total Restaurants | 37,855 | 37,241 | 36,899 | 36,525 | 36,258 | 35,429 |
| Company Owned Restaurants | 2,770 | 3,133 | 5,669 | 6,444 | 6,714 | 6,738 |
| Franchised Restaurants | 35,085 | 34,108 | 31,230 | 30,081 | 29,544 | 28,691 |
| % Franchised | 93% | 92% | 85% | 82% | 81% | 81% |
Splitting out MCD’s overall revenue into ‘company-owned’ and ‘franchise’ you can see how the changing store mix has driven the overall revenue number down.
| 2018 | 2017 | 2016 | 2015 | 2014 | 2013 | |
| Company Owned Restaurants | 2,770 | 3,133 | 5,669 | 6,444 | 6,714 | 6,738 |
| Company-Owned Sales ($m’s) | $ 10,013 | $ 12,719 | $ 15,295 | $ 16,488 | $ 18,169 | $ 18,875 |
| Franchised Restaurants | 35,085 | 34,108 | 31,230 | 30,081 | 29,544 | 28,691 |
| Franchise Revenue ($m’s) | $11,012 | $10,101 | $9,327 | $8,925 | $9,272 | $9,231 |
| Total Restaurants | 37,855 | 37,241 | 36,899 | 36,525 | 36,258 | 35,429 |
| Total Revenue ($m’s) | $21,025 | $22,820 | $24,622 | $25,413 | $27,441 | $28,106 |
In this 5 year period, sales from company-owned stores dropped 47% (off a 59% drop in the number of company-owned stores) and revenue from franchises rose 19% (off a 22% increase in the number of franchises).
Overall, that netted out to a 25% drop in revenue off a 7% increase in the total number of MCD restaurants. Putting it all together, we can look at the ‘revenue per store’ by company-owned restaurants and franchises.
| 2018 | 2017 | 2016 | 2015 | 2014 | 2013 | |
| Company Owned Sales | $10,013 | $12,719 | $15,295 | $16,488 | $18,169 | $18,875 |
| Company Owned Restaurants | 2,770 | 3,133 | 5,669 | 6,444 | 6,714 | 6,738 |
| Revenue / Restaurant ($m’s) | $4 | $4 | $3 | $3 | $3 | $3 |
| Franchise Revenues | $11,012 | $10,101 | $9,327 | $8,925 | $9,272 | $9,231 |
| Franchised Restaurants | 35,085 | 34,108 | 31,230 | 30,081 | 29,544 | 28,691 |
| Revenue / Franchise ($m’s) | $0.3 | $0.3 | $0.3 | $0.3 | $0.3 | $0.3 |
So we can sum up MCD’s recent strategy of selling restaurants that contribute $3-4 million in revenue per store and increasing the restaurants that contribute $0.3 million per store.
So, why pursue this strategy?
It seems strange like a strange strategy to pursue. To intentionally reduce their revenue. However, there are a number of reasons MCD are pursuing this strategy.
- Financial: Better profit margins on franchise stores and frees up working capital from inventory
- Operational: Don’t need to focus on managing restaurant operations. Leave that to franchisees.
- Business Certainty: Reduces revenue volatility
The most important reason is the far stronger margin from franchises compared to company-owned stores. This can be seen in MCD’s numbers. The gross margin from company-owned stores and franchise stores is world’s apart.
| 2018 | 2017 | 2016 | |
| Company-Owned Revenue | $10,013 | $12,719 | $15,295 |
| Company-Owned Gross Income | $1,747 | $2,309 | $2,596 |
| Gross Margin % | 17% | 18% | 17% |
| Franchise Revenue | $11,012 | $10,101 | $9,327 |
| Franchise Gross Income | $9,039 | $8,312 | $7,609 |
| Gross Margin % | 82% | 82% | 82% |
Splitting these numbers out on a ‘gross profit per store’ basis, we can see that the difference between gross profit isn’t nearly as large as the difference in ‘revenue per store’ we looked at above.
| 2018 | 2017 | 2016 | |
| Company Gross Income ($m’s) | $1,747 | $2,309 | $2,596 |
| Company Owned Restaurants | 2,770 | 3,133 | 5,669 |
| Gross Profit / Restaurant ($m’s) | $0.63 | $0.74 | $0.46 |
| Franchise Gross Income ($m’s) | $9,039 | $8,312 | $7,609 |
| Franchised Restaurants | 35,085 | 34,108 | 31,230 |
| Gross Profit / Franchise | $0.26 | $0.24 | $0.24 |
Putting it all together…
The 25% drop in the headline revenue number is worrying, but is explained by the changing store mix. MCD has protected its profit and free cash flow by counteracting its lower revenues with a higher profit margin.
| 2018 | 2017 | 2016 | 2015 | 2014 | 2013 | |
| Total revenues | $21,025 | $22,820 | $24,622 | $25,413 | $27,441 | $28,106 |
| Net Income | 5,924 | 5,192 | 4,687 | 4,529 | 4,758 | 5,586 |
| Net Margin | 28.18% | 22.75% | 19.04% | 17.82% | 17.34% | 19.87% |
One more thing, McDonalds as a property business
A familiar trope with MCD is ‘McDonalds is a property business that sells burgers’. Harry Sonneborn, a former McDonald’s CFO once said, “We are not technically in the food business. We are in the real estate business. The only reason we sell fifteen-cent hamburgers is that they are the greatest producer of revenue, from which our tenants can pay us our rent.”
Looking at the income MCD receives from its franchisees (‘total franchise revenue’) we can see that rent is the biggest source of revenue.
| 2018 | 2017 | 2016 | |
| Total Franchise Revenue ($m) | $11,012 | $10,101 | $9,327 |
| Rent | $7,082 | $6,496 | $6,108 |
| Royalties | $3,886 | $3,519 | $3,130 |
| Initial Fees | $44 | $87 | $89 |
However, when put in the context of overall MCD revenue, we can see that MCD still makes more money selling burgers than it does collecting rent.
| 2018 | 2017 | 2016 | |
| Overall MCD Revenue | $21,025 | $22,820 | $24,622 |
| Rent from Franchises | $7,082 | $6,496 | $6,108 |
| Rent as % of Overall Revenue | 34% | 28% | 25% |
Some other notes re: MCD’s financials
- Store sales are improving: MCD has had 14 quarters of comp sales growth
- Debt: Massive increase in debt over past 5 years
- Buybacks: Much of this debt has funded buybacks. (This means you need to be careful relying on ‘per share’ metrics e.g. earnings per share)
Valuing McDonalds
There are a few different ways to value McDonalds.
Relative Valuation
The simplest way to value a company is on a ‘relative basis’ (i.e. compared to similar companies in its industry). With a relative valuation, we are not asking for a specific valuation. Instead we are asking if it is cheap, in-line or expensive when compared to what investors are paying for similar companies.
The easiest way to do relative valuation is using the price-to-earnings ratio.
Where does MCD sit in relation to its peers?
| Company | P/E Ratio (as of 13/8) |
| Restaurant Brands (Burger King, Popeyes, Tim Horton) | 26 |
| Dunkin Donuts | 27 |
| Yum Brands (KFC and Pizza Hut) | 28 |
| McDonalds | 33 |
| Wendy’s | 46 |
| Domino’s Pizza (US) | 50 |
| Texas Roadhouse | 70 |
| Starbucks | 71 |
| Chipotle | 129 |
From this we can see that MCD trades right in the middle of the range of similar, franchise-heavy, fast-food businesses.
Discount Cash Flow
The DCF calculation is a two-step process where you estimate the future cash flows of a company, and then determine the value of this future cash flow today. To do the first step (estimate future cash flow) we need the current free cash flow per share or earnings per share and an estimated future growth rate.* For the second part we require a discount rate, because the value of dollar in the future is less than a dollar today. For discount rate, both Warren Buffett and Roger Montgomery suggest using 10% (and if it’s good enough for them, it’s good enough for us).
*The future growth rate is often split into growth rate for the next 5-10 years, and then a ‘terminal growth rate’. This is usually at or just above inflation (because projecting beyond 5-10 years is so uncertain).
So for MCD, the information we need to do this analysis:
- Earnings per share: $7.88
- Growth rate in the next 10 years: 5.3%
- (5.3% was the annual EPS growth rate over past 10 years)
- Terminal growth rate: 3% (assumed growth in line with inflation)
- Years of terminal growth: 10 years
- Discount rate: 10%
Fair Value: $100.35
This is far lower than MCD’s current share price of $206.02
Reverse Discount Cash Flow
We can flip the DCF process, and ask ‘based on a DCF analysis, what assumptions are built into the current share price?’. We know the company’s current per share metrics, and the current share price. Putting these numbers in – we can ask what growth rate is implied in the company’s share price. Or, asked another way, what growth rate would you need to be in the DCF model to have the current share price as ‘fair value’.
So for MCD, the information we need is:
- Share price: $206.02
- Earnings per share: $7.88
- Terminal growth rate: 3%
- Terminal growth period: 10 years
- Discount rate: 10%
Putting this information in, we ask what would the 10 year growth rate need to be to have the current share price match ‘fair value’ in a DCF calculation.
Required annual growth rate for next 10 years: 15.97%
Using this metric, we can ask ‘Do we think MCD will grow earnings per share at 15.97% every year for the next 10 years?’ Given the past 10 years has seen MCD growth earnings per share at 5.3% per year – we would summarise that it is unlikely MCD will hit this required growth rate.
Equity Value Growth (from Roger Montgomery’s Value.Able)
Unfortunately, we cannot do this valuation style for MCD. The reason for this is that MCD has negative shareholder equity – meaning we cannot calculate the company’s Return on Equity.
Shareholder Equity is the value of the assets the shareholders have a claim over once all debt has been paid. It is calculated by taking total assets and subtracting total debts.
MCD has had negative shareholder equity for the past 4 years, as its debt has nearly doubled (from $30 billion to $57 billion).
Concluding Thoughts
MCD is undergoing a fascinating business transition, as it intentionally reduces its revenue to focus on the more profitable franchise business rather than owning and operating its own stores. However, the current price the market is paying for shares in MCD makes it quite expensive. The market is paying for the consistent (and growing) dividend and the safety of low-risk, blue chip company. It is arguably too expensive based on its current share price and its future growth prospects. However, it is unlikely to get cheaper anytime soon.