Description

Thesis:

I recommend purchase of MCD for long–term investors.  Following remarkable business performance from 2019-2023 (system-wide comps up 30% over 4 years) comps have slowed. Barring a rapid improvement, EPS will not grow much in 2024 and the June quarter will likely be flat-down.  

So why read on?  Because you all are supposed to be value investors!  Given the power of the brand, the stability of its cash flow and the balance sheet strength, MCD represents good absolute value here and exceptional relative value in a very expensive market.

Over time, MCD should be able to generate 3-4% comps (in line with the historical average).  With accelerated unit openings, discussed further below,revenue should compound in mid-high single digits.  Coupled with slight operating margin expansion, steady share repurchases and an increasing dividend this should translate into a low double-digit total return without any multiple expansion.  I believe that MCD deserves a premium multiple to the S&P (as it has enjoyed historically) versus its current discount but I also think that the market multiple should and will decline over time–obviously a highly debatable belief.  When I managed mutual funds (many years ago) I tried to find stocks that could go up 30-50% in three years without a lot of help from the market.  On that basis I think MCD is quite attractive.

Background:

MCD has been written up four times in the past on VIC: the first time in 2002 (≈15%/year total return); twice in 2014 (≈14%/year total return) and most recently in 2021 (the stock is barely changed).  Note that in 2014 the company was struggling.

I am not going to go into great detail about the company as it is so widely analyzed and corporate disclosure is excellent.  Beyond the quarterly calls I recommend the Investor Days held in late 2020 and last December.  I will happily (try to) answer any questions.

Current Business Conditions:

Discount wars

The president of McDonald’s USA, Joe Erlinger, pushed back on “inaccurate” reports this week that said the chain had more than doubled its prices on some items over the last decade. But his retort wasn’t exactly reassuring: The average price of a Big Mac is up 21 percent from 2019.

Erlinger’s rebuttal underlines the heat that some companies are facing as the news media, politicians and consumers focus on steadily rising prices. Whether persistent price increases reflect price gouging, or simply companies’ own rising costs, is a matter of fierce debate. Either way, one thing is clear: Consumers are becoming fed up.

McDonald’s first-quarter earnings fell short of analyst expectations on sales, as “consumers continue to be even more discriminating” with their dollars, the chain’s chief executive, Chris Kempczinski said. Starbucks, Target and Yum Brands, the parent company of Pizza Hut and KFC, also reported earnings misses, each acknowledging increasingly cautious customers among other factors like the war in the Middle East.

Consumer spending remained surprisingly resilient in the face of stubbornly fast inflation, but now savings from the coronavirus pandemic have dried up, economic growth has slowed and many companies are working to counteract the belief that their prices have gotten out of control.

Source:  Axios, 6/1/24

Corporate Strategy:

CEO Chris Kempczinski:  Ultimately McDonald’s is in the business of selling a brand so that others can sell burgers and fries.

In 2005 Bill Ackman made headlines by proposing that MCD split up into a franchising/real estate entity and a restaurant operator.  This obviously did not happen, but in fact the company has changed considerably through a major refranchising program in the 2010’s.  Today only 5% of the more than 40.000 units worldwide are owned and operated.  Hence, corporate revenues are less than 20% of system-wide sales, which now top $130 billion/year.  In consolidated markets, MCD owns 57% of the land and 80% of the buildings.  Franchisees pay roughly 9% of sales in rent (with minimum rent payments) and 4-5% in royalties.  Until 2024 the royalty rate in the US and Canada was 4% but it will go to 5% on new restaurants and in some other situations.  It has been 5% in other international owned markets.  Of course this model leads to a highly predictable and inflation resistant stream of revenues. Moreover, Kantar ranks MCD as the world’s most valuable non-tech brand.

Accelerated Development:

In late 2023 MCD announced that it would ramp up new restaurant openings, going to 4% unit growth this year and rising to 5% by 2027 with a target of 50,000 by the end of that year.  Note that the number of US stores has changed little over the last decade–particularly in the mid-late 2010s management was focused on refurbishing and modernizing the existing base. Management believes that there is ample room for American unit growth, especially in the Southeast and Southwest, relative to the current population and trends over the next decades. Growth will also ramp in some international owned markets.  Importantly, average unit sales are significantly higher in some key countries than in the US.  Corporate returns are very attractive on new stores and, of course, this should also nudge up the underlying growth rate.

A thought on China:  Currently there are almost 6000 restaurants in a JV with CITIC (a very powerful local partner).  Earlier this year MCD increased its ownership in the JV from 20% to 48%, buying for $1.8 billion an interest held by Carlyle.  COVID restrictions and the economic slowdown have definitely impacted the business, but I believe China represents an important long-term opportunity; management has suggested that ultimately the country could support 20,000 to 25,000 stores.  Interestingly, the important trends of digital ordering and loyalty app members are far more advanced in China than the rest of the system.

Risks:

The major risk is an outbreak of price competition in many markets as the industry reacts to declining comp growth.  It’s very possible and I think it would be crazy to assume that it’s “in the stock”, as much as it has underperformed over the last 18 months. The mitigant is that MCD has gone through this at least twice before and emerged stronger.

A smaller risk, but one not to be dismissed, is unhappy franchisees.  Again, this comes and goes with MCD but it’s happened before and attracts headlines.

A third risk is the impact over time of GLP-1 drugs.  I think this is minimal but the fear of less consumer demand has already impacted the stock at least once,

Personal Investing:

I have owned MCD since late 2005 (average cost in the low $30s).  Recently I have added to an already substantial position.  It is demonstrably one of the world’s great companies and I think its long-term prospects are very bright.

I directly manage most of my family’s assets but have given some money to other managers.  One, now retired, managed money for my kids in a concentrated, low turnover, GARPy style with generally excellent results.  Though he did not own MCD (at least in the period I was involved) he had a set of principles that I think are extremely well thought out and will paraphrase here:

–Look for quality and value.

–High quality businesses earn high returns on capital without financial leverage and can reinvest in the business at attractive returns.

–Invest in these companies when owners’ cash flow yields are attractive versus long-term bond rates.

–Pay close attention to the underlying business risk.

–Be patient.

I believe MCD fits nicely in this framework, and should be especially prized by the VIC members who are interested in long-term compounders.

Corporate Presentation:

https://corporate.mcdonalds.com/content/dam/sites/corp/nfl/pdf/Investor%20Overview%20Deck%20v2024.4.8.pdf

Catalyst

Don't have one.