Description
MCD Overview - April 2015
I believe MCD represents a compelling risk/reward investment opportunity over the next 3-5 years, as the firm will get thru its current traffic and SSS challenges as it breaks its single domestic menu into 9 separate regions, improves product quality (reduce antibiotics in chicken, reduce/eliminate many preservatives) and advertises heavily to turn around its challenged brand image
*MCD is a dominant player in QSR with significant resources available to invest in product launches and menu innovation
-Over the past 2 ½ years, MCD has suffered a string of new product failures while peers (WEN/QSR) have done better - the fashion risk inherent in any consumer business is at a low point for MCD right now
-MCD has suffered SSS declines in the past and invested in stores to improve product offerings, with >$100K/store investment needed to launch McCafe, which paid off as a major contributor driving US SSS +3.8%/+5.0%/+5.6% in 2009/10/11
-No other QSR chain has the company-level financial resources of MCD, as MCD generates >10x the operating profit of QSR (Burger King/Tim Horton’s), >30x WEN and >4x YUM. MCD generates significantly greater profits and cash flows thru ownership of 45% of the land and 70% of chain-wide buildings, and it collects ~9% of franchisees’ sales in rent in addition to ~4%-4.5% in royalties where other chains merely collect ~4%-5% royalties
-Despite recent stumbles MCD remains ~3x-6x larger than each of its major rivals domestically, and with ~$2.6M sales/store at low average ticket MCD is by far the industry volume leader as well. MCD’s industry-leading advertising budget and product development resources are a significant advantage vs peers – MCD can develop a pretzel bun and put blue cheese on burgers like WEN – however its scale does make product changes more difficult and MCD has been slow to respond to market changes
*Risks to Thesis
-It is not clear when SSS will meaningfully turn around - MCD has fixed problems before, but in a less-crowded market. MCD's plans to run the US as 9 regions instead of one national menu will provide excellent marketing buzz and better tailor its menu to local tastes
-MCD's big risk is that poor product quality perception with teens could really begin to hurt traffic quickly as age 18-34 consumers are heaviest QSR users
-SSS slides are partly product-driven (will change with new intro's) but also partly product quality perception (complicated, longer-term fix required)
-MCD’s SSS slide could get much worse before it gets better – it takes time to change consumers’ perceptions – and investors could become more pessimistic about its prospects given its increasingly less favorable reputation and the fact that its winning economic model depends on very strong customer traffic volumes and efficient store throughput – the latter of which might be under fire due to both poor food quality perception and slowing speed-of-service from menu complexity
-While MCD could launch a hit new product after a multi-year series of poor products, its impact may be muted as MCD needs to cull its menu to improve throughput/service speeds and will lose customers as items are cut
*Mitigating Factors
-In the meantime, MCD's significant real estate ownership means it earns ~13% of franchise store revenues vs ~4%-5% at peers; barring a further severe downturn in SSS its ~$9.3B rent/royalty stream translates into ~$5B/year FCF on a $91B market cap
-US QSR category overall has been decent, with modestly negative traffic (~-1%), slight price/mix gains. Competition from Fast Casual matters, but Fast Casual is ~$38B segment vs ~$195B QSR in a ~$570B Food Away From Home market. Fast Casual growth is more the roll-up of higher-end segment from highly fragmented mom/pop industry - price points >2x MCD's is not as much a direct competitor
*Other Upside/Downside Wildcards
-MCD's sacrosanct real estate could be worth ~$140B alone, as its stores generates rents more comparable to BXP (Class A+ office in nation's 4 most expensive markets) than other triple-net lease real estate owners (NNN/O). Floating a REIT could save significant taxation, and with 30-year UST hitting all-time low (2.25% on 1/31/15) the rewards from partial real estate monetization have never been higher
-With US beef/chicken prices at/near all-time highs last fall, any reduction in protein costs will help improve menu affordability and enable financial results to come in above forecasts made in December/January during high pricing periods – though improving protein prices will benefit all QSR players and a majority of input cost savings will not drop to MCD’s bottom line
-While 8.5% of US public eats at MCD daily, institutional investors do not share middle/working class income profile - product perception among investors is highly negative and investor sentiment can turn sharply lower driving valuation far lower than industry-bottom present level
-MCD owns ~6,700 stores which generate ~$1.7B annual EBITDA/~18% margin – selling ~2,000 stores at ~5-7x EBITDA could generate immediate proceeds of $2.5B-$3.6B with modest earnings power dilution as MCD would retain ~13% of sales in rent/royalties. Selling just 2,000 extra stores comes on top of its current run rate of refranchising ~400-600 stores/year
*Risk/Return
-Overall, we believe MCD remains an attractive firm for long-term cash flow generation with modest growth potential. Given low multiple and negative sentiment due to short term struggles, MCD's ~5.4% FCF yield should provide a backstop on fundamental valuation limiting downside to perhaps ~$75-$85/share from $95 today – investors already give MCD industry-wide low multiples (~10.5x current EBITDA vs peers at ~11.5x (WEN/YUM) to ~14x (SBUX/PZZA), ~16x (DPZ) and ~20x (QSR).
-Against potential -10%-20% downside, we believe MCD represents a favorable risk/reward versus potential 3-5 year return comprised of dividends ($3.40/year and rising mid-single-digits annually) and potential +20% earnings growth over 3-years (and 35% over 5 years) which all-in equates to +30% (36 months) to +50% (60 months) assuming flat multiples with nearly 40% of total return driven by dividends
I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.
Catalyst
Positive product introductions combined with regional menu and product quality enhancements/annoucements could help get current ~-3% quarterly SSS run rate back to flat/positive low-single-digits by late 2015. Any improvement in SSS which drives franchisees' rents will materially boost MCD's earnings, in addition to positive operating leverage on 6,700 company-owned stores