Description

Mc Donald’s Corp -

Mc Donald’s Corp is the largest restaurant company in the world with more than 30 000 restaurants worldwide and 41+ billion in systemwide sales.
80% of the stores are franchised, 20% are operated by the Company. The fast food market is saturated in the US, but growing steadily in other parts of the world. Mc Donald’s currently adds around 500 net restaurants a year, versus 1500+ during mid 90’s.
For the last five years, the Company struggled with saturation in the US, a strong headwind due to the weak Euro (the Euro weakness cut EPS by more than 15c per share over the last three years), the Mad Cow (BSE) disease in Europe, and numerous crises in emerging countries, from Asia to Russia to Latin America.

One major point not well documented on Wall Street is the real estate ownership of the Company. Mac Donald’s owns 40% of the land on all its stores, and more than 50% of the buildings. The Company then turns around and rents the asset to franchisees, who are responsible for the maintenance. In the long term, this provides a significant competitive advantage to Mc Donald’s, as occupancy costs do not go up with inflation.

Moreover, the Company breaks down capex in 3 parts: money spent on new restaurants, on existing restaurants and “other”. Over the last 10 years, the money spent on existing restaurants + other has been 85% of depreciation. I would argue that the Company over depreciates and that the true economic earnings are understated by 15% of depreciation. The over depreciation is due to the real estate component, and the fact that the truly depreciable assets – kitchen equipment and fixtures – are bought and maintained by franchisees.

Here is a table of Total Capex, excess D&A and adjusted EPS over 10 years:
2001 2000 1999 1998 1997 1996 1995 1994 1993 1992
New 1198 1308 1231 1357 1531 1799 1550 1181 609 603
Existing 571 507 515 398 433 350 355 211 94 91
Other 137 130 122 124 147 226 159 147 55 47
Total 1906 1945 1868 1879 2111 2375 2064 1539 758 741

D&A: 1086.3 1010.7 956.3 881.1 793.8 742.9 709 628.6 568.4 554.9
Excess D&A: 378.3 373.7 319.3 359.1 213.8 166.9 195 270.6 419.4 416.9

Shares out: 1281.3 1304.9 1350.8 1356.2 1371.4 1389.2 1399.4 1387.4 1414.6 1454.4
Per share: 0.29 0.28 0.24 0.26 0.15 0.12 0.13 0.20 0.30 0.29

Reported EPS: 1.25 1.46 1.39 1.10 1.15 1.08 0.97 0.88 0.77 0.66
Adj. EPS: 1.54 1.74 1.63 1.36 1.30 1.20 1.10 1.08 1.06 0.95
Adj. PE @ 17: 11.0


The long term growth in EPS achievable by Mc Donald’s is in my opinion of the order of 6% for the next 10 years: 2% from opening new stores, 1-2% from comps, 2% from stock buybacks.
The Company spends half a billion dollars a year in buybacks, which at current prices amounts to 2% of the shares outstanding.

From a return on capital employed perspective, the Company is extremely profitable compared to competitors (on a fully capitalized basis, ie EBIT/(Real estate + equipment). This is due to higher asset turnover than competitors. The average revenue per Mc Donald’s restaurant in the US is around 1.65 million, versus 1.2 million for Wendy’s and less than a million for Taco Bell or Pizza Hut.

The slow but steady and reliable growth outside the US, the squeaky clean accounting, and the brand recognition, (especially outside the US where the market is growing), warrant a 20 multiple on 2003 E economic earnings (being reported earnings + excess depreciation for a total of 1.55). Fair value is therefore USD 31 per share.

The key over the long term is that MCD owns the burger market in the faster growth countries, ie outside the US. Wendy’s has no presence in Europe. The brand remains extremely powerful outside of the US. It is in my opinion impossible for Wendy’s or Burger King to compete in countries where they are not currently established. If Burger King were to go to France, for instance, they’d have to set up a base of store large enough to support advertising on a national level. Well, in fact, a decade ago, BK tried the experience. BK closed their 16 stores in Paris in the late 90’s: each time they would open a store, MCD would open one opposite from BK. Customers flocked to MCD, and the BK stores remained empty…

MCD outside the US is an unassailable brand in the Burger market.

Issues/Risks:
- Saturation of the US market –
- More importantly, is the fast food format obsolete in the US? Has management left the current base of store so unappealing that the Brand has been damaged in the US? Have they repelled the upper middle class for ever, or will MCD be able to attract these clients back into the stores?
- Management is looking for a new concept: bought Boston Chicken, Donatos Pizza, Aroma Café, a minority stake in Pret A Manger… A potential problem would be to develop one of these brands that would turn out to be unprofitable. This risk seems low as the Company understands the restaurant business better than most people. At the same time, if the Company is able to develop a new concept, the upside would be much larger, but I am skeptical they will be successful with these initiatives.
- Higher interest rates: the Company is A rated, and has debt backed by the real estate. Execution in the US – the initiatives for the last two years have failed to significantly improve same store sales in the US – No blockbuster new product for years.
- Franchisees unrest. They are disappointed with the Company’s performance, and had to invest substantially recently in new systems, with no tangible results.

The downside from USD 17 is extremely limited in my opinion, especially with strong asset backing from the real-estate.

Catalyst

None.