Temporarily Beaten-Down Shares, Key Management Changes Offer Long-Term Upside with Dividend Aristocrat and Undisputed Global Fast Food Leader
Shares drop on weak Q4 and FY 2014 results, offer buying opportunity
Key management changes should reverse revenue slide
Strong operating cash flow, well capitalized balance sheet and healthy dividend payout provide income upside
McDonald’s Corporation (NYSE: MCD) is the world’s largest restaurant company with over 36,000 restaurants across more than 100 countries that serve about 70 million customers daily. MCD manages its business as distinct geographical segments that include the United States, Europe and Asia/Pacific, Middle East and Africa (APMEA), with about 31%, 40% and 23% of total revenues, respectively. The company’s “Other Countries & Corporate” segment includes operations in Canada and Latin America, and Corporate activities, which together account for about 6% of revenues. MCD is the market leader in the $169 billion U.S. quick-service restaurant industry, and is several times larger than its closest competitors, Burger King (BKW) and
Wendy’s (WEN). Moreover, McDonald’s is a very powerful brand that its competitors have just not been able to replicate on a large scale, in the U.S. or abroad, and the company still has significant global expansion potential in emerging markets and under-developed economies. So it’s only a matter of time before sales growth resumes and shares rally.
Beaten Down Shares Offer Buying Opportunity
At $92.44 as of 1/30/2015, McDonald’s shares were down about 11% from their 52-week high of $103.78 and offer a 3.7% dividend yield. Shares trade at 19x earnings but have exceptional profit margins that are well ahead of competitors despite McDonald’s significantly greater scale.
Of the 28 analysts who cover the stock, 2 rate shares a Strong Buy, 4 a Buy, 21 have a Hold rating. There’s just one Sell rating and that suggests analysts realize the core strength of McDonald’s franchise and are taking a wait-and-see approach to new management and its turnaround plans. Changing operations and practices at MCD will take time so investors should not expect a quick bounce back in results but should look for a gradual improvement in core metrics. If done right, shares could light-up in anticipation and rise well above current levels.
On average, analysts have a 12-month share price target of $94 with a range of $86 to $110. That’s a fairly tight range and reflects a higher probability of upside off current levels of $92.44 – so it’s not a stretch to say that risk here is minimal while upside is compelling.
Dividend Aristocrat with Stable Dividend and Highest Payout in Quick Service Restaurant Category
McDonald’s is an S&P 500 Dividend Aristocrat that has steadily raised dividends every year for at least the last 25 years. The company has a solid business model that generates over $4 billion in annual free cash flow which will help it ride out near-term revenue growth problems. The company has a dividend payout ratio of 50.3% and has steadily increased dividends over the years. The company’s strong business model, revenues and cash flow virtually assure dividend stability at current levels.
For its fourth quarter, MCD announced a quarterly dividend of $0.85 per share ($3.40 annualized), payable 3/16/2015.
In addition to raising dividends every year, MCD regularly buys back shares which boost shareholder value on an ongoing basis.
Business Fundamentals Continue To Be Solid Despite Perceived Weakness
McDonald’s is the clear runaway leader in the quick service restaurant category, with worldwide sales (2013 sales in billions of dollars in graph below) that are orders of magnitude above its competitors.
In addition, McDonald’s enjoys some of the highest profit margins in the industry, with operating margin of 26.7% that is well above most of its competitors and net margin of 16.7% that is well above the industry average of 10.6% and 12% at Yum! Brands (YUM) and Chipotle (CMG), 6.3% at Panera (PNRA) and 4.5% at Wendy’s (WEN).
Even so, shares trade at a discount with a trailing price-to-earnings ratio of 19x that is well below its peer average of 33x, and below smaller, lower margin competitors such as 23x at Yum!, 56x at Chipotle and 31x at Wendy’s.
McDonald’s unique combination of massive global sales and high margins delivers exceptional cash flow, which gives the company a substantial cushion to weather temporary revenue losses and implement a multi-year turnaround plan.
In addition, McDonald’s fundamental trends continue to be solid, with a clear uptrend on key performance metrics over the past decade, with rising sales, operating income and free cash flow.
The graph below shows McDonald’s customer satisfaction (ACSI) over the past 14 years – with a clear uptrend as management listened to customers and took steps to improve product offerings and customer service, as competition nibbled at its customer base. While the graph below has ups and downs from year to year, the trend is steadily upward.
Déjà Vu All Over Again!
This is not the first time McDonald shares have taken a beating. Shares were down significantly in early 2003 after a string of bad quarters and worries about the company losing its growth potential. But the company’s high margin business model, robust franchisee base and core customer loyalty proved naysayers wrong and the company came roaring back, with shares moving to new highs before the crash of late 2007. As before, the company’s low share price now represents a strong buying opportunity for long-term income and capital appreciation.
Management Shakeup Expected to Energize Sales, Turnaround
On January 28, 2015, McDonald’s announced the retirement of long-time CEO Don Thompson after 25 years with the company, with Steve Easterbrook elected to take his place as new CEO and Board member effective March 1, 2015. Easterbrook earlier led growth at the company’s European and UK operations. In addition, the company’s CFO, Pete Bensen, was promoted to Chief Administrative Officer, a newly created role where he’ll manage functions that support company operations, and Kevin Ozan was promoted to be the new CFO, reporting to Bensen. MCD shares rose 5% on the news, with investors encouraged and hopeful that Easterbrook will iron out the company’s strategy and deliver growth.
Thompson had been CEO for just two years but his tenure was marred by strong competition from operators such as Chipotle and specialty burger joints such as In-n-out, Habit (HABT) and Shake Shack (SHAK), falling sales and a sharp drop in profits after a string of food safety concerns from suppliers in China, Hong Kong and Japan.
Corporate Strategy – Sound But Requires Tweaking
MCD corporate strategy has five pillars – people, products, place, price and promotion – and is focused on enhancing the restaurant experience for customers worldwide through three global growth priorities: to optimize its menu, modernize the customer experience, and broaden accessibility. However, ex-CEO Thompson’s ouster was tied to missteps such as trying to offer too many menu choices through a “Create Your Taste” touchscreen menu that was just too confusing for MCD core demographic, and inconsistent price points that partly contributed to revenue declines. The new CEO, Steve Easterbrook, will likely address these issues and hopefully get the company on a new format that customers find appealing.
The company plans to introduce new food items such as healthier foods that appeal to millennials and regional foods that better reflect local preferences. The company is in the midst of a multi-year restaurant remodeling initiative, with about 700 restaurants remodeled during 2013. The remodeling drive will improve restaurant design, add drive-thru convenience and improve accessibility. Additionally, more restaurants will stay open for extended hours.
Over the long run, MCD plans to grow total revenues at 3% to 5%, operating income by 6% to 7% and return on incremental invested capital in the high teens.
Management sees global sales as a key growth driver and has seen non-U.S. operating income rise over the years. However, a strengthening dollar could weaken international results in 2015, particularly with growing fears of economic softness in non-U.S. markets. Slow economic growth in Europe and Asia are near-term regional challenges which should get sorted out over time. On the positive side, MCD has long-term growth potential in China and other emerging markets, where it has far fewer restaurants per capita than in the U.S. As living standards in those countries rise, MCD will become a restaurant of choice due to its strong brand and favorable positioning. Falling fuel prices across the globe should help lower operating expenses while boosting discretionary consumer spending, and should play in MCD favor.
Q4, FY 2014 Results Disappoint – But Fundamentals Remain Strong
Investors were disappointed by MCD Q4 and FY 2014 results which showed declines on all key metrics – revenue, comparable store sales in all key geographies, and Q4 earnings per share of $1.13 which were down 19% (down 14% without currency changes) and missed consensus estimates by 7%. Fortunately, the sharp drop in EPS was partly attributable to tainted meat from a major supplier in China – an issue that MCD identified and moved quickly to correct, so earnings per share numbers should recover significantly in 2015 after this one-off drop. In addition, EPS was impacted by higher taxes in certain foreign markets (which will not go away) and a stronger dollar. Q4 operating income was down 20% (down 15% without currency changes) on lower customer traffic that was attributed to a strong pickup in competitive quick service offerings and to healthier dietary preferences.
MCD is an exceptionally strong and well-run franchise with a powerful global brand and significant upside potential. While the company has fumbled over the past two years under former CEO Don Thompson – with sliding sales on confused execution and a one-off meat supplier issue, capable new management under Steve Easterbrook is expected to reverse recent negative trends. And while competition is strong in the U.S., the company is on-track to execute global new store openings which will continue to drive up revenue. So though same-store sales disappointed, new stores do have a strong positive net contribution to revenue. However, turning around a giant like MCD will take time, so investors need to be patient but this patience will be rewarded and shares could easily pop significantly higher if Wall Street likes the new management’s plans.