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McDonald's - Buy and Hold Until a Rainy Day
Posted by: Invest E Gator (IP Logged)
Date: June 21, 2012 06:59AM

Yesterday, Goldman Sachs downgraded McDonalds (MCD) from buy to neutral and set a price target at $92/share, noting that they prefer instead other opportunities at Starbucks (SBUX) and Chipotle Mexican Grill (CMG) . Here is a link to an article about it: http://blogs.wsj.com/marketbeat/2012/06/13/mcdonalds-downgraded-goldmans-not-lovin-it/

The Goldman downgrade strikes me as particularly quaint as it comes with the noted preference for Starbucks and Chipotle Mexican Grill, but its not just Goldman taking part in this downgrade comedy show, as I have been watching various investment house downgrades popping up in the news over the past couple of months. Maybe I am wrong in this regard, but my intuition is telling me that these downgrades have more to do with the movement of the stock price, perhaps also tied to external economic factors, and less to do with the underlying value of the company, and this is feeding a market over-reaction to what are only slightly sub-par operational results. Furthermore, for the time being, I am more inclined to attribute the results to temporary economic factors, rather than any "real downgrading" taking place in the future potential of the MCD business and brand. I will get into this later in the article as, once someone comes to an intimate understanding of the company, these things become but blips on the radar screen to be tracked.

A Simple Ratio - PEGR

I don't see PEGR discussed too often on Gurufocus so lets just start with a quick intro. PEGR, or "Price Earnings Growth Ratio", isn't a tell-all for a company's value, but it's a tell-much. Its a very simple formula of dividing the growth in a company's earnings per share, plus dividend yield if there is one, by the current price earnings multiple. It looks like this:

PE/(Growth Rate % + Dividend Yield) Warren Buffet doesn't speak so much for it, but Peter Lynch rocked the investing world with it. A lower PEGR is better than a higher PEGR because it often means you are buying future earnings growth at a lower price. This is pretty much the same thing that Buffett looks for when he speaks of considering the intrinsic value of a company and buying it at a considerable discount with a margin of safety. Personally, I like PEGR because its a quick and easy way to guage the value of a company, however, other considerations must also be taken into account along with it. For example, all other things being the same, a company with a strong balance sheet warrants a higher PEGR than a company with a weaker balance sheet, and one must always inquire into the future sustainability of past growth.

PEGR of MCD vs CMG vs SBUX = Goldman Analysts Snorting Equity Stardust?

Lets take a look at MCD compared against the two other companies referenced in the Goldman Sachs downgrade...

MCD - McDonald's
Year EPS Growth
2011 5.27 (.15)
2010 4.58 (.11)
2009 4.11 (.09)
2008 3.76 (.15)
2007 3.25 (.41)
2006 2.29 (.13)
2005 2.02 (.13)
2004 1.79 (.52)
2003 1.18 (.53)
2002 .77

10 year growth rate: 25%
5 year growth rate: 13%
Projected future growth rate: 15%
PEGR = 16.74/(15%+3.12%) = .92 = Value purchase
Note: It might seem a bit contradictory to project the future growth rate at 15% when the last five years grew at 13%, however, even if they do only average 13%, the value is still comes out OK with PEGR at 1.03. The future growth rate of a company is a subjective estimation based on evidence available, I will get later in this article as to why I am so comfortable with them, so I am fine with giving them a long-term 15%.

CMG - Chipotle Mexican Grill
Year EPS Growth
2011 6.76 (.19)
2010 5.64 (.43)
2009 3.95 (.67)
2008 2.36 (.11)
2007 2.13 (.66)
2006 1.28 (-.10)
2005 1.43 (4.96)
2004 .24

Average EPS growth rate since 2007: 41%
PEGR = 58/41 = 1.41 = Very expensive
Note: CMG's growth rate of 41% since 2007 is astronomically high and certainly not sustainable for long. They run a great business and have a lot of room to expand, both domestically and internationally, but the share price for their growth potential is way too high. Looking at revenues for the past 10 years, they are increasing at about a steady 25%, but earnings have increased faster due to improved efficiencies and scale. If we were to calculate PEGR from 25% sales growth results, then they would be obnoxiously overpriced, and I am not sure how long CMG will be able to keep outpacing revenue growth with earnings growth.

SBUX - Starbucks
Year EPS Growth
2011 1.62 (.31)
2010 1.24 (2.38)
2009 .52 (.21)
2008 .43 (-51)
2007 .87 (.19)
2006 .73 (.20)
2005 .61 (.30)
2004 .47 (.42)
2003 .33 (.22)
2002 .27

10 year growth rate: 41%
5 year growth rate: 60%
Subtracting high and low years: 26%
Average: 42%
Projected future growth rate: 25%, although more difficult to ascertain.
PEGR = 31.93/(25%+1.23%) = 1.22 = slightly expensive
Note: Starbucks is a tougher analytical knot to untie. 2008 and 2009 were exceptionally rough years for them, they coincided with a recession, a period of deteriorating sales results, but also years where current CEO Howard Schultz was away from leading the company. They have since been closing down a considerable number of locations domestically, expanding internationally, and continuing promotion of their branded consumer products. It should be noted that they also had negative results from the recession in the early 90's but were ok for the mini-recession near the turn of the century.

We can see right here in this little exercise of comparing the current price against results over the past ten years that, at the very least, MCD appears to be the better value of the three. For the sake of this discussion, we can take easily take Chipotle right off of the table for being too prohibitively overpriced, Starbucks would then require a closer inspection. The only thing that would change this analysis would be if McDonald's were to unexpectedly decelerate growth over the long term, and Starbucks somehow find a way to acclerate unexpectedly. Both situations are less than likely, especially the part where Starbucks might somehow manage to acclerate growth more than they currently already are. The last recession hit them pretty hard, and its been some years since, every passing day is one day closer to the next downturn, whenever that might happen. It would be interesting to see how it works out for them while CEO Schultz is behind the Starbucks helm. Considering how well McDonalds performed through this period by comparison, a very simple and lucrative play might be had out of holding MCD and enjoying the dividends until it looks like the world is sure it's coming to an economic end, then switching the holdings over to (the recessionionary-sensitive)Starbucks. Eat your heart out Goldman Sachs.

A quick glance at a few others in the restaurant category

PNRA - Panera Bread Co
2011 4.55 (.26)
2010 3.62 (.30)
2009 2.78 (.25)
2008 2.22 (.24)
2007 1.79 (.04)
2006 1.71 (.04)
2005 1.65 (.32)
2004 1.25 (.24)
2003 1.01 (.42)
2002 .71

PEGR = 31.03/24 = 1.29 = slightly pricey

YUM - Yum! Enterprises
2011 2.74 (.15)
2010 2.38 (.07)
2009 2.22 (.13)
2008 1.96 (.16)
2007 1.68 (.15)
2006 1.46 (.14)
2005 1.28 (.06)
2004 1.21 (.20)
2003 1.01 (.07)
2002 .94

PEGR = 21.32/(12.6+1.70) = 1.49 = Expensive

BWLD - Buffalo Wild Wings
2011 2.73 (.30)
2010 2.10 (.24)
2009 1.69 (.24)
2008 1.36 (.23)
2007 1.10 (.19)
2006 .92 (.80)
2005 .51 (.21)
2004 .42 (.50)
2003 .28 (.03)
2002

PEGR = 30.11/26 = 1.16 = almost ok, but I like them relatively less because of possibly limited long-term growth potential.

Panera and Buffalo Wild Wings, as neat as they both might be, are sort of anchored to the USA for the time being for various reasons, Panera even more so. However, comparing the PEGR between companies, an investor begins to get an idea of relative valuation of which ones are better priced. Overall, I think McDonald's trumps them all for the time being, not only for PEGR, but for other factors as well. For example, I have owned Panera for a while and am quite familiar with the company, but it was exhausting to watch their competitive foundations deteriorating right out from under them; "Artesian bread" sold on Costco store shelves, "Artesian pizzas" sold at Dominos (Really??), "We Bake Our Own Bread" neon signs getting put up at Subway sandwich shops next door to Panera, Starbucks recent purchase of a bakery company, possibly in an attempt to mimic Panera's success as a baker, Panera CEO Shaich stepping away from active management (but he recently came back), mobile internet becoming more affordable and accessible, thus steadily fizzing Panera's wi-fi hotspot hangout advantage. These developments have not shown up yet in results but they are factors pressuring against them.

Of course, McDonald's is constantly faced with similar competitive obstacles, however, one thing that separates them is that they are one of *the* most quintessential American things. They are probably on the very top of the list for global brand recognition, and their executives are brilliantly and consistently striving to meet the demands of their customer base.

In the next section, take a good look at the top revenue generating countries. Who would have thought, decades ago, that FRANCE would become one of their top revenue generators? For all of the endless griping and moaning about their food, McDonald's has very well proven themselves that they can rise to the top while operating in very diverse culinary surroundings. And remember "Super Size Me"? This widely circulated documentary, released in 2004, had been a direct assault to McDonald's brand and product in the strongest means imaginable: despite this, same store sales have still increased steadily since its release in 2004. Healthier menu options have been made available over the years since, but their ability to so quietly maneuver these storms speaks volumes as to having a durable competitive advantage.

Global Expansion and Future Earnings Growth

OK. Now here is where we get the party started. MCD currently has 33,500 restaurants located in 119 countries. Sounds like they already have the whole world pretty much covered, right? Nope. Not even close, and not by a long shot.

The following countries comprise 70% of their 2011 revenues, along with their respective populations:
United States - 313m
Canada - 35m
United Kingdom - 62m
France - 65m
Germany - 82m
Australia - 23m
Japan - 127m
China - 1,347m

One more number we are going to need is that planet Earth has a population of about 7 billion. Now, all of the countries on that list, except for China, where they have hardly even touched, we can pretty much think of as being saturated markets, they make up about 700m people, or 10% of the world's population. China, a rapidly developing country, has almost twice that number of people. It might be possible that McDonald's could double their restaurant count in China alone. So now we are looking at 66,000 locations over the horizon saturating 2 out of the 7 billion human mouths to be fed. So then what about India? Even less penetrated than China. The global growth potential available is enormous, and they are nibbling away at this bit by bit and the earnings growth derived from this is quite nice.

A simpler way to look at it is 10% of the world's population generating 70% of revenues, then the inverse is the other 90% population generating 30% of revenues. Certainly, one must also consider the varying economic circumstances throughout the planet, but this is changing very rapidly as the world develops, and the demographic threshold for someone to be able to afford a Big Mac isn't that high. Bottom line: They have decades of growth ahead of them.

From the companies that we have analyzed earlier, some of them inherently come with this kind of underlying growth potential, some of them don't. YUM! has it, but they face the complexity of managing an entire portfolio of restaurant concepts, not just one, a higher debt burden, and the investment value isn't nearly as good. Separate Taco Bell from the rest of YUM! and then maybe let's talk turkey. Buffalo Wild Wings has a total restaurant count of a bit less than 900 locations, and management estimates that they can reach about 1500 in the USA... well then what? So each company is going to be very different from each other in this regard.

Additionally, along with this massive potential for restaurant location growth, we also have a considerable history for share repurchases. Over the past 10 years, shares outstanding have done this:
2011 1.02 Bil
2010 1.08 Bil
2009 1.12 Bil
2008 1.17 Bil
2007 1.20 Bil
2006 1.26 Bil
2005 1.27 Bil
2004 1.26 Bil
2003 1.27 Bil

Meanwhile, the current dividend yield is 3.12%. McDonald's has been paying and increasing the dividend every year since they first started paying it in 1976. Since 2000, dividends paid per share have increased like this:
2011 2.53
2010 2.26
2009 2.05
2008 1.625
2007 1.50
2006 1.00
2005 .67
2004 .55
2003 .40
2002 .235
2001 .225
2000 .215

(Is that a >10x increase in dividend payout over the past 10 years?)

Moving on, a quick consideration should be made regarding their balance sheet and cash flow statement to make sure that investors don't end up finding themselves sideswiped by a weak financial position. Their most recent quarterly report shows that they have $2.3 billion in cash and about $12 billion in long term debt. The 2011 annual report shows that 69% of their debt is held at a fixed rate, averaging 4.2%, and its all spread out over a diverse basket of currencies with maturities reaching far out into the year 2040. They also have a neat financial setup worth mentioning in that all of their contractual cash inflows, coming from minimum real estate rental payments under franchise agreements, are more than enough to cover all of their contractual obligations for operating leases and payments on debt, and this stretches out for years into the future. Pretty solid.

There have been some less-than-stellar results coming from McDonald's in recent months, along with sober economic warnings from management, like sales affected by austerity measures in Europe, and followed by investment institution downgrades. If we are at the beginning of an economic downturn, why are these institutions then pointing to Starbucks as a better alternative?? Are we going into an economic upturn? The most recent sales report shows Asia going slightly negative for comparable sales, but with overall global results still in the positive. There are some who argue that McDonald's is reverse-cyclical, with better results in bad times and vice versa, this may be the case for the USA, but not in China where they are more like economically like Starbucks, and we saw what happened to them in the last recession.

Last, but not least, Jim Skinner, former CEO who has been with the company for quite a few years retired very recently, with Don Thompson, who has also been with them for a while, most recently as the Chief Operating Officer, taking his place. The Skinner years have been great for McDonald's, will the Thompson years be up to par? This is a very hard question to answer and something that an investor must watch for with an eagle's eye. Ultimately, the one thing settling any doubts that I might have regarding this unknown factor in the equation is that their executive compensation policies are as good as can be, with approximately 85% of the CEO's compensation tied directly to operational performance. Don Thompson, the man of the hour, all eyes on him. Can a COO rise up to be a CEO? Im betting yes.

Over the last couple of months, I started selling out of my other restaurants and concentrating into MCD when the price dropped down to $95/share, and have been buying them up, along with enjoying the recent dividend payment, as the stock has been dropping since. There has been a neat joy in owning McDonald's in that they are so large, there is a constant churning of news and whatnots on the internet popping up over the course of the day. For example, as I am writing this article, a news story shows up online blasting them for having the lowest score in a customer satisfaction survey among limited-service restaurants (Right here - :8e98:http://blogs.ocweekly.com/stickaforkinit/2012/06/mcdonalds_last_customer_satisfaction.php:/8e98:), however, open the report and click on the column to re-order them by which scores have improved the most over the years? MCD is in 2nd place for the greatest percentage improvement. This is like a real-time neverending story, and I'm very interested in watching how this continues to unfold.



Stocks Discussed: MCD, SBUX, CMG, PNRA, YUM, BWLD,
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Re McDonald s - Buy and Hold Until a Rainy Day
Posted by: stock2score (IP Logged)
Date: June 21, 2012 08:52AM

Enjoyed your detailed analysis. I have been owning MCD for years and am still lovin' it especially with the recent price drop so I can add more to my position. MCD appears to represent the best value at this moment in the restaurant industry, with SBUX coming at second.


Stocks Discussed: MCD, SBUX, CMG, PNRA, YUM, BWLD,
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Re McDonald s - Buy and Hold Until a Rainy Day
Posted by: Invest E Gator (IP Logged)
Date: June 21, 2012 03:13PM

Thanks! Im really excited about them too. Its odd how some of the best buys in the stock market are often the most obvious, but also the most overlooked.


Stocks Discussed: MCD, SBUX, CMG, PNRA, YUM, BWLD,
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