McDonald’s (MCD, Financial) reported its second-quarter and first-half results on July 26. In its first-half operations, the fast food company reported a 2% sales loss to $12.2 billion and 10% profit growth to $2.2 billion. McDonald’s shares closed -4.47% that day while the Standard & Poor's 500 remained almost unchanged at 0.03%.
(McCafé restaurant, Business Insider)
Valuations
According to GuruFocus data, McDonald’s had a trailing 12-month (ttm) price-earnings (P/E) multiple of 22 times (industry median of 24), price-book (P/B) value multiple of 153.7 times (industry median of 2.7) and price-sales (P/S) multiple of 4 times (industry median of 0.95). McDonald’s also had a ttm dividend yield of 3.09% with a payout ratio of 67% and a 3.3% share buyback ratio.
Market performance
According to Morningstar data, McDonald’s had a total return of 14% while the S&P 500 had given 7.2%. Year to date, however, the fast food company has -0.16%. In comparison, the broader index, S&P 500, returned 6.3%.
(McDonald’s, Company website)
Comparable sales (1)
(McDonald’s comparable sales, annual and quarterly filings)
McDonald’s demonstrated an amazing comeback in its business operations since the third quarter of 2015, which was the period between July and September.
As it turned out, a change in the CEO helm in March 2015, accompanied by an all-day breakfast initiative under the new leader, Steve Easterbrook, brought the lumbering fast food giant back on a growth track again. For the past year, the market rewarded McDonald’s shareholders with a total return of 20.4%, beating the 9.6% provided by the broader S&P 500 index.
(McCafé restaurant, Business Insider)
McDonald’s
McDonald’s was founded in 1940 by Richard and Maurice McDonald. In 1955, Ray Kroc joined McDonald’s as a franchise agent and later on purchased the entire business from the McDonald’s brothers and further grew the restaurant business.
In its recent filing, McDonald's claimed to be the world's leading global foodservice retailer with over 36,000 locations in over 100 countries. More than 80% of McDonald's restaurants worldwide are owned and operated by independent local business men and women.
McDonald’s operates and franchises its namesake restaurants. The company is primarily a franchisor with 80%, approximately 29,000, of its restaurants owned and operated by franchisees as of fiscal year 2015. The fast food chain’s goal is to have 95% of its stores franchised over the long term.
According to McDonald’s, the expertise gained from operating company-owned restaurants allows it to improve its operations and success of all restaurants. Meanwhile, innovations from franchisees can be tested and, when viable, efficiently implemented across relevant restaurants.
Further, McDonald’s would own the land and building or is responsible in securing long term lease for a restaurant location under a conventional franchise agreement. A typical franchise term is 20 years. Further, McDonald’s requires its franchisees to meet rigorous standards that may generally not work well with passive investors.
The franchisees are responsible for financing equipment, signs, seating and décor. Franchisees are also responsible for reinvesting capital in the restaurant business over time. McDonald’s also co-invests with its franchisees to fund improvements in the restaurants.
McDonald’s believes that ownership of real estate, combined with the co-investment by its franchisees, enables the giant fast food chain to achieve restaurant performance levels that are among the highest in the industry.
Other than the conventional franchise agreement, McDonald’s also has a development license agreement. McDonald’s has its franchisees provide capital for the entire restaurant business; McDonald’s receives the royalty based on a percentage of sales as well as initial fees upon opening of a new restaurant.
In fiscal 2015, McDonald’s had the conventional franchise agreement arrangements in 15% of its stores (5,500) in over 70 countries. McDonald’s largest development licensee, Arcos Dorados (ARCO, Financial), operated some 2,100 stores in 19 countries in Latin America and the Caribbean. In comparison, however, Arcos Dorados had a three-year (fiscal 2013 to fiscal 2015) operating margin average of 3.57%. McDonald’s had 29.4%.
In addition to the first-half sales and profit growth above, McDonald’s had five-year (fiscal 2011 to fiscal 2015) sales and profit growth averages of 1% and -1.75%.
(McDonald’s, Image Source)
Cash, debt and book value
According to GuruFocus data, McDonald’s had a total cash of $3.1 billion. The company also had total debt of $26 billion with a debt-equity multiple of 40.6 times. McDonald’s also had just about 7.5% of its $33 billion total assets in goodwill and intangibles.
(McCafé restaurant, Business Insider)
Cash flow
McDonald’s also had a ttm cash flow from operations of $6.3 billion. The fast food company allocated $1.75 billion in capital expenditures, leaving it with $4.5 billion in free cash flow. McDonald’s also allocated 325%, $14.8 billion, of its free cash flow in dividends and share repurchases. Meanwhile, the company also took in $5.7 billion in debt ttm.
Observably, McDonald’s had its dividends and share repurchases paid out an average of 155% of its free cash flow in the previous three years (fiscal 2013 to fiscal 2015). McDonald’s share repurchase activity grew rampantly in 2015 by 90.7% to $6 billion.
Conclusion
As observed, the market did not fail to reward McDonald’s recent turnaround in its sales performance. The company seemed to find its groove by initiating several business strategies. Other than the all-day breakfast breakthrough, McDonald’s also recently opened a new version of its restaurant, McCafé. According to Business Insider, the café is to serve coffee and delicacies while also having an open kitchen.
Currently, McDonald’s analysts expect 15.8% earnings per share growth to $5.56. Using its five-year historical earnings multiple, I arrived at a value of $108 per share. Meanwhile, most analysts are bullish and had an average target price of $134 per share for McDonald’s. Deutsche Bank, for example, had a target price of $135 per share.
(McDonald’s Share Price, Google Finance)
Among several analysts that covers the fast food giant, only Nomura and Argus downgraded its recommendation of McDonald’s shares as an investment. Nomura lowered the company’s shares to neutral from buy, while Argus had issued hold from buy (2).
With its restaurant almost omnipresent in most countries around the world, steady business operations growth, strong balance sheet, and excellent shareholder stewardship, it is hard not to be bullish about McDonald’s.
Meanwhile, I consider it overvalued in terms of its historical earnings multiple.
I would have McDonald’s on HOLD.
Notes
(1) Annual filing: Comparable sales and comparable guest counts are key performance indicators used within the retail industry and are indicative of the impact of McDonald’s initiatives as well as local economic and consumer trends.
Increases or decreases in comparable sales and comparable guest counts represent the percent change in sales and transactions, respectively, from the same period in the prior year for all restaurants, whether operated by the company or franchisees, in operation at least 13 months, including those temporarily closed.
Comparable sales exclude the impact of currency translation.
(2) Financial Visualizations.
Disclosure: I do not have shares in any of the companies mentioned in this article.
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