With the Covid-19 pandemic still raging in many countries, McDonald's Corp. (MCD, Financial) is feeling the pain. Its earnings reports for the first quarter of 2020 and the first half of the year featured a lot of negative numbers.
Real relief likely is still some time away, but if we were to ask about investing for the longer term, say five to 10 years out, then we might be more bullish. Let's start with this 10-year price chart:
By including the trend line, we find the price has grown an average of 10.84% per year. In addition, over those same 10 years, the median dividend yield has been 2.94%. That means an investor who bought and held for the past 10 years would have enjoyed a total return of nearly 14% per year, and that's before compounding, which obviously would have occurred if investors held the stock through the decade.
Since 2017, the company's growth strategy has been defined by its Velocity Growth Plan, described in the 2019 letter to shareholders as follows:
"Velocity makes the most of our competitive advantages, from our unmatched global scale to our iconic brand to our tremendous presence in local markets around the world."
The plan has three key pillars:
- Retain existing customers
- Regain lost customers
- Convert casual customers into more committed customers.
Management also identified three accelerators:
- Digital
- Delivery
- Experience of the Future in the U.S.
In the letter, president and CEO Chris Kempczinski noted, "while this is the most challenging global crisis in our company's history, we remain confident that we are well positioned for the long term."
Can McDonald's management continue to deliver above-average returns to shareholders over the long-term? We will assess company fundamentals over the past three to 10 years to get a sense of what the answer might be.
Financial strength
It's not a promising start with the GuruFocus system giving the fast-food giant a 3 out of 10 rating for financial strength. As the first five lines of the table and the following chart show us, debt is a big issue:
How has the company used its borrowed funds? Among other things, it has expanded both the number of countries in which it has operations and the number of stores/restaurants. At the end of 2009, according to the 10-K for that year, the company operated 32,478 restaurants (both franchises and company-owned) in 117 countries. At the end of 2019, it operated 38,695 restaurants in 119 countries.
Keep in mind that McDonald's has a capital-intensive business model because it buys or takes out long-term leases for most restaurant properties and buildings (the franchisee pays for equipment, signs, seating and décor). The company puts up the initial capital and the franchisee pays fees that repay the capital over time.
Interest coverage at 6.38 is low, but above the minimum threshold of 5.0 set by the legendary Benjamin Graham.
The Piotroski F-Score is reassuring since it sees McDonald's financial situation as typical for a mature company. More of the same comes from the Altman Z-Score, which is high enough to indicate the company is on a sound financial footing.
The weighted average cost of capital is 4.24%, which is low when compared with its return on invested capital of 12.56%. That spread shows us the company has allocated capital effectively.
Overall, I think McDonald's enjoys greater financial strength than would be suggested by the overall rating.
Profitability
McDonald's gets a high rating of 8 out of 10 for its profitability, driven in large part by the excellent margins we see on the first two lines of the above table.
Revenue is down slightly, as we can see in the below table. My first thought was that it was the result of the Covid-19 crisis, but on closer examination we find revenue has been heading downward since December 2013:
Despite the decline in revenue, the two profitability measures shown at the bottom of the profitability table are positive. Ebitda growth has averaged 9.3% per year over the past three years, while earnings per share without non-recurring items averaged 13.1% per year.
If not for the decline in revenue, the company might enjoy a 10 out of 10 rating for profitability. We don't know how long it can continue to squeeze more income out of a declining revenue flow.
Valuation
As the GF Value chart above suggests, McDonald's stock suffers from modest overvaluation. The GF Value puts fair (or intrinsic) value at $169.81, compared to $218.18 at the close of trading on Sept. 25.
The DCF calculator puts the fair value at $68.82, which seems too negative in my view. The DCF valuation is based on a predictability rating of 2.5 out of 5. Normally, we wouldn't have much confidence in a predictability rating below 4 or 4.5.
The price-earnings ratio, at 34.54, is higher than the restaurants industry median of 26.77 and McDonald's own 10-year median of 21.27.
Given this high price-earnings multiple, we should expect the PEG ratio to show overvaluation as well. It does, at 3.76, which is more than a full point above its five-year median. The five-year Ebitda growth rate is respectable at 9.20%, but not enough to bring the PEG down to a fair valuation.
Dividend
McDonald's pays a modest dividend of 2.29%, but it will be higher for investors who bought when the share price was lower:
The dividend payout ratio is relatively high at 78%. While the company has not signaled its future dividend intentions, on Sept. 15, it announced its regular quarterly dividend payment of $1.25 per share.
In its 10-K for 2019, it reported it had hit its target of delivering $25 billion in returns through dividends and share buyback over three years (2017-2019). Presumably, investors can expect more of the same at some point in the future.
As we saw in the table above, the share buyback ratio is 3.1, meaning the company has been actively repurchasing its own shares. That's confirmed by the following 10-year chart, which shows the share count contracting by 31%:
That means earnings per share have been pushed up because profits are being divided among fewer shares.
Gurus
The value investing gurus have been relatively quiet on the stock this year, after being busy selling shares last year:
Fifteen gurus have positions in McDonald's, with Pioneer Investments (Trades, Portfolio) having the largest holding, 970,181 shares, good for a 0.13% stake in the fast-food empire. Pioneer added 5.32% to its stake in the second quarter.
The T Rowe Price Equity Income Fund (Trades, Portfolio) had the second-largest stake, with 180,000 shares, a reduction of 14.29% in the second quarter. PRIMECAP Management (Trades, Portfolio) was third with 152,000 shares after a minuscule sell in the quarter.
Conclusion
McDonald's still knows how to make money for its shareholders, despite the tribulations that have come its way in the past. Its financial situation is hardly ideal, with a lot of debt on its balance sheet, and the debt load has been growing.
As we have seen, it is overvalued, based on the fundamental data used by both the GF Value calculator and the DCF calculator. The rising share price behind the overvaluation also has dampened the dividend yield.
Still, those looking for a long-term investment might put McDonald's on their short-lists, knowing that potential capital gains and dividend yields could combine into a stable total shareholder return. Value investors will likely find the debt and lack of a margin of safety as serious detriments and look elsewhere. Income investors may be tempted to investigate the company further, but their dividends and potential capital gains will be more worthwhile if they wait for a pullback.
Disclosure: I do not own shares in any of the companies named in this article.
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