McDonald's (MCD, Financial), the largest restaurant chain in the world, has shot up by more than 25% since the start of the year as the stock continues to keep scaling new heights. But the problem is, at more than 25 times earnings and 5.2 times sales, does McDonald's offer any margin of safety for investors?
After struggling to get its same-store sales (SSS) back on its feet in 2013 and 2014, McDonald's made a lot of structural changes to get things moving. It changed its CEO, decided to take the franchise-heavy route, announced huge share buybacks, started offering all-day breakfasts, and little by little comparable-store sales have now moved back into positive territory.
One major factor, other than comps growth, that helped improve McDonald's outlook is the company's decision to take the franchisee route. During 2015, McDonald's announced its intention to get 95% of its restaurants franchised, much higher than the 81% franchised restaurants the company had at that time.
By decreasing the number of company-owned restaurants, McDonald's reduces risk because it reduces the company’s capital investment and ties its revenues to more stable fees from franchisees – rent and royalties based on a percentage of sales. A highly franchised restaurant chain will have slower sales growth and higher operating margin when compared to a restaurant chain that owns most of its restaurants.
The effect of this transition can be clearly seen in McDonald’s operating numbers. Sales by company-operated restaurants are down from $18.293 billion in 2011 to $15.295 billion in 2016 while franchisee revenue increased from $8.71 billion to $9.32 billion. All this happened when the percentage of franchised restaurants moved from 81% to 85%.
McDonald's is targeting 95% of franchised restaurants, but the company is re-franchising existing stores instead of opening new restaurants. With more than 36,000 stores around the world, McDonald's cannot keep opening stores at a pace similar to when it had only 10,000 restaurants. By the end of 2014, McDonald's had 36,258 restaurants around the world, which grew to 36,905 restaurants by the end of first-quarter 2017, a net addition of 647 restaurants over nine quarters.
Sales growth will continue to move down and can slowly grow after McDonald's hits the 95% franchised restaurant target. With new store additions coming in at a slow pace, its already sky-high 5.2 times sales will only keep going up from here, leaving a very narrow margin of safety for investors at the current price point. Starbucks (SBUX, Financial), the premium coffeehouse chain that is marching toward the 30,000-store mark, only trades at 4.28 times sales, a significantly lower level.
McDonald's is a great dividend play due to the stability of its highly franchised earnings stream, but chasing the stock at this level would hurt overall returns. It’s better to wait for things to cool down a bit before adding the stock. If you are patient enough, one bad quarter of comparable store sales will get you a much better price point.
Disclosure: I have no positions in the stock mentioned above and no intention to initiate a position in the next 72 hours.
