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Ben Reynolds
Ben Reynolds
Articles (735)  | Author's Website |

McDonald’s: What Recent Changes Mean for Today’s Investor

Analyzing the fast-food chain's recent changes

December 10, 2018 | About:

Illinois-based restaurant chain McDonald’s Corp. (NYSE:MCD) provides an interesting story in what can happen when a business starts to turn around. To be sure, McDonald’s has been a formidable business for decades now. Not so long ago, however, there was a period where the company was struggling to get its footing.

I’ll give you some examples to demonstrate what I mean.

Consider this stretch of earnings per share results from 2011 through 2014: $5.27, $5.36, $5.55 and $4.82. In turn, the share price remained stagnant as well – trading around $100 to end 2011 and ending 2014 at $94. Granted, this “no growth” earnings scenario still meant McDonald’s was churning out approximately $5 billion in net profits annually (plus a healthy dividend), but the growth factor was lacking a bit.

Since that time, things have begun to change in a big way. New leadership, namely CEO Steve Easterbrook, was brought in at the beginning of 2015. There has been a strategic shift and a noticeable difference in the operation of the business. In particular, there are six “big picture” items that you can see changing with both McDonald’s the business and the security.

Revenue

Back in 2014, McDonald’s generated $27.4 billion in revenue. The expectation for this year is closer to $21 billion, or a decline of almost 25%. This is a direct result of the company and Easterbrook’s push toward franchising 95% of McDonald’s locations. This reduces the revenue that can be credited to McDonald’s, but it increases the value of that revenue.

Margins

While revenues are down, the franchising model allows for a less capital-intensive business, resulting in higher margins. In 2014, McDonald’s had an operating margin of 35% and a net profit margin of 17.3%. This year, the expectation is for the company to have a 49% operating margin and a 28.9% net profit margin. Granted, some of that is a benefit from lower taxes, but it stands that McDonald’s business model is changing.

Increased debt load

McDonald’s has made a decision in the last couple of years to borrow significantly when interest rates are low. The company went from a $15 billion debt load in 2014 all the way up to $32 billion today, more than doubling its leverage in just four years. The company is able to handle this increased load, but it is something to watch nonetheless.

Reduced share count

The benefit of the higher debt load, at least so far, is that McDonald’s has been using these funds to buy back shares in a big way. The share count stood at 963 million in 2014 and has since dropped down to 765 million – a reduction of more than 20%. Some have questioned using debt to buy back shares at a historically elevated earnings multiple, but it is clear the goal of retiring a substantial block of stock has been achieved.

Earnings per share growth

In 2014, McDonald’s earned $4.76 billion. This year the expectation is for company-wide earnings to come in at $6.1 billion, a 28% increase. That’s solid, but per-share results are so much better due to the reduced share count. Using the same numbers, earnings per share would grow from $4.82 to $7.80, or a 62% increase, in just the last four years.

Valuation change

Finally, you have the valuation. If the valuation of McDonald’s were to stay the same, you would see share price appreciation that was in line with the 62% increase in earnings per share. Yet here, too, investors have seen a boost. Shares of McDonald’s have gone from $94 up to $183, a 95% increase, as a result of a valuation that has gone from 19.5 times earnings up to 23.5 times.

There’s a ying and yang aspect to these metrics, with both positives and negatives. Revenues are down, but margins are up. The debt load has increased, but the share count is down dramatically. And earnings per share are up significantly, but now current and prospective investors have to contemplate an elevated valuation.

So where does that put us today?

Over the last four years, McDonald’s has become a less capital-intensive, higher margin business with renewed growth expectations. Countering this to a degree is a noteworthy increase in debt to go along with a historically high valuation. Which factors win out?

The expectation is for McDonald’s to earn roughly $7.80 this year followed by around $8.30 and $8.80 in the next two years. The intermediate-term growth expectation for the fast-food restaurant chain is in the high single digits. For our purposes, let’s suppose 6% annual growth for the next five years (a touch under what the company achieved in the past decade, but acknowledging an increased debt load and the improvements already made recently).

After half a decade, this could mean McDonald’s earning $10.40 per share. Naturally, the security’s future share price is unknown, but we do have some historical information. In the past couple of decades, shares have routinely traded hands in the 18 to 21 times earnings range (with bouts as low as 10 and as high as 26).

At 19 times earnings, this would imply the potential for a future price of $198.

McDonald’s has a storied dividend increase streak, but given a payout ratio already above 50%, you would not anticipate dividend growth greatly exceeding earnings per share growth. If the dividend also grew at 6% annually, you would anticipate collecting $25 or so in cash dividends per share.

Put together, these three assumptions – 6% earnings per share and dividend growth with a price-earnings ratio of 19 – would imply a total nominal value of $223 after five years.

The attractiveness of this value depends on the current share price. Against a current quotation of $183, this would mean the potential for a 22% total gain, or about 4% per annum. In other words, McDonald’s heroic share price run of the last few years may be difficult to replicate moving forward.

Of course, just because estimates are provided, this does not make them so. McDonald’s can grow much faster or slower than 6% per year and 19 times earnings may not be the “right” multiple for the security.

This type of exercise nonetheless provides some insight. It shows you what is required in order to make an investment thesis. If you think 6% growth and a price-earnings ratio of 19 is fair, this leads to average (or perhaps below average) return expectations. Alternatively, if your view is that faster growth can come about and a multiple above 20 times earnings will hold, you can make an investment case a lot easier.

In short, McDonald’s had a stretch from 2011 through 2014 where earnings and the share price began to stagnate. Then from the 2015 through 2018 period, with a new CEO at the helm, the business results have improved dramatically and the share price has done even better. However, it’s important to reconcile where these improvements came from.

A good deal of it can be attributed to honest, company-wide profit improvement – moving profits up 28% in four years. A large chunk, however, is a result of increasing the debt load to retire shares – bumping up the growth from 28% to 62%. And the final piece was a result of a higher valuation – resulting in 95% share price appreciation.

Moving forward, these same factors that resulted in outsized performance of the past – namely borrowing to fund a share repurchase program and a higher valuation – could become hindrances.

Disclosure: I am not long any of the stocks mentioned in this article.

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About the author:

Ben Reynolds
I run Sure Dividend, a website that finds high quality dividend stocks for long term investors using the 8 Rules of Dividend Investing.

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