The last four months have been tough for McDonald’s (MCD). For one the shares are off somewhere in the region of 10% from their August highs. Granted, the stock was up almost 25% year-to-date at that point, but still, nobody enjoys seeing their investments decrease in value. The apparent catalyst for that drop was a rare earnings miss in its third quarter fiscal results. That was then followed a couple of weeks later by the departure of CEO Steve Easterbrook for well-publicized reasons. The company is also facing various lawsuits and strikes over pay and conditions (par for the course with McDonald’s but it all adds to the climate of negativity).
My own view is that the main issue here is valuation induced noise. What the heck does that mean, I hear you say? Well, consider the August high stock price of just over $220 – equivalent to a market-cap of $170,000m. Over the prior trailing-twelve-month (“TTM”) period McDonald’s generated $5,850m in net profit, equivalent to around $7.65 per share. Quick math puts that valuation at a rather expensive looking 28.75x annual earnings.
On a debt-adjusted basis the valuation looks even worse. Inclusive of capital lease obligations I have total debt at around $40,000m net of cash, equivalent to around $50 per share. As far as I’m concerned dropping 11% from that kind of height is no big deal. I mean even now McDonald’s stock trades at 25x estimated 2019 earnings excluding debt. Needless to say that is still comfortably above the long-term historical average of circa 18x earnings.
The Debt Load
Speaking of debt, as we head into the next decade the balance sheet looks more stretched than ever. Stripping out capital lease obligations gives us net financial debt of around $30,000m. Annual EBITDA currently stands at around $10,000m, or roughly 3x that net financial debt figure. That is rather high for my liking, though I don’t doubt that McDonald’s can carry it for two reasons.
First, cashflow is very stable and has become even more predictable as the company shifts further away from company-operated outlets. At the end of 3Q19, 93.1% of its 38,300 locations were franchised. Now, the great thing about franchised stores is that the revenue source is more stable and the profit margins are high. Franchisees pay rent to McDonald’s (often at a huge markup to boot), which then also takes a small cut on the sales of fries, burgers, salads and milkshakes. Basically McDonald’s is a hybrid real-estate/restaurant company.
Finally, the company retains plenty of that cash even after paying out its dividend. In recent years this excess cash went on stock buybacks, and when necessary McDonald’s can deploy it towards debt reduction. By my count the company should have an annual cushion in excess of $2,000m, post-dividend, going forward.
Stock Returns From 2020
The million dollar question: what will McDonald’s stock do going forward? Let’s take a look at management’s long term forecasts, which include annual systemwide sales growth of 3% to 5% and an operating profit margin in the mid-40% range. The company sees this leading to high single-digit earnings per share growth.
I have the company increasing its restaurant count at a rate of around 1.5% per annum. Given the company’s global footprint and size, that number shouldn’t really surprise anyone. Modest same store sales growth on top of that would be enough to see McDonald’s hit its 3% to 5% systemwide sales growth target. Reaching a mid-40% operating profit margin also seems very doable given it already stands at 42.5%. Adding in the positive impact of stock buybacks (and/or debt reduction) gets you to high single-digit growth on a per-share profit basis.
The final piece of the puzzle? The current 2.4% dividend yield. Throwing that into the mix implies long-term annual returns in the 10-12% region. I would add a caveat to that: the current rich valuation necessitates continual dividend reinvestment (or a further capital outlay at cheaper valuations) for anyone buying the stock today.
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