At $263.45 at time of writing, McDonald’s (MCD) stock is within 6% of its record high reached in Q4 CY2022. While the macro environment has deteriorated for restaurant operators, McDonald’s stock has proven resistant on (1) a business model that largely shields it from restaurant-level economics, and (2) a relatively flat P/E ratio that has not undergone a ‘de-rate’.

On the first point, the beauty of a business model that is tied more to system sales than store-level economics means it is relatively plain sailing right now for McDonald’s. I say that from a “will profits keep rolling into the corporate coffers?” perspective rather than a “what will the stock do over the next 12 months?” one. I stress the word “relatively” there as operations aren’t entirely divorced from what is happening at ground level, and that is something that is definitely a near-term consideration.

Largely Shielded From Unit-Level Goings-On

On the second point, the ins and outs of where valuation multiples are going is not typically something I worry about. What I would say, though, is that with the shares where they are right now the market is pricing a fair amount of medium to long-term growth.

For a restaurant stock, McDonald’s has an outrageously good track record of making money and sharing that money with shareholders. If you restrict your window to just the past ten years, you will find that McDonald’s has generated cumulative net income of $55 billion and, with the help of debt, has returned $74 billion to shareholders via dividends and buybacks.

What explains that is a business model that is mostly tied directly to the gross dollars spent on Big Macs, Cokes, fries and milkshakes. Of $23.2 billion in FY2022 company revenue, sales-based rent ($9 billion) and royalties ($5 billion) from franchisees accounted for around $14 billion, or 60% of the total. The latter figure rises to around 90% based on pre-SG&A operating margin, ultimately leading to company-wide operating margin in the mid-40s.

So, some near-term margin woes for franchisees don’t show up too much on McDonald’s operating figures. That partly explains why, for example, excluding FX and one-time charges like those related to the sale of its Russian business, operating income increased by around 10% last year, and is nicely ahead of pre-COVID levels.

Franchisee Health Still Important

That isn’t to say that franchisee health is unimportant. Tied to system sales, the growth recipe for McDonald’s shareholders is thus: net changes to restaurant count, restaurant footfall and check size. The ultimate health of the restaurant-level business is connected to all three. What’s more, I’d imagine that worsening store-level economics could eventually lead to less generous rents and royalties.

While McDonald’s has had its issues over the years, store-level economics are likely still very good. For instance, on FY2022 global system sales of $118 billion, the average McDonald’s outlet generated nearly $3 million in annual sales, with that based on a global restaurant count of around 40,000. The domestic U.S. figure is likely a fair bit higher.

Given their inherent operating leverage in running a restaurant, higher sales probably map to higher margins. McDonald’s also has an edge simply by virtue of its sheer size, with scale advantages likely in procurement and so on. In reality it isn’t quite that simple, and there are more moving parts which, for example, led to a 6ppt decline in company-operated margin between 2010 and 2019. Even so, U.S. company-operated margins were in the mid-teens area pre-COVID, which you can you as a starting point for franchisee level returns.

Trading Conditions Remain A Near-Term Consideration

While McDonald’s is largely a step above the unit-level business, there were still around 2,000 company-operated restaurants on its books last year. They are feeling the pinch from inflationary pressure on labor, utilities, commodity costs and so on.

Q4 FY2022 margin was 15% for the company-operated business, and management expects that to get worse this year:

“With significant inflationary headwinds across commodities, labor and utilities, our company-operated margin percent will be hampered in the near term, and we expect full year 2023 company-operated margin percent will be slightly lower than our quarter four results.” 

Ian F. Borden, McDonald’s CFO

Furthermore, the franchisees that run the company’s other 38,000 stores will all be feeling this pinch for themselves. In some cases, McDonald’s will step in to help them out:

“This elevated cost environment is also impacting restaurant cash flow for our franchisees, particularly in our European markets. As we’ve previously mentioned, our financial strength and scale gives us the ability to provide temporary and targeted support, ultimately keeping our entire system aligned on proactively investing to drive long-term growth. We estimate that these efforts will have an impact of between $100 million to $150 million in 2023.

Ian F. Borden, McDonald’s CFO

While McDonald’s will experience some of the impact of tougher macro conditions, it is still going to be in a relatively good position. I mean, for you regular restaurant owner the net impact of the macro environment could mean huge drop in margins and net income. For McDonald’s shareholders, it means net income growing less than it might otherwise have done.

With that, my screen shows FY2023 net income expectations of $7.7 billion, versus non-GAAP net income of approx. $7.5 billion in FY2022, which maps to FY2023 EPS of approx. $10.60, versus FY2022 non-GAAP EPS of $10.10. The company expects to open a net of 1,500 new restaurants, which is expected to contribute 1.5% to constant currency systemwide sales growth.

What Does The Market Think?

With the shares at $263.45 currently, McDonald’s trades on an implied P/E of 24.7x expected FY2023 earnings. The dividend yield is 2.3% based on the $1.52 per share quarterly dividend payable March 15.

I don’t explicitly attempt to forecast growth on the basis that (1) much of a stock’s value stems from the cash profits it is expected to make many years in the future and (2) it is very difficult to accurately forecast even near-term cash profits. Instead, I like to see what the market thinks based on the kind of assumptions needed to justify the current share price.

Given all that, my benchmark for McDonald’s stock in terms of a simple dividend discount model is high single-digit annualized dividend growth over the next ten years, before fading to a mid-single-digit and then finally a 2.5% terminal rate, all of which is discounted at an 8% hurdle rate.

On a discounted earnings basis, I’d be looking at annualized EPS growth of 8-9% over the next ten years, with that assuming a constant dividend payout ratio, 8% equity hurdle rate and an exit multiple of 20x EPS. The implied level of retained earnings over this period is $45 billion, which can be used for debt repayments, buybacks and reinvestment. These are the figures I’ll be using as a benchmark for future coverage.

Summing It Up

McDonald’s quasi-real estate business, with rent and royalties based on sales of hamburgers, fries and milkshakes, should shield it from a lot of the macro issues facing less advantaged peers.

Nevertheless, with the stock at $263 the market is baking in a fair amount of future growth. McDonald’s does have a runway ahead of it. U.S. system sales still account for over 40% of the company total, for instance, with good international prospects implied, but it remains a tough sell to argue these shares are anything other than expensive. With McDonald’s bonds arguably the most competitive they have been for years versus the equity, I’m not sure these shares are particularly compelling today.