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We like McDonald’s (MCD): The Golden Arches’ future looks as bright as its past.
There’s little need for us to explain to investors the story behind McDonald’s. At the end of 2011, McDonald’s will have over 33,500 restaurant locations nationwide, and total sales (including franchisees, which don’t count for McDonald’s Corp.) will likely exceed $100 billion. We think a discounted-cash flow method is the most effective way to determine the intrinsic value of a company in order to determine what investors should pay for shares. In the spirit of the transparency of our process, we make our discounted cash-flow valuation model template, which can be used to value any operating (non-financial) company, available to subscribers and visitors to our site. As much as we like McDonald’s, we think shares are about fairly valued at $85, but we would be bigger buyers of this iconic brand on any significant pullback.
Best in class management sets the tone for the rest of the company.
How many CEOs started out working as an assistant manager in a McDonald’s restaurant? The answer is one, and his name is Jim Skinner. Skinner started working with the company in 1971, and has held several positions since then, including the COO of McDonald’s Asian-Pacific, Middle East and Africa (APMEA) and COO of the entire company. Skinner never graduated from college, and knows his business better than almost any CEO on earth. After becoming CEO in the midst of falling profits and high turnover (three CEO’s in one year), Skinner continued the plan he started as COO and has transformed a once struggling giant into the envy of the fast-food industry.
He dealt with “Supersize Me” and negative health concerns by expanding healthy options and eliminating the outsized servings. McDonald’s now offers oatmeal, fruit smoothies and salads, though burgers and fries remain the stalwarts of the business. He also directed billions of dollars to reinvest in dated-stores to make customer friendly environments, which includes faster service time, friendly service and drive-thru screens that confirm entire orders.
We also like that management requires executives to spend significant time inside the stores to learn the business as well as Skinner. This prepares a long-line of succession that holds the same core values as current management, and quite possibly the same prudence with shareholder capital.
International strategy: We’re ‘Lovin’ It.’
Though much has been made about Yum Brands’ (YUM) dominance in China, McDonald’s pioneered the journey and continues to grow sales throughout Asia and other emerging markets. Although a few initial hiccups occurred, the company continues to open profitable franchises throughout China and other emerging markets. Sales were up 16% in 2010 in the APMEA region, with same store sales increasing by 6%. By offering unique regional products coupled with its core consumer experiences, McDonald’s opens up its doors to more and more customers on a daily basis.
Additionally, the company has toned down the Americana in Europe, creating restaurants that better fit European style and landscape. McDonald’s has also started automated ordering in Europe, lowering costs and improving order accuracy. Gross margins in Europe improved over 100 basis points in 2010.
Continued innovation drives more traffic.
Returning to our early point about new product offerings, McDonald’s U.S. stores now boast over forty-five beverage choices, in addition to high-margin smoothies and lemonades that seem to be resonating with customers. We’ve seen different figures for market share, which could be anywhere from 40-50% in the fast-serve market. While Wendy’s (WEN) and Burger King continue to falter, McDonald’s continues to fire on all cylinders.
New products in the last two years include Angus beef burgers, oatmeal, smoothies, exotic lemonades, snack wraps and $1 soft drinks, which we think drives a lot of traffic (at least tired analysts in need of Diet Coke). As the economy continues to languish, customers have flocked to the various cheap options it provides. In this difficult environment, not many places can provide several different meals for under $5, but McDonald’s is certainly one of them. Investors will also notice that the company is quick to eliminate products that don’t work (McPizza, Big N’ Tasty, etc.), and expand on those that customers love, as seen in the explosive growth in McCafe products.
Much like in Europe, the company plans to invest $2.5 billion in capital expenditures in 2011, with approximately half of that going toward store updates and renovations. Improving the customer experience makes McDonald’s more appealing to every type of customer that is being squeezed by time constraints, as eating habits in the United States shift toward even more meals prepared outside the home.
Few companies are as kind to shareholders.
McDonald’s continues to be one of the most shareholder friendly-companies in the fast-food space. The company has returned over $5 billion to shareholders in each of the last three years, which is split between buybacks and dividends. In the first quarter of 2011, the company bought back $1.4 billion worth of shares and paid out $635 million in dividends. With around 1.7 million shares, Skinner is a significant shareholder whose interests (and net worth) are tied to McDonald’s continued success. We think the long-term focus of McDonald’s will continue to align shareholders and management. The company also floats a significant amount of low cost debt that can be easily covered (EBITDA/Interest coverage of 19x).
Although there are fewer negatives, we still think shares are fairly valued.
In the mid-$80s range, however, we think McDonald’s shares are fairly valued. The threat of a backlash against the healthfulness of its food is always a risk, though the recession appears to have tempered fears about obesity in the U.S. Additionally, McDonald’s has literally been firing on all cylinders for the last six or seven years, and any slip-ups could negatively impact growth. An increase in commodity costs could also pressure margins, as McDonald’s tries to squeeze every last penny out of suppliers.
In the event of margin compression and lackluster sales growth, McDonald’s could fetch a value south of $70 per share (based on our down-side scenario). However, continued success and improving operating margins could send the shares to over $95 each. In the near term, however, we’d hesitate to enter the stock as our required margin of safety is not yet present. That said, a pull-back could make McDonald’s a more compelling investment, and we would not hesitate to add it to our Best Ideas List.