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McDonald's (MCD) - Thesis

McDonalds (MCD)
Rating: BUY
Current Price: $97.10
Price Target: $122.69

 

Thesis: 

McDonald’s earnings have declined recently due in large part to supplier issues in China, an unfavorable lower court ruling that resulted in a large increase to foreign tax reserves, the strong US dollar’s negative impact on non-US operations, and a brand that seems to be in decline.  However, the company continues to deliver enormous amounts of free cash flow, new management is pursuing significant top and bottom line improvements, and the stock’s recent declines are overdone.  Using a discounted cash flow valuation model, we believe MCD is worth $122.69 per share, giving it more than 26% upside versus its current market price.  We rate MCD a “Buy.”


Current Situation:

Things seem bad at MCD.  The company has delivered a negative earnings surprise (versus the consensus estimate) in all but the most recent of the last six quarters (they beat by $0.02 in calendar Q2).  Net income (2014) declined considerably versus previous years, and Q1-15 and Q2-15 EPS was well below Q1-14 and Q2-14.  The CEO was replaced in 2015, and public perception seems to be negative.  Additionally, it seems a daunting task for MCD to deliver significant growth considering it’s already very large, and consumers’ tastes seem to have shifted to prefer higher quality, higher-service competitors.

 

Free Cash Flow:

Despite negative public perceptions and declining earnings, MCD continues to generate an enormous amount of free cash flow.  Cash flow from operations minus capital expenditures continues to exceed $4 billion per year, and will likely increase in the future due to managements plans to limit capex to $2 billion (it’s been $2.5 to $3.0 billion in recent years), and to achieve $300 million of net annual savings in SG&A expenses by the end of 2017.  This will put free cash flow around $5.3 billion per year, leaving plenty of room for the company’s roughly $3.2 billion of annual dividend payments.

However, the free cash flow becomes somewhat concerning considering MCD is in the middle of a 3-year plan (2014-2016) to return $18-$20 billion of cash to shareholders.  It’s concerning because they’re only generating roughly $14 billion of free cash flow during this period.  The shortfall is made up through debt issuances and cash generated by refranchising of restaurants.  It doesn’t seem entirely unreasonable to finance dividends and share repurchases with debt (to an extent) if management believes the stock is undervalued especially considering they’re paying a 3.5% dividend yield on the equity and MCD’s cost of debt is in roughly that same neighborhood.  Further, MCD has plans to refranchise 3,500 restaurants by 2018 which will add to cash inflows.  However, there are only so many restaurants they can refranchise, and there is a limit to the amount of debt they can issue.  Something will need to change for MCD in the long-term because the current operating status quo will not allow this much cash to be returned every year beyond the next few years.

During the most recent post earnings conference call, MCD CFO, Kevin Ozan, announced they’ll be delaying their next dividend payment announcement two months until November which suggests there may be big changes coming with regards to how MCD uses its extra cash.  MCD may be announcing expensive restructuring, expensive growth initiatives, a big acquisition, a reduction in share repurchases, changes to the dividend policy, or some combination of the above.


Valuation:

We value MCD at $122.69 per share using a discounted cash flow model.  Our model assumes approximately $5.3 billion of free cash flow in 2016, a 6% required rate of return and a conservative 1.5% growth rate.  A 1.5% growth rate is very small, and could easily be eclipsed over the next two years simply if foreign currency exchange rates stop working against MCD (for example, MCD’s Q2 investor relations earnings report notes foreign currency translation had a negative impact of $0.13 and $0.23 on diluted earnings per share for Q2-15 and year-to-date, respectively.  And MCD lost 2% of net income to currency in 2014).  If MCD grows at 3% into perpetuity its worth $184.03, and if it grows at 0% it is worth $92.02.  And there is room for growth considering MCD’s 2013 (most recently available data) system-wide restaurant business accounted for only 0.4% of the outlets and 7.5% of total sales within the “Informal Eating Out” segment of the market (2014 MCD Annual Report).

 

Turnaround Plans:

MCD is engaged in a variety of initiatives to stem the company’s slumping sales growth and declining profits.  One major initiative is improving the brand image.  The newly appointed CEO was formerly in charge of branding at MCD, and he will bring expertise in this area to the highest level of the organization.  There is a strong focus on enhancing the appeal of core products and addressing food perceptions; MCD is focused on improving and highlighting the quality of ingredients.  Another initiative is expanding breakfast, which is the company’s strongest day-part.  Market testing around all day breakfast availability continues.  Previously mentioned cost reductions are also an important initiative.  The company plans to reduce capital expenditures to around $2 billion and decrease annual SG&A expenses by around $300 million.  If successful, these reductions will improve free cash flow and profitability.

 

Conclusion:

We’re giving new management time to execute on its turnaround plans; especially considering the company is already worth significantly more than its current stock price suggests (we value MCD at $122.69 per share based on discounted cash flows); and because we are comfortable taking the contrarian stance on a stock that we believe has been overly beat up by public perception.  We own shares of MCD, and we rate the stock a “Buy.”

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