McDonald’s (MCD) is the world’s largest Quick-Service Restaurant (QSR) as measured by system-wide sales (i.e., sales directly to end consumer). MCD has twice the sales of Yum! Brands (e.g., KFC, Taco Bell, Pizza Hut), the next closest competitor, while having roughly 5,000 fewer units worldwide. MCD operates throughout the world but is mainly established in developed countries while Yum! Brands competes more aggressive in developing countries, especially China. MCD reprioritized via a new strategy developed in 2003 that still drives their decisions today and has led to significant growth in profits and customers per store. They have touted the return of at least $5B to shareholders over each of the past 3 years via stock buybacks and dividends at a yield of ~6.7%, but this is not sustainable in my opinion for reasons explained below. Their overall strategy focused on “better, not just bigger” and their individual strategies in their 3 reportable segments appear to be well developed and should allow them to continue to maintain their sustainable competitive advantage worldwide. However, the market has already priced in the past and expected future success of those strategies, and, as a result, the stock is currently overvalued.
Dividends and Stock Buybacks
MCD returned on average over $5B per year to shareholders 2007-2009, which does not net any exercise of stock options. However, they only generated cash from both operating and investing activities of ~$4B each of those years. They had to make up the difference by borrowing money.
So, in effect, the company is simply returning to shareholders every dollar earned from operating and investing activities and then shifting financial structure between equity and debt. Given current debt levels, current cash balance, and available credit, this trend is not sustainable. I expect the annual return of cash to shareholders to decline materially within the next few years. Dividends should not be affected as they have increased dividends over each of the past 34 years, so share repurchases should decrease instead.
James Skinner, who has been with the company 38 years, took over as Vice Chairman of the Board in January 2003 and then as CEO in November 2004. At that time, the company developed their “Plan to Win” strategy with the objective of increasing sales and profitability at existing locations. The strategy focuses on the following areas:
- Increase menu variety
- Increase beverage choices
- Improve restaurant operations
- Added convenience and extended hours
- Maintain everyday affordability
- Continued restaurant reinvestment
In short, it worked. FCF, same-store sales, and guest count increased dramatically since then. Of particular interest, customers served per day increased from 46 million in 2002 to 60 million in 2009 while maintaining $2.2M sales per unit, which is more than double the industry average of $1M and well above Yum! Brands’ less than $1M per unit. The latest annual report still talks about that strategy being their driving force.
The following, taken from the 2010 Q1 10-Q, sums up their strategy and results pretty well:
“McDonald’s customer-focused Plan to Win – which is centered around being better, not just bigger – provides a common framework for our global business yet allows for local adaptation. Through the execution of multiple initiatives surrounding the five key drivers of exceptional customer experiences – People, Products, Place, Price and Promotion – we have enhanced the restaurant experience for customers worldwide and grown sales and customer visits in each of the last six years. This Plan, coupled with financial discipline, has delivered strong results for shareholders.
The Company is pursuing initiatives in three key areas: service enhancement, restaurant reimaging and menu innovation. These initiatives include leveraging technology to make it easier for restaurant staff to quickly and accurately serve customers, accelerating our interior and exterior reimaging efforts and innovating at every tier of our menu to deliver great taste and value to customers. These efforts successfully resonated with consumers driving increases in sales and customer visits in many countries despite challenging global economies and a contracting informal eating-out market. As a result, every area of the world contributed to first quarter 2010 comparable sales and guest counts increasing 4.2% and 3.3%, respectively.”
In addition, as part of MCD’s refocusing, they sold their interest in anything that was not McDonald’s. They owned a minority interest in Boston Market, Chipotle, Pret A Manger (UK company), and Redbox. That last one is no typo. They owned a big chunk of Redbox, which is not publicly traded. They sold each of those positions over the past 5 years for over $100M each, realizing significant gains on each one. My guess is that they had some immaterial investments that they disposed of also, but they explicitly stated they got rid of all things not McDonald’s so that their efforts and attention would be 100% focused on their core brand.
To understand MCD’s valuation, it is important to first understand the difference between company-owned and franchised stores, their short-term strategy, and their long-term strategy. That sounds obvious, I know, but allow me to explain. The company franchises about 81% of their stores and owns the rest. They are also constantly adding stores, but the key is the existing locations and MCD’s plan for them.
With franchised-owned stores, the franchisee pays an initial fee, then MCD either buys the land and building or secures a lease for the land and/or building. MCD then charges the franchisee a minimum fixed rent amount plus rent equal to a percentage of total sales plus royalties as a percentage of total sales. Franchise agreements are typically for 20 years. In other words, MCD gets the franchisee to give them the money to buy the building and/or land, then buys the building and/or land in their own name, and turns around and charges the franchisee a significant amount of rent. Rent revenue was actually more than double royalty fees for MCD last year. The franchisee is responsible for all decor, equipment, signs, and seating. This is a standard franchise. For about 20% of the franchises, the franchisee buys the land and building themselves and MCD just receives royalty payments. Because of this arrangement, MCD owns 45% of all land their locations are on and 70% of all buildings. They also realize an operating margin of about 82% on franchised-stores versus about 18% for company-owned stores. As a result, even though revenue from company-owned stores was twice that of franchised, the franchised stores contributed more to net income.
MCD has started a concerted effort to increase the percentage of stores that are franchised versus company-owned, a process dubbed “re-franchising.” They are primarily accomplishing this task by actually selling some of their company-owned stores to franchisees. The result is a large cash infusion at the beginning and then, of course, the rent and royalty fees at the much higher operating margin.
MCD plans to keep company-owned stores, however, because they use it in different parts of the world to help them figure out best practices as well as try out new products, especially products that require some capital expenditures (such as the coffee which required new coffee machines).
The Company has also undertaken efforts to control costs and boost margin that has seen their operating margin overall go from 24% in 2007 to 27% in 2008 to 30% in 2009, which is an incredible three year change for a company this large. I think there is room for those efforts to continue, particularly with the “refranchising” efforts. They have also undertaken a complete “re-imaging” of every location in Europe which they have since expanded to U.S. and other parts of the world because it was very successful in Europe. Re-imaging is basically just renovating the interior and exterior decor to modernize it and make it more appealing.
The company is also trying out new initiatives, each in different parts of the world, that should improve margins, such as the installation of self-order kiosks in Europe. Finally, they have rolled out and are continuing to roll out higher margin products that their competition hasn’t offered yet, such as coffee and smoothies.
The company has begun focusing more on emerging markets, such as China. In fact, roughly half of their 1,000 planned store openings this year are in East Asia, Africa, and the Middle East. These efforts are part of MCD’s overall goal of growing system-wide sales 3% to 5% annually. While most people salivate at the thought of the potential in China and other emerging markets, the fact is that MCD already has an extremely large revenue base. As a result, new stores and focused efforts on improving sales at existing stores in emerging markets will be somewhere between a drop in the bucket and a material but still small incremental addition, especially in the beginning.
It is important to remember that MCD does not operate in a vacuum in these emerging markets. It is not like the idea of fast-food restaurants is new to these consumers. Yum! Brands is a substantial force in these markets. Which brings me to my next topic.
Yum! Brands (YUM), formerly part of PepsiCo, Inc., has 3 international brands (KFC, Pizza Hut, and Taco Bell), 2 brands found mainly in the U.S. (Long John Silvers, A&W), and 1 minority-owned brand in China (East Dawning). Long John Silvers and A&W are both stagnant and not at all a focus of the company. In fact, with a recent decision to reduce the emphasis on “multibranding” (combining two brands into one building) in the U.S., Long John Silvers and A&W were written down by 26%. East Dawning is a minority interest ownership in a small but rapidly growing “Hot Pot” concept restaurant in China with some locations abroad. The focus, however, is clearly on KFC, Pizza Hut, and Taco Bell.
While not explicitly stated, this is my sense of YUM’s thought process: “There is no way we can beat McDonald’s in the U.S. and Developed countries where they already have a strong presence, so we’re not going to try. Instead, we will try to become the McDonald’s of emerging markets.” And YUM has done their best to do so. They have built up a substantial presence in China and other emerging markets and place significant emphasis on China, India, and Russia. The KFC and Pizza Hut we know here in the U.S. is not the KFC and Pizza Hut the rest of the world knows. It has a much better reputation abroad. In fact, 85% of YUM’s operating profits come from KFC, Pizza Hut, and Taco Bell outside of the U.S. YUM has approximately 40% of their units in developing countries versus only approximately 21% for McDonald’s (a percentage that is admittedly growing for MCD).
So MCD has to compete with the reputation, customer base, familiarity with the local government, and supplier relationships already established by YUM in these markets. However, MCD does have a few things going in its favor. First MCD has a larger advertising budget at over $600M versus between $500M and $600M for YUM. And MCD only has to advertise for one brand. Even ignoring the 2 smaller brands that YUM should probably dispose of for being a distraction as well as the Chinese restaurant chain they have only a minority interest in, YUM has 3 very different brands to split those advertising dollars between.
Furthermore, MCD has substantially more credit capacity than YUM for any new store openings, renovations, or essentially any opportunity that arises. A major reason for this excess credit capacity relative to YUM is due to the divergent strategies showcased by the two companies in recent years. Since 2003, MCD has focused on improving profitability at existing stores instead of simply expanding the number of stores in operation. While YUM is also focused on profitability, they appear to have placed a higher premium on growing for growth’s sake in their bid to establish a very strong base and infrastructure in emerging markets before MCD.
Of course, competition in emerging markets will not be a zero-sum game. The middle class, particularly in places like China and India, are growing, per capita income is increasing, and they are becoming more and more comfortable with “Western” companies. So all participants should benefit to some degree as the rising tide lifts all boats. The question is whether or not MCD can steal significant market share as, for example, YUM currently has 40% market share in China compared to MCD’s 16%. Given MCD’s advertising and financial advantages, it is highly likely that they will chip away at this market share over time. But it is unreasonable, in my opinion, to assume they will make significant headway in the immediate future given YUM’s already established base and reputation.
Is now a good time to buy?
The company is growing system-wide sales even higher than projected so far in 2010 and revenue growth at the high-end of their long-term range of 3% to 5% annually for at least the next couple of years appear reasonable. More importantly, margins are improving as result of the efforts described above. However, using a free cash flow model, the company’s strong management, strategy, and future prospects appear to be fully priced in. I value the company, somewhat conservatively, at $64.31/share, which is ~$13 less than the current stock price of $77.01. MCD has such a strong premium for a reason. It is a wonderful company, is in no way flying under the radar (who hasn’t heard of McDonald’s?), and has no pending potential negative catalyst that would depress current prices (e.g. the Mad Cow Disease scare in the early part of this decade).
I require a substantial margin-of-safety to buy into a company, and this stock is currently at a premium. I will certainly keep it on my radar and be ready to pounce should the stock price drop or my valuation increase.
Jonathan Booth, CEO