McDonald’s: Headwinds Slow Return Opportunities

Introduction

McDonald’s stock (MCD) has performed significantly better than the underlying company’s fundamentals over the past 6 years. The reason is no secret. Management proactively engaged in a levered recapitalization of the firm’s balance sheet that has returned significant capital to remaining equity shareholders. 24% of McDonald’s shares have been retired since 2015.

Management has $9.5 billion left in its current buyback authorization and will likely continue to repurchase shares using free cash flow as well as from cash raised from issuing additional debt when economic conditions improve. Additional debt would be based on maintaining a targeted debt-to-capital ratio, which we estimate at 20%.

Given the wind down of share repurchases, a lack of fundamental momentum in the business, as well as the impact of covid-19, it is no surprise that equity price gains have been flat since the third quarter of 2019.

Using an inductive valuation process that is designed to estimate current market expectations to assess opportunities and reduce the risk of anchoring, I am estimating that the market is expecting an approximate 4.5% compounded return over the next decade (plus or minus a year).

Assumptions required to accommodate the existing premium are somewhat optimistic and I think there is a greater risk of missing expectations than exceeding them. Offsetting this is the potential upside based on management’s ability to return capital via share repurchases over the next several years.

Business Description

McDonald’s currently operates or franchises 39,198 McDonald’s restaurants, 93% of which are franchised. Revenue is generated from owned operations and from fees generated from franchised restaurants. Fees are based on the franchise agreement. McDonald’s was founded in California in 1955.

Given McDonald’s global presence, it competes against other national chains as well as regional and local restaurants.

McDonald’s reported $19.2 billion in revenue for 2020 and employed roughly 200,000 people at the end of 2020.

Credit: Cogart Strangehill

Leverage Recapitalization Discussion

In May of 2014, McDonald’s initiated a 3-year plan to return $18 to $20 billion in cash to shareholders. That plan was extended to return between $22 to $24 billion in cash through 2019. Indeed, a total of $48 billion was distributed to shareholders as a combination of dividends and share repurchases.

The result was a significant swap of equity for debt. The yield based on both return on capital and return of capital was up to 14% in 2016, using a $120 average price. In 2017, 2018, and 2019 the yield average was closer to 6%.

The challenge for management is to determine an appropriate ratio based on the credit rating of the firm’s debt. 2015, S&P downgraded McDonald’s debt to BBB+ from A-, which is where it has remained since and is still considered investment grade. It seems McDonald’s has settled in at a 20% debt-to-capital ratio.

Over this period (end of 2014 through end of Q1 2020), McDonald’s reduced shares from 986 million down to 751 million, or a 24% reduction. Debt over this period increased by $23 billion while McDonald’s market capitalization increased $51 billion.

Lastly while there are no hard and fast rules on when to do a levered recapitalization, there is the argument that the additional debt focuses management and signals to investors management’s confidence in the business. The outsized gains in McDonald’s equity relative to debt seems to support this wisdom.

Current Plans

McDonald’s has a $15 billion buyback plan in place of which there is $9.5 billion remaining. The program was suspended in March 2020 due to the economic slowdown given the impact of covid-19. While I haven’t seen a targeted capital structure, it’s clear that McDonald’s is targeting a specific investment rating on its debt given that it has remained stable for the past 5 years. If the company continues to pursue a 20% debt-to-capital strategy, then there should be periodic increases in debt.

This excess cash would then be used for incremental share repurchases. Regardless, investors should not expect future share repurchases to be nearly as significant as during the 2015-2020 period.

Lack of Fundamental Momentum

The equity gains from the recapitalization are even more impressive given the business fundamentals over that period. McDonald’s revenues have been in decline after hitting a high water mark at $28.3 billion trailing twelve months ending June 2014 to $20.8 billion for the twelve months ending March 2020.

However, the shift from company owned restaurants to franchised restaurants brought operating margins up significantly. Therefore, over the same period that reported revenue declined, trailing twelve-month operating income remained essentially flat from $8.7 billion ending June 2014 to $8.6 billion ending March 2020.

In my opinion that makes the gains in market capitalization from $100.3 billion (Q2 2014) to $146.3 billion (Q1 2020) that much more impressive. This is also why I argue there is a premium headwind given the outperformance was driven by the return of capital versus the return on capital.

Introducing Price Implied Expectations (PIE)

The best way in my opinion to approach valuations is using a discounted cash flow (DCF) model. While multiples are more expedient, they don’t do as well capturing a longer view. However even with cash flow models, I believe there is real risk investors (including myself) can make in anchoring on a single estimated value. Rather I believe it is beneficial to frame the valuation process in terms of what expectations exist today and then assess attractiveness from that vantage point.

Furthermore, once a consensus view and any non-consensus personal beliefs are established, one can project an estimated internal rate of return (IRR) and use that as a benchmark for what to expect and as well as to compare with other investment opportunities.

To do this, a simple 2 stage DCF model is used that is based on free cash flow to the firm. The equity value is determined after debt has been paid off.

Price Implied Expectations Discussion

I am using the market price for McDonald’s at the time of writing which has hovered around $210 over the past couple of months.

I’ve settled on the following for a consensus view:

Source: Author

I’ve normalized 2020 revenue to $21 billion in order to smooth the growth estimates versus the reported $19.2 billion.

The cost of capital is based on the restaurant industry of 6% (sourced from Aswath Damodaran). I’ve also included a 1% inflation rate in the terminal value.

Looking forward and assuming all free cash flow is returned to shareholders in the future, the implicit share price is $260 in 2025 for a 4.3% IRR return.

Using a bearish scenario of 3.0% sales growth and a 42% operating margin, the value drops to $160.50. A bullish scenario of 8.0% sales growth and 44% operating margin, the value increases to $270. If we use a simplistic range of outcomes of 25% bearish, 50% consensus, and 25% bullish, the weighted average of $212.60.

In order to find current shares more attractive we would need to take non-consensus bullish view. Even if we shifted to 15% bearish, 25% consensus, and 60% bullish, the weighted average moves up to $238.50. This would provide some upside but I don’t have the conviction to take that view.

Therefore, for enterprising investors looking for mispriced equities, I do not see McDonald’s at the current share price as attractive. The estimated 4.5% annualized return clearly beats the yield on a 10-Year U.S. Treasury note of 1.3%, but is below its own 6% cost of capital. There are likely better opportunities for motivated investors.

Conclusion

McDonald’s has had a tremendous stock appreciation run since 2015 when management proactively engaged in a leveraged recapitalization of the firm’s balance sheet. However, shares have stalled since the winding down of share repurchases given several headwinds including past premium due to the 24% reduction in share count over the past 6 years, the lack of current share repurchase activity, and the lack of fundamental momentum.

Expectations required to meet McDonald’s current share price are not outlandish but not very conservative either. Therefore, I do not believe there is a meaningful margin of safety for opportunistic investors.