- Investors need stocks in their portfolios that perform well in any phase of an economic cycle.
- Few companies provide as reliable an earnings stream and cash flow as McDonald’s.
- While the U.S. market is saturated and we are talking about a giant, there are sufficient avenues for growth for the years ahead.
In investing there are no certainties. However, in the case of McDonald’s (MCD), we are talking about one of the most reliable investments out there. Just think about it – how often have you seen an empty McDonald’s or one without a line of cars in the drive through. This company has been reporting positive net income for over three decades. The free cash flow numbers are equally impressive with positive free cash flow reported every year since 1991. With this kind of consistency and the comfortable payout ratio of 60%, there is little risk that the dividend will be cut. More likely the dividend will continue to increase over time from its current yield of 2.44%. Management has shown confidence in its long term strategies by setting a $22 to $24 billion cash return target for the three year period ending in 2019.
Of course, just because we believe the dividend is safe does not mean that everything is perfect. Revenue and income growth have stalled in recent years. The annual revenue and income numbers for 2016 were both lower than they were in 2011. There has not been a collapse in sales by any means but the years of impressive growth are well in the past. There are a few reasons for this including market saturation, fierce competition, and a trend toward healthier eating.
Despite these challenges, McDonald’s still makes sense in a diversified portfolio. This cash cow has the financial means and the demonstrated capacity to adapt and remain relevant in the years ahead. The company is not going to give up on its hamburgers and French fries but will continue to enhance the menu. With the success of McCafé coffee and other snack offerings, the menu is expanding to reach a wider audience while still retaining existing customers.
Opportunities in Delivery & International Expansion
One reason for the halt in growth mentioned earlier, market saturation, actually may lead to a new growth avenue. Because of McDonald’s footprint there is an opportunity to become the leader in food delivery which has recently become a hot area with dramatic growth in third-party delivery companies like Grubhub (GRUB). In McDonald’s Global Growth Plan, the company mentions this opportunity stating that in its top five markets (U.S., France, the U.K., Germany, and Canada) nearly 75% of the population lives within three miles of a McDonald’s. No other food company has this kind of reach. The company already delivers food in China, South Korea, and Singapore with annual system-wide delivery sales of $1 billion.
There is also still room for international expansion despite the fact that McDonald’s already operates in over 100 countries. In its most recent annual report, the company identified China, Italy, Korea, the Netherlands, Poland, Russia, Spain, and Switzerland as markets that it believes have relatively higher expansion and franchising potential. For fiscal 2016, international markets accounted for 34% of revenues. Overall, the company is targeting sales growth of 3 to 5% with an operating margin in the mid-40% range. The company is targeting EPS growth in the high single digits. While these targets are achievable they are far from certain. Earnings grew by a more modest 3.5% on average for the trailing 5 year time period.
High Marks for Consistency
It is doubtful that investors can find many companies as reliable as McDonald’s with its impressive cash flow and manageable debt levels. The profit margin for the trailing twelve months was 22.75% while return on invested capital came in at a solid 20.42%. Further evidence of McDonald’s consistency is found by looking at the financial performance metrics with five year averages for return on assets, return on equity, and return on invested capital coming in at 14.6%, 77.6%, and 19.52%, respectively. The reason for the inflated return on equity numbers has to do with the considerable long term debt compared to equity.
McDonald’s had $25.9 million of long term debt as of December 31, 2016. Of course, given its track record and associated low interest requirements by its bondholders, this is a relatively cheap way for the company to finance its operations. The graph showing the change in debt to assets provided below shows that the level of debt actually increased substantially in recent years starting in 2015.
This sudden increase in the debt level was a result of what the company calls optimization of the capital structure. The idea of this restructuring was to leverage the access and favorable terms available for credit. The strength and reliability in free cash flow as well as this availability of credit is what allowed McDonald’s to increase its dividend and return $30 billion in cash to shareholders in the three years ending in 2016. While these debt levels undoubtedly increase risk, we feel that McDonald’s made a savvy decision to take advantage of the low interest rate environment to the benefit of shareholders.
Despite this Mc Donald’s has slightly under-performed the S&P 500 over the last 5 years, returning 69.5% compared to 72.57% for the S&P 500. However, to see the true benefits of consistent operating results and owning McDonald’s we need to look at a time period that includes the contraction phase of an economic cycle or a recession. Looking at the most recent 10 year time period, which includes the 2008 financial crisis, we see real out-performance by McDonald’s. McDonald’s returned 189% over this time period compared to 96.77% for the S&P 500. The impact of the financial crisis on the stock was negligible in comparison.
Discounted Cash Flow Analysis
With the recent decline in the overheated markets, McDonald’s has dropped back to a slightly undervalued level. Of course, the valuation depends on what growth estimate you use. Our first model considers the following inputs:
- Quote: $160.80
- Discount rate: 10% (desired annual return)
- Dividend: $4.04 (2.51%)
- EPS: $6.36 (trailing twelve months)
- EPS average annual growth rate for the next five years: 8.3% (Average analyst estimate from Reuters)
- PE ratio in year 5: 25 (this is about equal to the current PE of 25.28)
Using these inputs shows that McDonald’s is currently trading at 96% of fair value. Clearly, this is not much of a margin of safety. However, we should keep in mind that we used a 10% discount rate and that we are talking about one of the most consistent companies out there. On the other side of this argument let’s consider a change to one number in the model. We could have used the meager average annual EPS growth rate over the last five years, 3.52%, in place of the analyst estimate. In this case the model shows us that McDonald’s is actually trading at 118% of fair value. Overall, we think that the average analyst growth estimate of 8.3% may be too optimistic, while the historical growth rate of 3.52% is actually reasonable. Reuters only provides three analysts estimates. The lowest of these three was 8%, so not much lower than the average.
The table below considers some other metrics to provide another view of the current market valuation of McDonald’s relative to the industry.
From the table we see that McDonald’s Beta, a measure of volatility, is quite low. This is also true for the industry in general. This has to do with the earnings reliability discussed throughout the article. Since we discussed the ballooning debt level we included the interest coverage. Here we see that this level of debt is actually quite comfortable for a company like McDonald’s. This number tells us that the company could pay its annual interest expenses about nine times with its earnings in a given year. This gives us further confidence that McDonald’s has not increased its leverage to a level we would consider to be overly risky. Overall, the table seems to indicate that McDonald’s is trading at a reasonable level relative to peers given that it is arguably the most reliable and well known name in the space.
Options are available for McDonald’s. However, the current price per share is $160.80 and since selling covered calls requires 100 shares; this is likely only something an investor with a substantial portfolio balance would consider. We will discuss how using a buy-write strategy with McDonald’s could provide a yield boost. An investor that buys 100 shares can sell a covered call to provide some extra income. One call of interest is the one expiring on June 15th with a strike price of $175. This option would provide a premium of $2.88 per share or $288 per contract. In this case the seller of this contract would only need to sell his or her shares if the price increased by almost 9% over the next 4 months. If the call is exercised the investor would make about 10.5%. If on the other hand, the stock does not go up by 8.83% over this time frame the investor will keep his or her shares. The $288 premium would equate to an annualized yield of 5.17% after considering fees of $14 which may vary slightly based on your brokerage. We think selling this option would be a reasonable thing for an investor with 100 shares to do since McDonald’s could be considered slightly overvalued at that point and the annualized return from the premium is attractive.
When the market is overvalued and volatility is finally finding its way back into the market, it’s nice to have a stock that performs well in every phase of the economic cycle. Stable cash cows like McDonald’s are almost never trading at a large discount to fair value. Why would they? However, while McDonald’s is not necessarily cheap at its current level, we think the recent decline has made it a suitable opportunity for investors to initiate a position. In the next five years, we think that McDonald’s can at least achieve its historical average annual EPS growth rate for the last five years of about 3.52%. Anything above this would be a bonus. Even if McDonald’s just maintains this growth rate, we think investors will receive satisfactory results by holding this stock which is fit to handle any type of market. Therefore, investors may want to consider giving the burger giant a spot in their portfolios.