Company description
Mc Donald’s is an international restaurant operator from the United States. It provides fast food and with approximately 38.000 stores it is the largest restaurant supplier in the world. Most of its restaurants are franchised. Meaning that a franchisee is operating the business and hire employees. McDonald’s as a franchisor provides the products, the menu, marketing and the real estate object. In return, McDonald’s receives rent income (ca. 10% of revenue) and a franchise fine (4% of revenue) for the brand’s rights from the franchisees.
Porter Five-Forces Analysis
To properly assess the attractiveness of an industry, it is useful to look at the Five Forces model of Porter. This is consists of the rivalry among competing sellers, the buyer bargaining power, the supplier bargaining power, the threat of substitution and potential new entrants.
The rivalry among competing sellers is very high in the fast-food business due to a very high number of competitors. Since there exists a wide variety of different restaurant types, the market has many potential entrants. Furthermore, market entry barriers are very low. Low buyer’s switching cost but high firm’s fix costs, makes the competition a really strong force.
As the rivalry among competitors, the buyer bargaining power is also very strong. Due to the huge availability of substitutions and transparent information about price and quality, buyers are in a strong position to make their own decision about their purchase. The low switching cost and the popularity of other competitors (such as Burger King, Starbucks, etc.) makes it not a big deal to visit another restaurant.
However, supplier bargaining power is a weak force. A large number of suppliers put Mc Donald’s in a position where they do not rely on just one big supplier. Furthermore, Mc Donald’s own logistic network weakens the bargaining power of its supplier.
The threat of substitutions also remains pretty high for McDonald’s. Not only the heavy competition within the fast-food industry but also the competitors of other industries, makes it hard for McDonald’s to escape the strong competitive forces. Not only other fast food companies compete with McDonald’s but also normal restaurants, delivery services and supermarkets to a certain extent.
The threat of new entrants can be considered as moderate. Although entry barriers are very low, Mc Donald’s strong brand and reputation is a very valuable immaterial asset which takes decades to build. Its brand is worldwide known and people associate positive emotions with it. Therefore, its brand is a moat which makes it harder for other companies to compete with McDonald’s.
Macroeconomic analysis
To assess the macroeconomic environment it is crucial to look at the current macroeconomic trends. Normally, the trends related to the fast food industry are negative. Rising awareness of a healthy diet, more concerns about greenhouse gases and stricter governmental interference on workers’ rights and food regulation led to a decline of fast-food restaurants.
However, the current Covid 19 situation can be seen as a huge advantage for the industry in the long term. What may sound contracting in the first place, is indeed absolutely logical. Due to the lockdown, many restaurants have gone into bankruptcy. Especially in the US, where governmental aid is smaller than in Europe, thousands of restaurants have already closed. According to a recent study from Aaron Allen & Associates, two-thirds of publicly-traded companies are facing serious bankruptcy risks if the situation does not change rapidly. Due to the size of McDonald’s, it is more resistant towards bad macroeconomic conditions and it can just lend more money to get through this crisis. Therefore, consolidation in the restaurant industry can see as an opportunity for McDonald’s to expand its market share.
Overall, it is essential to know that McDonald’s and its industry is in a decline. However, due to the bankruptcy of many competitors, the decline in this industry will occur much slower since their market share increase. Though, it would be wrong to assume that the trend will reverse. It just shifts the curve higher which is illustrated here.
Risks
Losing market share: If the company loses market share, it will weaken its competitiveness and difficulties to sustain a high profit margin may occur. Causes for the decline in market share could be if the company fails to reinvest into restaurants, it fails to anticipate consumer preferences or if it damages their brand image in any way. Due to a highly competitive environment, competitors would take over McDonald’s market share rapidly.
Debt problems: McDonald’s huge amount of debt is a threat to the business. If net income drops for a longer period of time, credit agencies could downgrade the company’s rating, which would make the debt for McDonald’s far more expensive.
Political impact: Political actions could harm McDonald’s in multiple ways. First, increased social standards like the minimum wage are raising costs and make its business model less profitable. Furthermore, geopolitical tensions that could trigger restrictions on McDonald’s can be seen as the most dangerous political risk. McDonald’s is a global diversified company that would suffer tremendously from tariffs or from even whole bans in one country.
Profitability
In order to indicate the company’s profitability, we will take a closer look at its fundamentals. With the help of the DuPont ratios, we will assess McDonald’s profitability.
Profit Margin
By looking at the net profit margin, you see that this ratio has increased by around 60% in the last four years. This seems incredible, especially giving the fact that McDonald’s is more on the end of its product cycle and revenue is falling. The reason for this big increase lies in the re-franchising process. In 2014, around 80% of restaurants were run by franchisees. Now this rate is at 93%. So, McDonald’s avoid costs by delegate these to its franchisees which makes the business more profitable.
Furthermore, the tax cut also minimized their cost. It is essential to know, that these factors are temporary because they cannot repeat a second time. This will be important for the future prediction of its business later.
Asset Turnover
The asset turnover is 0,525. With every dollar worth of assets, the company is able to generate around 50 cents of income. Around 10% are not assets directly related to the operating business, like Intangibles or Receivables. Therefore, its effectiveness in generating cash with assets is actually higher. However, there is a steady decline of this ratio in the last years. This is predominantly caused by an increase in other assets.
These assets include more intangible assets, like Goodwill. By looking at assets directly related to the operating business of McDonald’s, you see that the asset turnover ratio is remained quite stable.
The graphic puts emphasis on the management’s strategy to offer differentiated products in a competitive environment with normally low profit margins, especially in the conventional restaurant business. The extraordinary profit margin of McDonald’s is an indicator that McDonald’s has competitive advantages or a so called “moat”. This is caused by its brands and its economies of scale.
Together with the total leverage we are able to derive some more measures of productivity, namely the Return on Equity (ROE) and the Return on Assets (ROA).
Total leverage
A negative total leverage means that the company has negative equity. Therefore, its percentage of debt is over 100%.
Return on Equity and Return on Assets
Its Return on Assets has remained relatively constant over the last year and quite high relative to the industry:
Negative Equity: Negative Equity was caused by McDonald’s share buybacks. When a company buys back its own share when the share price is about the book value per share, the company has to keep the repurchased shares in the balance sheet and cannot just eliminate those. The difference between the book value per share and the market price needs to be subtracted from the equity. Due to McDonald’s massive repurchases, the negative equity grew a lot over the last years. However, it is worth mentioning, that McDonald’s is a real estate company that has a lot of assets (highly valuable real estate objects) that are listed by its purchase price not its market price in the balance sheet.
Therefore, McDonald’s is not facing any bankruptcy risks or something like that due to its negative equity.
You can find more information on McDonald’s risks liked to its negative equity here.
Graham Criteria
To assess the quality of the company and its fair price, we are using the Graham cheapness and quality.
Measure of Cheapness
Besides the high dividend yield, McDonald’s fails to comply the cheapness criteria which may be an indicator of an overvaluation and that McDonald’s will underperform the market in the next years.
Measure of Quality
As you can see in the first row, it says that -6 > 1. Mathematically this is a wrong equation. However, McDonald’s has negative equity. Therefore, its debt ratio is about 100% and its book value is infinite which makes the quality criteria fail the requirement of a ratio below 1.
That McDonald’s failed at every single quality criteria shows that it lacks financial strength and is financed quite risky. Moreover, their cash flow stream is not as constant as we saw in the last criteria. This makes its finance structure even more dangerous and prone to disruptions and unpredictable risks.
Adjustment
Due to negative equity and a historical low bond yield, we must make some adjustments to the valuation. To take the high debt into account we have to use a measuring method that does this like the Enterprise Value. This figure is calculated by the market capitalization plus debt minus liquidity. Therefore, EV/EBIT shows how many years it would take to pay the entire price of the company just by using its EBIT.
This measuring method confirms the results of the “Graham analysis”. Even when we adjust a valuation method that fits best to McDonald’s unique finance structure, etc. we can see that the company is valued very high historically and within its peer group. In conclusion, the stock is not cheap, and underperformance is likely to happen. More about this, in the Forecasting &Valuation chapter.
Forecast & Valuation
Sales
First, I need to make an adjustment for the expected sales in 2020 due to the Covid-19 crisis. I expect a revenue decline of 13,75%. This estimation is based on quarterly earnings. In the Q2 earnings, McDonald’s reported a drop in revenue by 30 %. However, many restaurants were totally closed through the lockdown in many countries in the second quarter. A complete lockdown is, nowadays, quite rarely. Therefore, I expect only a drop in revenue of 10 % in the other quarters. This will lead to a decline in annual revenue of 13,75%.
Although I believe that McDonald’s revenue will decline in the U.S. and in Europe due to changing customer preferences and more competitive advantage, emerging markets will compensate this effect to a certain extent. A rising middle class in Asia will demand more fast food. Overall, I think that will set the long-term growth rate of McDonald’s to 2%. This number is lower than long term growth of the US economy of 3%. The 3% of the US economy already implies a stronger middle class in Asia that would buy more products as well as an increase in productivity that also would be beneficial to McDonald’s. Due to lower demand in the most important markets for McDonald’s, however, I need to subtract 1% from the long-term growth rate of the US.
Discounted Cash-Flow
For the Discounted Cash Flow Analysis, I assumed equity costs of 10%. Due to the volatility and the risks of the stock market, I always take a minimum of 8% of equity cost for all stocks. In the case of McDonald’s, I add 2% more because of its poor financial statement.
This lead to a fair value of 90,89$ per share, while the stock market is trading it at 226,11$. This means that the stock has a potential downside risk to its fair value of -59,8%.
Consensus of Analysts
Most analysts come to a more optimistic forecast of future earnings than me. There are two main reasons for this discrepancy: Sales growth and expenses. As I mentioned earlier, I don’t believe that the industry will grow as fast as the overall economy. Regarding expenses, most analysts think that McDonald’s can take advantage of the digitalization. As many of them claim, the number of employees can be reduced by using digital terminals and automatization processes. A German analyst team published this graphic in order to put emphasis on this effect.
This graphic shows the growth in revenue per area or m^2. This suggests that McDonald’s can use its resources more efficient.
This graphic is flawed and points out the mistakes made by analysts perfectly. McDonald’s started closing many restaurants in 2014.
This means that McDonald’s has less area available. So, of course, the revenue per area grows. However, this is not an indicator of digitalization but of a declining industry. Furthermore, McDonald’s started in the year 2014 with its digitalization strategy. Obviously, it had not changed anything dramatically. So, there is no way to assume that this will change somehow in the future. McDonald’s has, indeed, already fully digitalised most of its restaurant. So future technological improvements will very likely turn out like the previous ones: very little impact on the overall expenses.
Final recommendation
I am convinced that McDonald’s has established a very smart business model in a competitive industry that allows McDonald’s to earn extraordinarily high profit margin due to its moats, namely its brand. Furthermore, the business model seems to be antifragile in the current Covid 19 crisis because it increases McDonald’s market share. On the one hand, many small competitors in the restaurant industry face bankruptcy threats and on the other hand, McDonald’s drive-thru and delivery service are a beacon of stability in a time of social distancing and local lockdowns.
Although its business strategy is profitable, the number of visitors is constantly declining and there is little to no chance that this trend will reverse in future because McDonald’s has already reached its product life cycle pike.
The increases in earnings in the past years are only an illusion and give investors a false sense of security. In reality, earnings from the operating business are declining. Only in the balance sheets, they are rising through special effects, like the re-franchising process or the U.S. tax reform. Since these effects will not occur in the future a second time, investors need to be aware that rising earnings (after inflation) are unlikely.
I consider the management as not capable to create long term value for the shareholders. The management bought back its own shares when the share price were above its fair value, which destroyed shareholder value. Furthermore, they took on debt to do this progress and messed up their balance sheet. The high amount of debt and the lack of equity make the company prone to a recession or other risks. Although they own valuable real assets objects, these objects are illiquid and cannot be sold fast to follow their short term liabilities.
I am sure that the changes in the industry will occur, for example more digitalization or ore delivery
services. However, I doubt that McDonald’s will maintain their Number One status in this industry because entry barriers are low for disruptors (for example Starbucks) and McDonald’s financial situation does not allow to heavily investing in future technology.
A poor financial situation, bad management, high risks of new entrants and declining customers’ popularity make McDonald’s a risky investment.
However, the current stock price does not reflect these risks in any way and is significantly overvalued. Therefore, my recommendation is: Never buy it and never sell a short!