The objective of this exercise is to research a company to a reasonable depth using a reasonable amount of time, with the belief that a) whatever level of research conducted, there will still remain an area of unknown b) the most efficient way to get better at analyzing is with a manageable single cycle, that gets iteratively better c) getting my hands dirty by covering a breadth of companies will yield a new sense of understanding or at least provide the subsequent sense of direction.
1. How the Business Makes Money
Product
McDonald’s makes money by selling uniform fast food all over the world through their 42k stores. Menu includes burgers, chicken sandwiches, chicken nuggets, McFlurry ice cream, fries a.k.a “World Famous Fries”, sundaes, cookies, pies, soft drink, coffee. They offer breakfast including McMuffin, McGriddles, etc. They have LTO menus. McDonald’s mission is to make delicious feel-good moments easy for everyone. It highlights the taste factor, price factor, and the ubiquitous factor.
Sales Channel
The company franchises and operates stores in more than 100 countries. Of the 42k stores as of 2023, 95% were franchised. There are two categories for franchises. First is the “conventional franchise” where the company owns or secures a long-term lease on land and building for the restaurant location and the franchisee pays for the pre-opening interior and exterior furnishing. McDonald’s generates revenue primarily from rent and royalties based on percentage of sales. They also receive initial fees paid upon the opening of a restaurant or grant of a new franchise. The company may co-invest in reinvesting capital for improvements over time.
The second is “developmental license or affiliate“, where licensees have a bigger role. In this segment the licensee is responsible for finding restaurant locations, funding the lease of real-estate, on top of the responsibilities of franchisees, without receiving capital investment from headquarters. Licensees also have to pay royalties and opening fees. Affiliate is when the company has a stake in regional companies, some with non-controlling interest such as McDonald’s China and Japan. Of the 42k restaurants 22k was conventional franchised, developmental licensed 9k and foreign affiliated 9k. Only 2k was company-operated.
Restaurant-level profit margin
The sales from company-operated restaurants was $9.8b and reported company-operated margins were $1.5b, taking into account restaurant-level operating costs such as rent, utility, food and labor costs. The margin is 15.6%. Systemwide sales was $129.5b. Taking away revenue of $9.8 attributable to company-operated portion and $0.3b in “Other revenues segment”, leaves $120b for the franchised portion of systemwide sales. While revenue from franchised restaurants were $15.4b, taking into account the rent expense on behalf of franchised restaurants (revenue from licensed restaurants are already net of rent) which is $2.4b, gives a rough franchised margin of $13b, almost identical to the reported franchised margin figure. That gives a franchised restaurant-level margin of 10.8%. The discrepancy is about 4.8%p.
While 10-K did not give the percentage point of royalty, this CNBC article from Sep 2023 says “McDonald’s to raise royalty fees for new franchised restaurants for first time in nearly 30 years. McDonald’s franchise royalty fees for U.S. restaurants will rise from 4% to 5% for operators opening new locations.” The other 0.8%p could be from initial fees or markups in rent etc. Wingstop charges 6% as royalty and 5% for national advertising. I think Wingstop’s fees could afford to be like that since the restaurant level margins are much higher at around 26% including advertising expense. Also, it has less far less economies of scale compared to McDonald’s for operational cost.
Source: McDonald’s
2. Key Metrics
As of Oct 2024
• Market Cap: $218b (58th biggest in the world)
• PE ratio (TTM): 26.6x
• Stock price: $303
2023 Earnings
• Revenue: $25.5b
• Gross Profit: $14.5b (57%)
• Operating Profit: $11.6 (45%)
• Net Income: $8.5b (33%)
• Systemwide sales: $129.5b (10% YoY)
24Q2 Balance Sheet
• Asset/Liabilities/Equity: $53.8b/$58.6b/-$4.8b
• Debt-to-equity: -11
• Current ratio: 1.08 ( = $4.2b / $3.9b)
2023 Cash Flow
• CF from operations: $9.6b
• CF from investing activities: -$3.2b
• CF from financing activities: – $4.3b
• Capital expenditures: -$2.3b (50% to existing restaurants and 50% to new openings)
• FCF: $7.2b (+32% YoY)
• FCF margin: 28%
• FCF yield: 3.4%
KPI for the company / industry
2023
• Comp: 9% YoY globally
• Comp guest counts
• ROIC: 25% (after-tax return on invested capital from continuing operations: capital-allocation effectiveness over time)
• FCF conversion rate: 85% (FCF / net income : ability to convert net profit into cash resources after reinvesting in the core business)
• Net restaurant unit expansion: 2,000 new stores
• Systemwide sales
• SG&A % of Systemwide sales
• Effective tax rate
• Capital expenditure
• FCF
3. Key elements of recent earnings call
From 24Q2 earnings call
Overall Summary
The company was impacted by a industry-wide decline in traffic due to economic pressures on the low-income consumer. Raising menu price hurt the brand’s value offering, diminishing McDonald’s status as a value leader in the quick-service restaurant (QSR) industry. The company has introduced $5 Meal Deal in the US, which is demonstrated in their landing page. Global comp sales declined in all segments, particularly in major markets like the US, Australia, Canada and Germany. Positive comp sales in Latam and Japan were offset by geopolitical turmoil in Middle East and a less confident consumer in China. Despite the downturn, leadership is confident that McDonald’s will regain market share and deliver cost effective value meals to customers.
Growth Strategy
• Continuing to deliver good food and customer experience. e.g. Best Burger initiative.
• New menu. e.g. The Big Arch
• Growth opportunity for chicken: capturing more market share through McNuggets, McChicken, McCrispy, McSpicy. McDonald’s chicken sales are on the same level as beef sales.
• Continue expanding digital sales and loyalty program.
• Re-establishing the value leader image. e.g. McSmart program in Germany, $1-3 program in US.
Headwind
• Inflation and economic pressure curbing consumer spending
• Ongoing conflict in Middle East
• Challenges in value proposition
4. History
Source: Bigcharts
MCD stock closely follows earnings. p/e ratio is stable. Below are highlights from this year-end earnings call transcripts. I deem performance, growth strategy and headwind the three points to be on the lookout. I have several takeaways
1. Corporate strategy is critical. In 2014 McDonald’s started pushing into digital kiosks and apps. In 2015, the decision to serve all day breakfast increased traffic and becoming lean and leveraging more heavily on franchising proved to be efficient in scaling. Catching the delivery app-wind in 2017 brought in more sales. A renewed focus starting 2018 proved timely, prior to Covid. Not missing out on the chicken market share with a clear focus since 2019 was a good decision.
2. Good, new strategies don’t have to be introduced every year. For the most part, the execution of a good strategy would take 2-3 years.
3. New menu, increasing operational efficiency, improving store quality – are said every year. Therefore, it seems fine to not go crazy about these. But sometimes, these could become critical. Like when Wingstop first introducing chicken sandwich to the buffalo wing dominant menu, it brought new traffic. This may be the case for McMornings. Also, just because these are commonplace doesn’t mean they are not important. It wouldn’t be decisive in determining who’s going to win. But it could determine who would fail.
4. CEO is important. McDonald’s succeeding in a sharp turnaround after Steve Easterbrook came in. I think he hit all the right points in hindsight. Although, probably, the wind was better during his days, Yum Brands’ turnaround wasn’t as successful as McDonald’s. This CEO had to go because he had sexual relations with company members.
5. Food poisoning issue is a big risk. It must be monitored since regional sales will take hit.
6. Consumer confidence, inflation, rise in cost, labor, rent, and dollar appreciation are things to be mindful of.
7. Value proposition is critical for the brand. It’s interesting how comp suffered in 24Q2 when the low-income consumer confidence was dampened. One might think QSR brands would be celebrating in such climate.
CEO: Don Thompson
Performance
• 2012 comp +3.3%, 12Q4 comp flat, Q4 traffic falls.
Strategy
• Menu optimization
• Marketing highlighting value
• Partnership with NFL
• Expand stores
Headwind
• Rising labor and commodity costs, higher occupancy expnse
• Economic pressures around consumer uncertainty hindering eat-out sector. Economic condition in Japan, China
CEO: Don Thompson
Performance
• 2013 comp up slightly, but Q4 was flat. US -1.4% comp in Q4, guest traffic is down.
• Positive comp in UK, Russia, France offset by decline in Germany and Japan.
Strategy
• Menu optimization, enhance breakfast experience, invest in key markets such as Germany and Japan
Headwind
• Low consumer confidence in Europe and high competition in Japan
• Increasing commodity, labor, rent cost
CEO: Don Thompson
Performance
• Operating income declined 8%
• Comp fell 1%, systemwide sales grew 1%
• Supplier issue in APMEA, volatile Russia and Ukraine
Strategy
• Menu innovation
• Digital initiative such as kiosks and mobile
• Enhance value proposition
• Recover brand trust in Japan
Headwind
• Chinese supplier food safety scare, pieces of vinyl found in McNuggets in Japan, closed 150 stores in Japan and remodeling others.
• Strengthening USD
• Growing competition in US, Japan impacting guest count and sales
CEO: Steve Easterbrook
Performance
• Comp +1.5% in 2015 and +5% in Q4.
• Operating Income +16% in Q4
• Benefit from mild weather.
Strategy
• Become leaner and rely more on franchise. 80% of global restaurants are currently franchised.
• Expand kiosks
• Focus on expanding in China, despite supplier issue
• All day breakfast is working
• Value offering McPick 2 seems to be working.
Headwind
• Need to win back frequency of loyal customers even more
• Macroeconomic issues in some high growth market
• Limited pricing increase since commodity outlook is benign
CEO: Steve Easterbrook
Performance
• Strongest result since 2011. Comp +3.8%
• Operating income +11%
• Customer satisfaction score has gone up
Strategy
• Turnaround plan from 2015 is working
• Shift towards a more franchised model, powered by partnerships in China, reducing capital investments
• G&A cost reduction
• Leverage on grocery store deflation when consumers are coming back
Headwind
• Macroeconomic pressure in Russia and France
• Need to reverse guest count trend in the US even more
CEO: Steve Easterbrook
Performance
• 5.3% comp growth
• Franchise grew to 92% up from 81% of total fleet.
• Margins improvement 40bps, while US margins declined 150bps from higher labor, commodity costs
• Saved G&A costs as planned
Strategy
• Introduction of Uber Eats
• Experience of the Future (EOTF) initiative, modernizing stores and equipping kiosks
• Focus on digital ordering and mobile app
• Company and US franchisees will benefit from the tax reform. A single corporate tax rate of 21%
Headwind
• Choppy outlook for 2018
• New accounting method will change recognition of revenue for initial franchise fee and recognize over the life of the franchise term
• Food poisoning in South Korea
18Q4 earnings call
CEO: Steve Easterbrook
Performance
• 4.5% comp growth
• Consecutive year of guest count growth
• $4.2b FCF, a 14% increase
• Delivery is growing rapidly
Strategy
• 2 full years of executing Velocity Growth Plan – EOTF investment, digital and delivery expansion
• Refranchising strategy is largely complete
• Renewed focus on drive-thru operation
Headwind
• Inflation in construction industry drove up capital expenditure more than expected
• Currency pressure as dollar strengthens
• Consumer uncertainty growing in France, China, UK
CEO: Chris Kempczinski
Performance
• 5.9% comp growth
• Strong earnings
Strategy
• EOTF of 10k stores reached, expected completion 2020
• Strengthen digital and drive-thru. Acquisition of Dynamic Yield, aiding suggestive sell capability in kiosks and drive-thrus.
Acquisition of Apprente, aiding voice recognition for drive-thru
• Substantial expansion in China
• Excel in breakfast to drive up guest count
Headwind
• Sluggish industry traffic growth creating competition
• Starting to close restaurants in China from the epidemic
CEO: Chris Kempczinski
Performance
• Strong results despite Covid
• US saw 6 consecutive years of comp growth. Global comp declined 7.7%
Strategy
• Accelerating the Arches strategy
• Marketing: effective social media marketing. “Serving Here” campaign
• Commitment to the core menu: improved chicken offering, new buns and cooking procedures
• Double down on digital delivery and drive-thru
Headwind
• Covid
• High depreciation expense from extensive modernization effort
CEO: Chris Kempczinski
Performance
• US comp +13.8%
• Digital sales accounts for 25% of system-wide sales
• Expanded delivery
Strategy
• Focus on Marketing, Core product, and Digital/Delivery
• Expansion of royalty programs
• Improve personalized digital engagement through Dynamic Yield
Headwind
• Covid in China and Europe
• Rising inflation
• Inrcreasing labor cost
CEO: Chris Kempczinski
Performance
• Strong performance
• 10.9% comp growth, 5% increase in guest count
• Digital and Loyalty program success. Significant app downloads, 50m active loyalty users in top six markets
• Gain market share in beef and chicken
Strategy
• Focus on Marketing, Core product, and Digital/Delivery
• Fourth pillar: Accelerate restaurant openings
Headwinds
• Inflation
• Covid
• Franchise margins are taking a hit from inflation. $100m-150m expenditure to support franchisees
• Strong USD
CEO: Chris Kempczinski
Performance
• 9% comp growth
• Maintained leading market share
• Expansion of loyalty program
• Growth in chicken
Strategy
• MCD strategy
• Store expansion. targeting 50k store by 2027
Headwind
• Inflation
• Low consumer confidence
• War in Middle East
CEO: Chris Kempczinski
Performance
• Decline in comp
• Slowing in QSR sector
Strategy
• MCD strategy
• Loyalty program growth
• Restaurant expansion
Headwind
• Inflation
• Tightening value leadership gap
5. If I had to predict the prospects of the business
McDonald’s adds thousands of new stores every year, on par with total stores worldwide for smaller chains. As far as I can see, they’ve hit all the right points that I don’t know how much more surprisingly they can grow. They serve all-day breakfast. They have their apps with a loyalty program, deliver on third-party apps. They are already heavily franchised. They have kiosks and a good drive-thru presence. They are already all over the world. They seem to have overcome the value proposition issue of 2024. They overcame all the food poisoning issues that happened in the past – in Korea, Japan, China. They already cut operating costs. As a value stock, it will be about thorough calculation of fair value, and buying when there is a margin of safety. China consumer confidence coming back would be a growth point that I can think of, although it seems yet to be realized. I would have to calculate the impact of other growth initiatives to know whether right now is a good time to invest. McDonald’s will be McDonald’s is my verdict for now.