McDonald's,
world's largest real estate company!
McDonald's
world's largest real estate company!
SHARE PRICE: $178.78
MARKET CAP: $137.8B
1. INTRODUCTION
In the interest of full transparency, I must tell you that I love McDonald’s food, so I’m starting this analysis aware of some bias I might have.
For those of you who don’t know a thing about the McDonald’s history, I highly recommend you to watch the “The Founder”. I’ll leave you the inspiring trailer here – it’s just 2:33 min long – WATCH IT!
2. BUSINESS OVERVIEW
2.1. BUSINESS DESCRIPTION
McDonald’s revenue comes from two different sources: fees from franchised restaurants and sales from Company-operated restaurants.
The Company restaurants operations are pretty straight forward and work as any other restaurant.
The franchise system differs from other franchise systems because McDonald’s typically owns the restaurant or the land and leases it to the franchisee. This way it can make money on two separate ways from the franchised restaurants. The several royalties they collect and the rent the franchisee pays the company.
This rent is composed of Base Rent and Percentage Rent. The Base Rent is a minimum monthly rent amount and the Percentage Rent is a percentage of every dollar of sales above a monthly sales target. Whenever sales are down, the company can just raise the rent to compensate.
You can either call them smart or sleazy! I think both of them are correct.
Here are some of the fees the franchisee has to pay McDonald’s to keep the restaurant running:
Franchise Fee: $45.000 (you pay it when you open a new restaurant)
Service Royalties: 4% or 5% of Gross Sales
Advertising Fee: Not less than 4% of Gross Sales
Rent: Base Rent + Percentage Rent
Microsoft Subscription Fee: $449
Email Fee: $79.8
Technology Fee: $1200
2.2. LARGEST SHAREHOLDERS
I’m starting to become bored by these bigcaps. It’s hard to find founder-ownership, or at least find that the descendants still own part of the business. Instead, I keep seeing the big funds.
2.3. MANAGEMENT TEAM
Easterbrook is CEO since 2015 after being Chief Brand Officer and head of the UK and Northern Europe. He is the responsible for the great changes we are seeing right now like the shift to a 95% franchised restaurant mix, the modernization of restaurants, the food delivery, the McDonald’s app, etc.
3. HISTORICAL CONTEXT
3.1. LONG TERM CHART
The current stock price is $178,78.
3.2. MARKET CAP AND SHARES OUTSTANDING
McDonald’s IPO was back in 1965. Unfortunately I don’t have data going that far back in time. The current Market Cap is $138B and the company is buying back shares. Usually this is a good sign.
3.3. SALES - OPERATING INCOME - OPERATING MARGIN
The CEO is undertaking the task to shift the business mix to a 95% of franchised restaurants and just 5% of company owned ones. This negatively impacts consolidated revenues as Company-operated sales are replaced by franchised fees, which are lower.
2018 results came out this week, and unfortunately sales decreased 8%, from $23B in 2017 to $21B in 2018, mostly due to the re-franchising efforts the company is making.
On the other hand, they’ve been successful on their strategy of growing operating margin, which was 42% for 2018.
3.3.1 SALES BY GEOGRAPHY
McDonald’s groups its largest markets not in a traditional way like North America, Europe, Asia Pacific, but in its own peculiar way:
• U.S. – the Company’s largest segment.
• International Lead Markets – established markets including Australia, Canada, France, Germany, the U.K. and related markets.
• High Growth Markets – markets that the Company believes have relatively higher restaurant expansion and franchising potential including China, Italy, Korea, the Netherlands, Poland, Russia, Spain, Switzerland and related markets.
• Foundational Markets & Corporate – the remaining markets in the McDonald’s system, most of which operate under a largely franchised model. Corporate activities are also reported within this segment.
3.3.2 SALES BY SEGMENT
Let’s take a look at the left hand chart below where we can see the number of franchised restaurants and the number of company-operated restaurants.
We can clearly see the number of company-operated restaurants diminishing over the last 3 years and we can see the opposite trend for franchised restaurants as the company rolls out its plan.
If we analyse the right hand chart, the thing that stands out is the huge amount of revenue that comes from those “few” company-operated restaurants in comparison to the revenue that comes from the franchised ones.
At this point you might be asking. So why doesn’t McDonald’s operate more restaurants? Well, that’s the exact opposite from their current strategy. Let’s take a look at their operating income to find out why.
3.3.3 OPERATING INCOME AND MARGIN SPLIT
Although the franchised restaurants bring in lower revenues, they bring in much more cash than those operated by the company, because the company doesn’t have that many expenses with them.
As we can see on the right hand chart, the franchised restaurants have much higher margins than the ones the company operates. With “less effort”, the company earns more money. That’s basically it.
Just so we have a means of comparison, let’s take a look at the operating margin of some of McDonald’s competitors. I’ll use Morningstar data.
Burger King has had better margins for the last 5 years (hats off to the guys at 3G Capital) but the trend shows McDonald’s coming in fast and taking the first place this year. Yum’s 47% margin in 2017 was due to the sale of its operations in China.
3.3.4 REVENUE FROM FRANCHISEES
The title of this analysis is “World’s Largest Real Estate Company”. McDonald’s owns thousands of restaurants around the world and they lease them to their franchisees. So, how much of their revenue comes from rents and how much comes from royalties? Let’s take a look.
We can now see why McDonald’s is considered the largest real estate company in the world (we’re not considering the Catholic Church).
Revenue from rents is about double that from royalty fees. This unique structure gives a gigantic boost to McDonald’s revenue, an advantage that its competitors just aren’t able to easily mimic.
3.3.5 COMPARABLE SALES
Whenever we talk about retail we have to talk about comparable sales or “comps”, as they call them. Although the chart below might lead us to think that there are more people going to McDonald’s it isn’t quite like that.
This growth is lead by an increase in average check rather than guest count growth, and that is a two-edged sword. On the one hand, foot traffic is not increasing. On the other hand, this greater average check indicates that McDonald’s still has some pricing power.
3.4. NET INCOME, NET MARGIN
Despite declining sales, the company has been able to raise all of its margins and consequently, its profits. For 2018, the net margin reached an all time high of 28%. I must say I’m impressed with the management team.
3.5. SEASONALITY
There is a high seasonality of sales with Q3 being the strongest one and Q1 the weakest one.
3.6. DIVIDENDS
Mcdonald’s has been increasing its dividends since 1987. The dividend yield is now 2,6%.
3.7. PROFITABILITY RATIOS
Now let’s take a look at the profitability of the business. As usually I expect to see ROE (Return on Equity) above 20%.
So McDonald’s doesn’t have ROE after 2015! Hummm…..
Let’s take a look at the ROA (Return on Assets) and try to figure out what’s going on. I Like to see ROA above 15%.
If in 2016, 2017 and 2018 there is no ROE but there is ROA I suspect that McDonald’s equity for the last couple of years has been negative. Let’s dig in.
3.8. FINANCIAL RATIOS
Let’s take a look at Current Ratio and Debt to Equity.
When analyzing a big company like this, one must expect some level of debt, but this seems odd. Let’s take a look at the latest reports.
There it is. Negative Equity of -$6,2 Billion. And why is Equity negative? Well, mostly because they are buying back shares.
The 2018 full results haven’t come out yet, but we can take a look at previous years. Just look at how much stock the company has bought back in 2016, $11,1 Billion while cash from operations was just $6 Billion.
This means that McDonald’s has been returning to shareholders much more than it actually earns, taking advantage of the low interest rates environment.
And this leads me to wonder about the long-term sustainability of the EPS (Earnings per Share) on a shrinking sales scenario that hasn’t yet stabilized.
3.9. PRICE TO EARNINGS RATIO
McDonald’s historical PE is 19 and with a 2019 PE ratio of 22, our friend Mr. Market is slightly overvaluing the company.
3.10. RISKS AND COMPETITION
Let me just say that this is not a good time to be in the Quick-Service Restaurant business.
Whenever I open my Uber Eats app, McDonald’s is there at the touch of a finger, but so are all the other family owned pizzerias, trendy gourmet hamburger houses and what not.
These days, I’m seeing supermarkets offering prepared meals that look like they’re home cooked, people eating healthier, cooking shows everywhere, and McDonald’s is seeing all of this too, of course. The main risk right now that McDonald’s is facing is competition.
3.11. TYPE OF PLAY
I consider McDonald’s both a turnaround play and a dividend play. The first because of its sales decline and all of the steps management has been taking to invert this trend. The second because it has been paying a quarterly dividend since 1976.
4. OVERVIEW AND CONCLUSION
4.1. OVERVIEW
McDonald’s management is relying on three growth accelerators to invert the sales decline:
Experience Of The Future: This is the company’s largest construction project ever with $1 Billion already spent this year alone. Modernization of restaurants with new technology like self-order kiosks, delivery to the table and wifi are some of the new perks and it seems to be working. Easterbrook recently said that they are seeing higher average checks at the self-order kiosks because people dwell for longer.
Delivery: McDonald’s is teaming up with Uber Eats to bring the food to your doorstep. I’ve already tried it, I’m a fan, but let me tell you that the fries get all soft and mushy. I’m not ordering them again. Delivery might as well be the most probable driver of growth for McDonald’s. Easterbrook said that delivery orders represented something between 1,5 to 2x the normal average check.
Digital: McDonald’s app, Uber Eats, Self-Order Kiosks. Digital is what’s allowing the other 2 drivers to become a reality.
Although we’ve been watching a year over year decrease in sales I think we are going to see some stabilization in a couple of years (if not sooner) when the re-franchising come to a halt.
Management has been executing their plan brilliantly, growing not only same store sales, but operating margin to historical highs of more than 40%, and net margin of 28%.
Even with sales declining for 4 years in a row, operating income has never been higher in the company’s history and net income stands at levels of 5 or 6 years ago when sales were much higher. This means that if and when sales start do increase, profits should explode.
This being said, considering this healthy eating trend we’ve been living in for some time now, coupled with the sales decline, strong competition and the high valuation, McDonald’s doesn’t quite fit the bill for me yet. I’m almost loving it, but not quite.
4.2. CONCLUSION
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