A Wide-Moat Restaurant?

A couple of months ago, we raised our economic moat rating from "narrow" to "wide" for  McDonald's (MCD), making it the lone restaurant stock on the Bellwether Watchlist that is published in each issue of Morningstar StockInvestor. I sat down with analyst John Owens to figure out what makes the "Golden Arches" so different.

Just about everyone knows what McDonald's is, but to get a quick lay of the land, can you profile the company?

McDonald's chain spans more than 31,000 restaurants in 118 countries. The company currently operates about 28% of its restaurants, while franchisees and affiliates run the rest. The U.S. and Europe segments each deliver around 35% of total revenue, while the Asia Pacific, Middle East, and Africa segment chips in another 15%. McDonald's in Latin America and Canada account for most of the balance. The company also operates Boston Market and has a minority interest in the U.K.-based Pret A Manger. In 2006, McDonald's disposed of its investment in  Chipotle (CMG).

I can think of few industries that have a higher degree of rivalry than the restaurant industry. Why do you think McDonald's has a wide moat?

McDonald's has tremendous advantages in scale. Last year, the company, its franchisees, and affiliates generated roughly $57 billion of systemwide sales on a global basis, which compares with around $13 billion and $8 billion for rivals  Burger King  and  Wendy's (WEN), respectively. This provides McDonald's with a lot of power over its suppliers, many of which owe their existence to the burger chain. Its size also provides incredible advertising muscle, with McDonald's more than tripling the total U.S. advertising spending of both Burger King and Wendy's. In addition, McDonald's has secured some prime--and valuable--real estate. We believe that these competitive advantages, along with the strength of the firm's brand, gives McDonald's a wide moat in this highly competitive industry. Also helping to boost returns on capital is the fact that the corporation collects an annuitylike stream of rent, service fees, and royalties from franchisees and affiliates with little associated invested capital.

How do the competitive advantages show up in the financial statements? Is this firm generating returns above its cost of capital?

McDonald's boasts the highest sales per restaurant among major fast-food chains. Its average unit volume exceeded $2 million last year, which compares with Wendy's at $1.4 million and Burger King at $1.1 million. During the 12-month period ending in March, McDonald's generated a 21.5% operating profit margin versus just 4% for Wendy's and 9% for Burger King. The company generated a 15% return on invested capital in 2006, easily surpassing our 8.5% cost of capital estimate.

We profiled  YUM Brands (YUM) in a recent issue of StockInvestor, and the two companies appear to be pretty similar. What's the difference between McDonald's and YUM?

McDonald's is the clear market leader in the U.S. and most foreign markets, with the notable exception of China, where YUM Brands dominates at this early stage. Another point of differentiation is that McDonald's management is almost entirely focused on its flagship brand, while YUM's executives must oversee a portfolio of brands, including KFC, Pizza Hut, and Taco Bell. McDonald's also spends significantly more on advertising its flagship brand than YUM does on its entire portfolio. So, it's no surprise that McDonald's ranks as the ninth-most-valuable global brand, according to Interbrand's 2006 annual ranking of global brands, while KFC and Pizza Hut come in at number 60 and number 66, respectively. (Taco Bell was not ranked.) Domestically, McDonald's restaurants, on average, generate about double the sales of Taco Bell and KFC, and roughly 3 times the sales of Pizza Hut. McDonald's is also more profitable, with an operating profit margin over the 12-month period ending in March of 21.5% versus 13% for YUM Brands.

Walk me through the main projections you made to come up with your $49 fair value estimate.

Over the next five years, we project more than 4% average annual revenue growth, largely driven by increases in same-store sales. (Net new unit growth contributes only about 1% of the increase in annual revenue in our forecast.) Beyond inflation, we think new snack foods and beverages will lift sales between meals. Other initiatives, including double drive-through lanes, extended operating hours, restaurant remodeling, and cashless payment systems, should also boost top-line growth. On the back of this revenue performance, we expect the operating margin to gradually rise from 20.6% last year to nearly 23% by 2011.

How much of the real estate under the restaurants does McDonald's own? Do you explicitly model the net asset value of this real estate in your model?

The company owns approximately 45% of the land and nearly 70% of the buildings for its restaurants. We do not separately value the real estate, but their value is implicitly reflected in the cash flows these assets generate. Given the productivity and profitability of McDonald's restaurants, we believe the company is, by and large, maximizing the value of its real estate through its restaurant operations and franchising business. If the company decided to pursue a leveraged recapitalization through a sale-and-leaseback transaction, there could be further upside to our valuation to account for a lower cost of capital. But, this does not appear imminent.

What do you think of McDonald's management? There has been quite a bit of turmoil at the top in recent years.

No doubt about it, McDonald's has experienced considerable turnover in the executive suite. The company lost two CEOs in 2004, its marketing chief and European president in 2005, its president and COO in 2006, and will now lose its CFO of more than six years. Fortunately, McDonald's had a deep bench of management talent to draw upon. In spite of this turnover, the company has enjoyed an incredible turnaround, with its share price nearly tripling over the past four years. We believe this reflects the strength of the McDonald's competitive advantages.

McDonald's is in the crosshairs already of those targeting obesity. Is there any risk of an attack on its labor practices similar to what  Wal-Mart (WMT) has experienced? What steps is McDonald's taking to protect the value of its brand?

As a leader, McDonald's, like Wal-Mart, will always be a lightning rod for criticism, warranted or not. Management, however, is responding more aggressively to such criticisms and making its voice heard on these issues. In addition, McDonald's is providing its customers with more choices, including salads, grilled chicken, slices of fruit, yogurt, low-fat milk, and bottled water. On the labor front, the company is more actively promoting its pay, benefits, and opportunities for advancement, emphasizing that about 40% of its global senior management, including CEO Jim Skinner, began their careers as crew members.

Bottom line: Should I be comfortable buying McDonald's and holding it for the long term, assuming the price was right?

McDonald's is certainly not immune from temporary setbacks. Management may occasionally stumble in its execution or the company could suffer because of factors beyond its control (such as a bird-flu or mad-cow epidemic). Still, its competitive advantages over rivals give McDonald's ample opportunities to bounce back from missteps and misfortunes. I believe that the company will continue to generate healthy returns on invested capital over the long run. The stock would be an excellent long-term holding, in my view, but I would still encourage investors to seek a margin of safety to our fair value estimate.

A version of this article appeared in the May issue of Morningstar StockInvestor.