Secrets of Successful Consumer Discretionary Companies

The fifth annual Morningstar Stocks Forum will be held November 4, 2010, in Chicago. Last year, the forum brought together more than 300 institutional clients, registered investment advisors, and high-net-worth individuals. This year, more than 30 high-quality companies are scheduled to present, including two high-profile consumer discretionary firms:  Choice Hotels  (CHH) and  McDonald's (MCD). We are looking forward to having Choice Hotels CEO Steve Joyce and McDonald's senior director of investor relations Donna Rodriguez speaking about their companies' prospects and strategies in a still-uncertain consumer environment.

Even when the economy moves a little, fundamentals at consumer discretionary firms can fluctuate a great deal. When the economy plummets like it did during the "The Great Recession" of 2008 and 2009, fundamental swings can assume seismic proportions. When global consumer demand evaporated due to a confluence of factors--soaring unemployment, stagnant wage growth, and housing or equity market pressures--traffic plunged across the restaurant industry, and hotel occupancy levels sank, leaving most industry participants with excess capacity. Yet, McDonald's and Choice Hotels both demonstrated exceptional resilience during the downturn--a function of their well-established economic moats. Now, these firms find themselves in an even stronger competitive position than they did prior to the recession.

We think it's worth taking a closer look at what makes these firms so durable during tough economic times, and why we expect these firms to retain their competitive advantages over an extended period. We also touch on several of the relevant topics that we anticipate management will discuss at the Stocks Forum. Although the market has rewarded these stocks with premium valuations as a result of their strong performance during a difficult economic environment, we believe both McDonald's and Choice Hotels should be on the radar for long-term investors looking to exposure to the consumer discretionary sector.

 Choice Hotels (CHH)
Uncertainty Rating: Medium | Price/Fair Value Estimate 1.22
We grant Choice Hotels a narrow economic moat because we think its asset-light business model and vast hotel network create a moaty business. The firm's franchise model requires little capital investment, which leads to very high returns on invested capital. Additionally, Choice controls some of the largest brands in the economy and midscale segments, providing a network effect that is hard for new entrants to replicate. In our opinion, travelers are drawn to the familiarity of the properties, which in turn attracts property owners. Once part of the network, owners are locked in for a long period of time, often around 20 years. Switching costs are high for property owners, who must pay to rebrand and refit a property into a new set of standards if they choose to defect to a competitor's brand.

Behind the company's moat is a successful management team. Investors attending the 2010 forum will get the rare opportunity of direct access to Choice Hotels' senior management, including CEO Steve Joyce. We expect the company's presentation will discuss how it deals with the constant pressure for short-term results, while also managing the long-term strategies that make their businesses fundamentally attractive. For those who can't attend the event, Morningstar.com will offer on-the-spot blog coverage, followed up by video interviews with attendees and presenters.

Near-term Challenges Persist Despite the Gradual Recovery
We like Choice's positioning in the industry, but there are several near-term issues that we believe deserve greater clarity. The overall travel industry has experienced a gradual recovery throughout 2010 after a two-year slump. Lack of financing for hotel developments, however, has lead to a smaller pipeline for hotels in the United States, which could slow growth in the near-term. Additionally, the industry remains competitive. Other economy brands, such as  Intercontinental's (IHG) Holiday Inn and Accor's Motel 6 have undergone widespread system upgrades, intensifying competition for Choice's value-priced offerings.

At the 2010 Morningstar Stocks Forum, we intend to learn more about the firm's expansion plans given a slowdown in the development pipeline. We suspect that the company can grow via conversions of existing properties, as well as in international markets where many properties still run as independent operators. We also believe that Choice's main consumer is still largely strapped for cash, and we hope to gain more insight into whether these consumers' behaviors have changed over the past few quarters, and where they are headed.

We believe Choice's shares are slightly overvalued at the moment, but we continue to like the firm's asset-light business model. As a pure franchiser, the firm is not susceptible to the large business swings that property owners face in times of economic volatility. As a result, although fee revenue declined in 2009, Choice's operating margins stayed relatively stable and returns on invested capital remained high. The firm generates strong cash flows and returns much of it to shareholders in the form of stock repurchases and dividends, which we expect to continue given its financial stability.

 McDonald's (MCD)
Uncertainty Rating: Low | Price/Fair Value Estimate 1.04
As the largest restaurant operator in the world with a universally recognized brand, McDonald's needs no introduction. There is little question that McDonald's dominates the global quick-service restaurant industry. Although there are currently more Subway franchise units in the U.S., and  Yum Brands (YUM) has the largest number of restaurants across the globe, McDonald's maintains a sizeable sales lead. In fact, McDonald's generated more than $72 billion in sales at its company-owned and franchised restaurants during 2009 (almost 4% of the $1.85 trillion global restaurant industry), doubling Yum Brands' $36 billion, and dwarfing Subway's $10 billion. This comes out to about $2.2 million per McDonald's restaurant, which easily trumps the quick-service restaurant industry average of approximately $1 million per location.

The Widest Economic Moat in the Restaurant Industry
Nonexistent switching costs, intense industry competition, and low barriers to entry make it difficult for restaurant operators to establish an economic moat. However, we believe McDonald's has the widest economic moat in the restaurant industry, owing to a mix of structural and intangible competitive advantages. McDonald's has considerable influence over its suppliers, ensuring access to food and other raw materials at predictable, competitive prices. Abundant advertising resources make the brand one of the most widely recognized in the world. With a consistent customer experience, convenient restaurant locations, and a largely uniform value-priced menu (with minor geographic variations), McDonald's is among the few restaurant concepts to be successfully replicated across the globe. Moreover, we believe its considerable land assets (the firm owns 45% of the land for its restaurants, representing roughly $5 billion in assets) provide an additional competitive buffer that other restaurant firms can't match. As a result, McDonald's generates excellent free cash flow, and delivers returns on invested capital in the midteens to high teens. This is well ahead of our well ahead of our 9% cost of capital assumption, further bolstering our wide economic moat rating.

As long as it can replicate its restaurant concept across a wide variety of geographies, and continue to use its capital wisely, we believe McDonald's moat trend should remain stable. Subway, Yum Brands, Burger King, and  Wendy's/Arby's Group (WEN) are all vying for share in the intensely competitive quick-service restaurant industry, but they do not pose a serious threat to the firm's tremendous economies of scale or strong brand equity. The firm accounts for about 13% of U.S. quick-service restaurant sales, and about 4% of global restaurant sales. The next closest competitor--Yum Brands--generates roughly half the systemwide sales that McDonald's does.

McDonald's Firing on All Cylinders, But Can It Last?
McDonald's has been the one notable exception to the sluggish trends plaguing quick-service restaurants. Its expanded beverage platform initiatives (including the nationwide rollout of frappes and smoothies), the launch of a dollar breakfast menu, and the successful marketing campaigns behind core menu classics, have allowed the firm to outperform its peer group. McDonald's continued to fire on all cylinders during the third quarter, with comparable-sales gains and increased profitability across all geographic regions. Momentum has also carried into the fourth quarter: Management expects October global comparable sales to grow 5%-6%, and we remain comfortable with our full-year outlook of 5% global comparable-store sales growth, and consolidated operating margins around 31%. We think McDonald's current valuation (17 times our forward fiscal-year EPS estimate, an enterprise value/EBITDA of 11 times, and a free cash yield of 4.5%) appropriately reflects the firm's current momentum. However, given its consistent fundamentals, we would require only a modest margin of safety before taking a position in McDonald's if concerns about commodity costs put undue pressure on the stock.

With three quarters of fiscal 2010 in the books, we expect management to focus its attention on fiscal 2011 and beyond during its Stocks Forum presentation. In the United States, we're interested in hearing about what new product platforms the company has in store to keep rivals at bay, and how successful restaurant reimaging efforts have been. Management also discussed the possibility of menu price increases during its most recent conference call. We hope to gain additional visibility regarding the potential magnitude, and which areas of McDonald's menu these increases could impact (we suspect price increases will be restricted to more premium products, such as Angus burgers or specialty coffee products).

Overseas, we're curious to hear about management's plans to maintain European sales trends when faced with elevated unemployment rates and austerity measures in several key markets. We also hope to hear about its plans to build incremental market share in China, where it competes with a well-entrenched competitor in Yum Brands. Lastly, we also expect additional details as to how McDonald's plans to cope with rising beef and other commodity costs over the next several months. While we expect operating margin gains to be less pronounced in 2011 than they were in 2010, we believe the firm's considerable bargaining power over suppliers, and diligent focus on labor and other operating expenses, position McDonald's to better weather these cost headwinds than its rivals.

For a preview of the consumer staples firms presenting at Morningstar's Stocks Forum, including McCormick (MKC) and General Mills (GIS) please click here.

Morningstar equity analyst Michelle Chang also contributed to this report.