McDonald's Poised to Accelerate Growth

Finally, backed by expectations of improved comps and a less capital-intensive franchised business model, McDonald’s should remain a compelling income play, with the possibility of more than $15 billion returned to shareholders via buybacks and dividends over the next three years. While we’d prefer a wider margin of safety, we think longer-term investors should keep McDonald’s on the radar screen because of the firm’s management improvements, operational enhancements, and a strong cash return profile.

McDonald’s March 1 investor event will shed additional light on management’s updated long-term strategy and financial targets, but we can piece together some preliminary priorities based on the company’s recent performance and other announcements. On the customer experience front, we expect management to emphasize a more rapid migration of its Experience of the Future platform to the U.S. and other markets in 2017, citing the recent success of Spain and other markets where guest counts have improved following the adoption of these enhancements. While we don’t expect the Experience of the Future rollout to have the same magnitude as last year’s all-day breakfast launch--and thus don’t expect the U.S. segment to return to positive comps until the second quarter of 2017 at the earliest--we believe the combination of ordering flexibility (including counter, kiosks, web, and mobile ordering), menu customization (including the ability to custom-build burgers, chicken sandwiches, and salads), and customer experience (including a blend of front counter, table service, and curbside kiosks) will have a more prolonged impact than a platform like all-day breakfast, giving us comfort in our aforementioned five-year comparable sales targets.

The company appears to be well on its way to meeting its goal of moving to 93% franchise ownership by 2018 and 95% over a longer horizon when factoring in the recent China/Hong Kong partnership with CITIC and Carlyle, expected to close in mid-2017, as well as recently closed transactions in Malaysia and Singapore. As with other players in the restaurant space that have moved to a 95%-plus franchise ownership structure, we anticipate material operating margin expansion in the years to come, including an increase to the mid-40s over the next five years and pushing 50% over a longer horizon.

We still don’t expect McDonald’s 2017-19 cash return targets to match the $30 billion returned to shareholders over 2014-16; that would probably require to company to take on debt that would move it below investment grade, something management is unlikely to do, given the negative implications for corporate and franchise funding opportunities. Still, between the proceeds from recent and upcoming refranchising efforts (and subsequent capital expense reductions) and greater confidence over meeting its SG&A targets, we would not be surprised to see management target $15 billion-$20 billion for its 2017-19 shareholder return goal (combining share repurchases and dividends). This would imply an acceleration from the mid-single-digit dividend per share growth we’ve seen from McDonald’s the past few years and aligns with our model assumptions calling for 6%-7% dividend per share growth over 2017-19.

Wide Moat Is Intact Nonexistent switching costs, intense industry competition, and low barriers to entry make it challenging for restaurant operators to develop an economic moat. Although McDonald's has faced increased competition, self-inflicted product pipeline, pricing, and marketing issues, a tepid macro environment, and evolving consumer views about menu composition and in-restaurant experience in the past, we believe it still possesses a wide moat. Our moat rating is based on a mix of structural and intangible competitive advantages, including a widely recognized brand, a franchisee system focused on driving unit-level productivity improvements, and meaningful economies of scale. These qualities were instrumental in helping McDonald's to build the largest restaurant system in the world (based on systemwide sales) and leading market share in the majority of countries in which it operates, with the notable exception of China. McDonald's generated $85 billion in sales at its company-owned and franchised restaurants during 2016, representing almost 4% of the $2.4 trillion global restaurant industry (using Euromonitor estimates). This almost doubles our expectations for Yum Brands' YUM systemwide sales of $46 billion (pre-Yum China spin-off) and dwarfs Restaurant Brands International QSR ($25 billion) and Subway ($12 billion).

With strong brand awareness, consistent customer experience, convenient restaurant locations, and a uniform value-priced menu balancing core menu items with locally relevant options, McDonald’s is one of the few restaurant concepts to enjoy global success. McDonald’s average trailing 12-month sales of around $2.3 million per restaurant trumps the quick-service restaurant industry average of just over $1 million per location. Additionally, we believe exterior and interior restaurant decor upgrades, more-efficient kitchen and drive-through configurations, and an Innovation Center (a 38,000-square-foot facility where the company can simulate new restaurant prototypes across a wide range of configurations, technologies, dayparts, and guest count volume) can assist with management’s turnaround plans and drive restaurant productivity metrics higher over an extended horizon.

Menu innovation has historically played an important role in enhancing McDonald’s intangible asset moat source. Management has cited executional and complexity issues with its menu over the past several years, but we’re encouraged by ongoing menu rationalization efforts and a more streamlined value menu offering. We view these decisions as prudent, but also acknowledge that the composition of McDonald’s menu will require a careful balancing act between rationalization and incorporating local preferences, something that could take additional time and resources (capital, labor, data analytics) to fine-tune.

We’re also intrigued by management’s emphasis on creating an Experience of the Future program flexible enough to accommodate the demographic, competition, taste, and franchisee permutations across its different operating regions while incorporating input from local and regional decision-makers. This is most apparent in McDonald’s international lead segment (Australia, Canada, France, Germany, United Kingdom), where innovations in each company are establishing a blueprint for more sustainable growth across the entire system. In particular, we’re intrigued by the full-restaurant model rolled out in France in 2015, which is perhaps the best example of a McDonald’s format fully integrating ordering flexibility, menu customization, and customer experience. Innovations like these--which have also been successful to some degree through the Experience of the Future rollouts across each of the other international lead markets--contribute to our longer-term same-store outlook.

Although migrating innovations from international lead markets to the U.S. will take additional time to implement, given the company’s size and competitive set, we’re becoming more constructive about the longer-term opportunity for McDonald’s to return to sustainable comparable sales growth in the low- to mid-single-digit range. Our confidence stems from a combination of recipe changes using higher-quality ingredients and incremental labor investments and training, driving improved speed of service and order accuracy metrics and helping boost comparable sales in the U.S. and helping to improve McDonald’s brand perception among consumers even before the successful launch of all-day breakfast, reinforcing our wide moat rating. While all-day breakfast has exceeded management’s expectations and helped to bring back guest traffic, we continue to believe the more important takeaway is that the program went from a single test market in May to nationwide rollout in October. This implies McDonald’s is overcoming its recent supply chain execution hurdles while demonstrating a greater level of coordination across the system, which we believe portends a more seamless rollout for new products, promotions, and other in-store innovations.

While McDonald’s full transformation will still take time, we’re comforted that the company’s brand intangible asset moat source is backed by a cohesive franchisee and affiliate system, which collectively operates 83% of the chain (a metric expected to grow to 95% over a longer horizon through refranchising efforts). This structure allows the company to expand its brand reach with minimal corresponding capital needs while providing an annuitylike stream of rent and royalties, even during challenging economic times. As a result, McDonald’s generates excellent free cash flow and returns on invested capital in the mid- to high teens. These results are even more impressive when considering that the firm owns 45% of the land for its restaurants (around $5.6 billion in land assets), meaning that the returns are generated on a higher invested capital base than most franchised restaurant chains. We believe considerable land assets provide an additional competitive buffer that most other restaurant firms cannot match.

We also appreciate McDonald’s aspirations to becoming a more nimble organization, particularly with respect to making more menu and marketing decisions at the local and regional level. Although we consider McDonald’s size and scale to be a key competitive advantage--the foundation of our cost advantage moat source--questions about the agility of its supply chain have surfaced in recent years, especially in a restaurant industry experiencing changing taste preferences at a local and regional level, a more pronounced consumer shift toward healthier foods, and fast-casual players reaching critical mass (which we believe have captured a share of McDonald’s previous middle- to upper-middle income consumers). There have been instances when competitors have been able to bring new products to market more rapidly than McDonald’s because of raw material procurement constraints, but we are hopeful that impressive speed-to-market for the all-day breakfast launch in the U.S. paired with localized menu decisions will help to alleviate some bottlenecks in the system and level the playing field somewhat.

Competition a Constant Threat Restaurants are susceptible to cyclical headwinds, including high consumer unemployment rates and volatile commodity, labor, and occupancy costs. We expect quick-service restaurant chains, including McDonald's, Restaurant Brands International, Chick-fil-A, Subway, and Yum Brands, to increasingly compete on price and product differentiation in the years to come while also dealing with encroaching competition from fast-casual players like Panera PNRA and Chipotle CMG and specialty burger chains like Five Guys, In-N-Out Burger, and Smashburger. If heightened competition were to cause a material decline in restaurant productivity metrics, it could signal impairment of the McDonald's brand and negatively affect its intrinsic value.

With 60%-65% of total operating profits coming from outside the U.S., McDonald’s is sensitive to regional economic fluctuations across the globe, including currency movements, minimum wage hikes, and negative publicity tied to food quality concerns. Additionally, we believe the company will face heightened competition from other limited-service restaurant rivals as they develop scale and expand globally.

While its size affords McDonald’s scale advantages, questions about the agility of its supply chain have surfaced. Although we agree with management that it possesses an infrastructure positioned for growth, there have been instances when rivals brought new products to market more rapidly than McDonald’s because of raw material procurement constraints. We are starting to see signs of improved speed to market through better communication with its key vendors and franchisees and giving local and regional decision-makers more autonomy, but believe further supply chain improvements are needed.

We generally believe the company’s brand and scale advantages better position it to weather global macro pressures and increased competition than most quick-service restaurant peers, but uncertainty surrounding the company’s turnaround initiatives makes near-term free cash generation less visible.