MCD - McDonald's CosMc's Suggests Upside Potential

2024-01-10 15:58:37 ET

Summary

• McDonald's is positioned well in the market with its strong brand name and mostly-franchised business model.
• The company's recent quarterly results showed resilience and growth, with global systemwide sales and comparable store sales performing well.
• McDonald's new beverage-led concept, CosMc's, has the potential to be a successful competitor in the long run.
• Though our fair value estimate is below where shares are currently trading, the high end of our fair value estimate range speaks to upside potential.

By Brian Nelson, CFA

We like how McDonald's ( MCD ) is positioned in the current market environment. The company's brand name is nearly unmatched on the world stage by any other restaurant save for Yum Brands' ( YUM ) KFC, and its mostly-franchised business model shields it in part from operational inflationary pressures as it collects franchise fees. Though prices on some of its value-offerings have increased since the last time we wrote about McDonald's in this article , the firm continues to deliver menu items that resonate with the cost-conscious consumer, as it seeks to capitalize on new opportunities with its new beverage-led concept CosMc's.

More recently, McDonald's has noted that the war between Israel and Hamas is having an impact on its business in the Middle East due to the actions by some franchisees to offer discounts and free meals to Israeli forces. McDonald's mostly-franchised business model has been one of the major drivers behind its success allowing owners flexibility to meet customer demands that may be unique to the region in which they operate. This has been a boon for shareholders, but more recently, it has revealed that the strategy is not foolproof. Though the news that McDonald's is facing some pressure on sales in the Middle East is not great, the firm is heavily diversified geographically across its International Operated Markets [IOM] and International Developmental Licensed Markets [IDL].

Latest Quarterly Results

When McDonald's reported third-quarter results October 30, the firm showed the resilience of its business model. Global systemwide sales advanced 11% (10% in constant currencies) in the quarter, while it put up 8.8% global comparable store sales performance thanks in part to strength in its digital rollout. Global comp sales in its IOM and IDL regions advanced 8.3% and 10.5%, respectively, in the period, and the firm leveraged the top-line strength into a 16% increase in consolidated operating income (13% in constant currencies).

Here's what CEO Chris Kempczinski had to say about the quarter in the press release:

With global Systemwide sales growth of 11%, our third quarter results reflect our position of strength as the industry leader. The macroeconomic environment is unfolding in line with our expectations for the year, and we continued to deliver convenience and value for our customers. Thanks to the entire McDonald's System's outstanding execution of Accelerating the Arches, we remain confident in our future and the strategic direction of our business.

The firm's diluted earnings per share advanced 18% on a year-over-year basis in the quarter (15% in constant currencies), and its free cash flow generation was impressive. For the nine months ended September 30 , cash flow from operations increased to $7.12 billion from $5.19 billion in the year-ago period while capital expenditures advanced to $1.6 billion from $1.37 billion in the same period last year. The company's free cash flow through the first nine months of the year of ~$5.52 billion was nearly 45% higher than what it achieved during the same period in 2022. We're huge fans of this robust free cash flow generation, which we expect to continue.

New Opportunity

Here is what we wrote on our website regarding McDonald's new opportunity in CosMc's:

We think McDonald's has found another winning concept in CosMc's. The new, small-format , beverage-led concept is drive-thru only and opened its first location in Bolingbrook, Illinois, and according to reports, “ people lined up for hours to try the new McDonald’s restaurant.

The company’s menu is filled with drinks such as a Sour Cherry Energy Burst and Berry Hibiscus Sour-ade, as well as various iced teas, lemonades, slushies and frappes. CosMc's has numerous coffee-based selections and a few classic McDonald’s items, too, including a suite of McMuffins.

We’re liking McDonald’s innovation in this area and think the concept has promise to be competitive in the long run against the likes of Dunkin’ and Starbucks ( SBUX ). Ten locations are planned initially, with two expected in the Dallas-Fort Worth and San Antonio metro areas.

Right now, we're not building any contribution from CosMc's in our valuation model, but McDonald's does have a track record of helping create big hits, with perhaps the best known example being its investment in Chipotle ( CMG ). It's far too early to determine whether CosMc's will have as much success as that of Chipotle, but we do think McDonald's has another winner on its hands.

Valuation

McDonald's has a number of trends working in its favor. For starters, the company is putting up strong comparable store sales numbers, and while it is experiencing some pressures on sales in the Middle East, we think this is a temporary issue, and not something that will permanently impair its brand by any stretch.

Specifically, our $282 per-share fair value estimate is supported by continued strong comparable store sales in the U.S. and strength across its markets in the U.K., Germany, and Canada, all three of which were stand-out performers during its most recently-reported third quarter. The company's store growth should remain strong as well .

Our near-term operating forecasts are roughly in-line with consensus estimates, as our edge is thinking about how McDonald's performance will look in year 5 and beyond, not necessarily whether it will beat or miss next quarter's or next year's earnings. Most of the value of McDonald's is driven in the out years in arriving at our $282 per share fair value estimate, as shown in the image below.

Downside Risks and Upside Potential

McDonald's has a number of downside risks to its story, but it also has upside potential. The unrest in the Middle East is one area that could drive variance with respect to our future forecasts, while a trend to healthier options given the rollout of weight loss drugs could impact revenue to the downside.

To the upside, we can look to potentially better-than-expected comp growth in the U.S. and the possible monetization of its CosMc's brand in the years ahead. Today, we're leaning more towards the high end of our fair value estimate range ($345 per share) of McDonald's as an optimistic valuation for the firm. Shares are trading at ~$290 at the time of this writing.

Concluding Thoughts

McDonald's is a fantastic, well-run operation, and as evidenced by its strong comparable store sales performance through thick and thin, the company's value offerings continue to resonate with cost-conscious consumers. We're huge fans of its mostly-franchised business model that in part shields it from inflationary operating costs at the franchise level, and its free cash flow generation has shown tremendous improvement in 2023. McDonald's pays a ~2.3% dividend yield to boot. We like shares for the long haul.

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