McDonald’s Overview: Segments, Buybacks, Valuation

McDonald’s (MCD) is a limited-service fast food restaurant with more than 36,000 restaurants in over 100 countries. It employs more than 2 million people worldwide, including employees at company-owned stores and corporate office employees. According to Euromonitor International data, the company had a 7.1% revenue share in the global IEO (informal eating out) market in 2017.

McDonald’s offers a uniform menu that includes fries, the Big Mac, chicken sandwiches, chicken nuggets, hamburgers, wraps, and shakes. To ensure that it connects with its international markets, it offers locally relevant food menus as well.

For example, it serves gazpacho in Spain, the black-and-white burger in China, and the Veg Pizza McPuff in India. As a global company with local operations, McDonald’s has to adapt to local food choices, especially when it comes to meat.

McDonald’s and competitors Yum! Brands (YUM) and Burger King use the franchise model as well as the company-operated model. Notably, these are the two most common models in the restaurant industry.

McDonald’s divides its revenues into company-operated stores and franchised stores. In the third quarter of 2019, McDonald’s earned 44% of its revenues from company-owned restaurants. Plus, McDonald’s earned its remaining revenues from franchises. Notably, the contribution of franchise stores to McDonald’s revenues has grown significantly over the last six years.

Last year, McDonald’s announced a new business segment structure. It divided its business into four segments:

• The US market: This is the company’s largest market.
• International lead markets: This segment includes developed markets like France, the United Kingdom, Canada, and Australia.
• High-growth markets: These are the markets where McDonald’s senses high growth opportunities for expansion. Key markets in this segment include China, Spain, Russia, Korea, and Italy.
• Foundation markets and corporate: All other markets that fall outside the above three markets form part of this segment. McDonald’s also reports corporate activities in this segment.

Ronald McDonald is a nostalgic clown character that represented the McDonald’s brand globally in electronic, print, and television marketing materials. This iconic mascot inhabited a fantasy world called McDonaldland and had adventures with his friends, the Hamburglar, Mayor McCheese, Grimace, and the Fry Kids.

Ronald came into existence in 1963, modeled after legendary TV personality Willard Scott. At that time, Scott played Bozo the Clown on WRC-TV in Washington, DC. However, in the last decade, McDonald’s has stopped using McDonaldland in its campaign.

In 2003, the company initiated its customer-focused “Plan to Win” strategy. This initiative provides a common framework for its global business while allowing for local adaptation.

Through the execution of multiple initiatives surrounding the five pillars of its plan—people, products, place, price, and promotion—it enhanced the restaurant experience for customers worldwide. Plus, it improved its global comparable sales and guest counts.

In 2017, McDonald’s introduced its “Velocity Growth Plan.” The company’s three key pillars of its growth strategy are “retain, regain, and convert.”

The company also identified what it calls the “three accelerators,” which include Digital, Delivery, and Experience of the Future in the US. Notably, its key need is going digital, as an increasing number of its customers move to e-commerce.

McDonald’s launched its IPO in 1965, offering stock at $22.50 per share. Fast forward to November 2019—the company is trading near $200. Based on its November 8 closing price, McDonald’s stock is up 9.0% this year.

In the last five years, its aggregate stock returns are 103%. This equates to a compound annual growth rate (or CAGR) of 15.3% over the period. Notably, this is only the stock return and does not account for dividends. McDonald’s also pays a dividend with a yield of around 2.5%.

McDonald’s has a long history of share repurchases. In September 2009, the company’s board of directors approved a $10 billion share repurchase program with no specified expiration date (“2009 Program”). As most of the amount authorized under the 2009 Program was used, the company’s board of directors terminated the 2009 Program and replaced it with a new share repurchase program that became effective on August 1, 2012.

This new program authorized the purchase of up to $10 billion of the company’s outstanding common stock with no specified expiration date. Between 2014 and 2016, McDonald’s returned $30 billion to its shareholders for an eye-watering increase of 80% over the preceding three-year period.

Last year, McDonald’s returned $8.5 billion to shareholders through a mix of share buybacks and dividends. It intends to return $25 billion to shareholders in the three-year period ending 2019. The company repurchased $5.2 billion of its shares in 2018 and $4.6 billion in 2017.

McDonald’s has a long history of paying dividends. The company has paid dividends on its common stock for 43 consecutive years and has increased the dividend amount every year. In September, McDonald’s announced a quarterly dividend of $1.25 per share—an 8% increase over the previous quarter.

This quarterly dividend translates into an annual dividend of $5 per share. As in the past, future dividend amounts are considered after reviewing profitability expectations and financing needs. At that point, dividends are declared at the discretion of the company’s board of directors.

Over the last three years, we’ve seen a divergence between McDonald’s top line and bottom line. The company’s revenues fell from $24.6 billion in 2016 to $21.0 billion in 2018. At the same time, its net income increased from $4.7 billion to $5.9 billion.

Notably, McDonald’s is chasing profitability and not top-line growth. Looking at its key ratios based on its 2018 numbers, McDonald’s had a current ratio 0f 1.36. Plus, its return on assets stood at 18.0%.

The company’s return on invested capital was 19.8% based on its fiscal 2018 numbers. Looking at its leverage, the percentage of long-term debt in McDonald’s total capital was 125%.

In addition, McDonald’s looks at ROIIC, or returns on incremental invested capital. According to McDonald’s, ROIIC is a measure used over one-year and three-year periods to evaluate the overall profitability of the business, the effectiveness of capital deployed, and future capital allocation. This measure is calculated using operating income and constant foreign exchange rates to exclude the impact of foreign currency translation.

The numerator is the company’s incremental operating income plus depreciation and amortization from the base period. The denominator equals the weighted-average cash used for investing activities during the applicable one- or three-year period.

The weighted-average cash used for investing activities is based on a weighting that is applied quarterly. Plus, these weightings are used to reflect the estimated contribution of each quarter’s investing activities to incremental operating income. According to McDonald’s, its ROIIC was -80.4% last year. However, the three-year ROIIC was 78% at the end of 2018.

Based on its 2020 estimates, McDonald’s has an EV-to-EBITDA of 17.1x and 16.3x its expected 2021 EBITDA.

Looking at the PE ratio, McDonald’s commands a 2020 PE multiple of 22.9x. The company’s PEG (price-to-earnings-to-growth) ratio might also appear stretched. Notably, it has a PEG ratio of 5.4x based on its 2020 estimates.

Among its competitors, Chipotle Mexican Grill (CMG) has an EV-to-EBITDA of 22x and 18x based on its 2020 and 2021 estimates, respectively. While McDonald’s earnings growth is expected to be tepid, Chipotle’s earnings are expected to rise at a CAGR of almost 26% between 2019 and 2021.

As a result, Chipotle’s PEG ratio is a much more reasonable 1.06x based on 2020 estimates. Unlike McDonald’s, which has a long track record of paying dividends, Chipotle does not pay dividends.

Plus, Wendy’s (WEN) has an EV-to-EBITDA of 16.3x. This multiple is based on its 2020 estimates and 15.2x based on its 2021 consensus EBITDA. Wendy’s PEG ratio is 4.6x based on its 2020 estimates.