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McDonald's Brand and Scale Advantages Intact

R.J. Hottovy, CFA

McDonald's (MCD) fourth-quarter update was consistent with several themes laid out at the November 2013 analyst day, including muted top-line growth and lingering cost pressures amid difficult industry conditions, but also visibility regarding plans to re-engage with consumers and better compete in the evolving informal eating out category. We expect fourth-quarter trends, including flat global comparable sales and restaurant margin pressures (which fell 60 basis points to 17.2%), will carry into early 2014 but inflect in the back half of the year through new menu innovations (supported by the rollout of high-density kitchen prep tables in the U.S. designed for greater customization and menu choices while improving speed of service), enhanced value platforms across all regions, and individualized customer-engagement tactics. Although these efforts will take time, we believe they will ultimately enhance McDonald's brand intangible asset and bolster returns on invested capital, giving us conviction in our Wide Economic Moat Rating.

We plan to make some minor adjustments to our model, but they won't materially affect our fair value estimate. Our free cash flow model remains aligned with management's long-term goals, including 3%-5% system sales growth and 6%-7% operating income growth. We expect 3% top-line growth and a modest operating margin contraction during 2014 as a result of product innovation and capacity and throughput expansion initiatives. However, our model assumes a return to mid-single-digit top-line growth in 2015 and operating margins in the 31%-32% range over the next several years, owing to increased international scale and mix shift to franchised locations but partly offset by labor and occupancy cost headwinds. We believe comps may take several months to accelerate against aggressive industry promotional activity and limited price increase opportunities, but believe the current market price underestimates McDonald's long-term potential.

Laying Foundation for More Consistent Long-Term Growth
Following an impressive run from 2004 to 2011 highlighted by average annual global same-store sales growth of 5.6% and roughly 1,500 basis points of operating margin expansion to 31.6%, McDonald's fundamentals have weakened the past two years amid increased competition, self-inflicted product pipeline and marketing issues, and a tepid macro backdrop. Although management anticipates that muted top-line growth and ongoing cost pressures will persist in 2014, we believe it has put together a blueprint to better adapt to cyclical and competitive headwinds while also laying the foundation for more consistent long-term growth. In particular, management has discussed plans to enhance its brand reach while maintaining profitability, emphasizing new product innovations across all dayparts and pricing tiers, capacity and throughput expansion initiatives, store openings in underpenetrated emerging markets, individualized customer-engagement tactics, and ongoing modernization efforts.

It will take time to reposition McDonald's to better compete in the evolving $900 billion global quick-service restaurant industry, especially with aggressive industry promotional activity and limited price increase opportunities. But we believe the company can return to its longer-term goals of 3%-5% system sales growth, 6%-7% operating income growth, and returns on incremental invested capital in the high teens. Our confidence stems from one the widest economic moat ratings in the restaurant industry, the result of a strong brand intangible asset, convenient restaurant locations, a cohesive franchisee system, and unrivaled bargaining and advertising scale. These qualities have put McDonald's among industry leaders with respect to average unit volume ($2.6 million per restaurant compared with the QSR industry average just north of $1 million) and operating margins. Despite recent pressures, McDonald's remains one of strongest free cash flow generators in the restaurant industry, which allows it to fund growth initiatives while returning cash to shareholders.

Widest Moat in the Industry
Nonexistent switching costs, intense industry competition, and low barriers to entry make it difficult for restaurant operators to establish an economic moat. Nevertheless, we believe McDonald's possesses the widest economic moat in the restaurant industry, stemming from a mix of structural and intangible competitive advantages including strong brand equity, cohesive franchisee system, and tremendous scale advantages. These qualities have helped McDonald's build the largest restaurant system in the world and leading market share in the majority of countries in which it operates, with the exception of China.

With a widely recognized brand, 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. McDonald's average trailing 12-month sales of around $2.6 million per restaurant easily trumps the quick-service restaurant industry average of just over $1 million. Additionally, exterior and interior restaurant decor upgrades, more-efficient kitchen and drive-thru 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) should keep McDonald's restaurant productivity metrics ahead of the competition.

Menu innovation has also played a central role in enhancing McDonald's intangible asset moat source the past several years with introduction of several new, margin-accretive products like McWraps and the McCafe beverage platform. Management has acknowledged executional issues with its product pipeline during 2012 and 2013, but we believe the company's menu innovation plans appear more robust over the next several years, with launches planned across multiple dayparts, menu categories, and pricing tiers. In particular, management has emphasized new sales layers across protein categories (primarily beef and chicken) and reiterated the tremendous opportunities that still exists for the breakfast daypart across the entire system (breakfast represents approximately 25% of system sales in the U.S., but only 13% in Asia Pacific, Middle East, and Africa and roughly 5% in Europe). Each of these core categories (beef, chicken, breakfast) represent an incremental sales opportunity of more than $2 billion in the years to come, which should be accretive to comparable-restaurant sales trends and average unit volume.

We also share management's enthusiasm for its opportunities in the beverage category, which could represent $3 billion in incremental sales and could help to expand the McDonald's brand beyond its restaurant locations. Coffee is the most significant opportunity in the beverage category, and management has laid out a blueprint to build market share in the $65 billion global informal eating out coffee category through new beverage product innovations, further rollout of blended iced coffee beverages, a grocery packaged-coffee partnership with Kraft (to build greater awareness of the McCafe brand), and additional McCafe restaurant locations and kiosks. Management estimates that it currently accounts for 13% of the informal eating out coffee market, and we believe there is an opportunity to exceed 15% over time. More important, coffee not only represents an opportunity to drive incremental traffic and drive restaurant margins, but it can also be employed as a loss leader to help develop the breakfast daypart (and by extension, the brand intangible asset) in its Europe and Asia Pacific, Middle East, and Africa segments.

We believe McDonald's brand intangible asset is also enhanced by its cohesive franchisee and affiliate system, which collectively operates more than 80% of the chain. This structure allows the company to expand its brand reach with minimal corresponding capital needs while also 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 (more than $5 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.

As the world's largest restaurant chain in terms of systemwide sales, McDonald's wields tremendous economies of scale relative to its QSR peers. The firm can exert a significant amount of bargaining power over its suppliers, many of whom owe their existence to McDonald's, thus ensuring access to food and other raw materials at predictable, competitive prices. The McDonald's brand is also one of strongest in the world, aided by an unrivaled advertising budget of $788 million in 2012.

Competition, Volatile Costs Could Be Factors
Even the best-operated restaurant chains are susceptible to cyclical headwinds, including high unemployment rates and volatile commodity, labor, and occupancy costs. We expect restaurant chains to increasingly compete with one another on price and product differentiation in the years to come, including Burger King, Subway, and Yum Brands--many of which have recently adopted variations of McDonald's products--as well as fast casual restaurant competitors like Panera and Chipotle Mexican Grill, and specialty burger chains like Five Guys, In-N-Out Burger, and Smashburger. If heightened competition were to cause a material decline in sales at company-owned or franchised locations, it could impair McDonald's intrinsic value. Additionally, volatile food, energy, and labor costs could affect profitability.

While its size affords McDonalds's several scale advantages, a few questions about the agility of the company's supply chain have surfaced in recent years. Although we agree with management that the company possesses an "infrastructure positioned for growth," there have still been recent instances where rivals have been more nimble and been able to bring new products to market more rapidly because McDonald's struggled to procure the necessary raw materials before rollout. We believe the company can improve speed to market through better communication with its key vendors, though supply chain flexibility can be difficult to turn around overnight.

Considering its risk profile, however, we assign McDonald's a low fair value uncertainty rating, as we believe the company's brand and scale advantages make it better positioned to weather global macroeconomic pressures and increased competition than most QSR peers.