Can CosMc’s Improve McDonald’s Results?

An investor with the intestinal fortitude to acquire a few hundred shares when McDonald’s went public on April 21, 1965 and to hold them while reinvesting the dividends, would be sitting on a nice ‘nest egg’.

Having said this, past performance is not indicative of future performance.

MCD’s has repeatedly boasted about its ability to raise menu prices without negatively impacting sales. A sizable segment of its customer base, however, is the lower income consumer. People can only put up with so much. Some are turning to social media to complain about the high cost of everyday necessities; MCD has become a regular target.

Many North American consumers have been treading water financially. It appears, however, that many have finally reached a tipping point. Credit card and car loan delinquencies in the US are at their highest point in more than a decade. Mortgage delinquencies in Canada continue to rise and some homeowners have mortgage amortizations that extend well beyond 50 years. Furthermore, many households are eating into their savings to cover their basic living expenses. For many, the cost of living far exceeds any income growth.

When an increasing number of consumers struggle financially, it stands to reason that people will be forced to change their lifestyle. Although some financially challenged customers may still go to MCDs, the frequency and average ticket size will likely change.

On February 5, MCD reported weaker than expected sales at its US stores. On the Q4 earnings call, management acknowledged that a large segment of its customer base cannot continue to indefinitely absorb price increases. In order to address this, MCD plans to lower the price of some menu items. This will undoubtedly contribute to margin pressure although the extent is currently subject to debate.

In addition to an ‘affordability’ problem, MCD is a very sad example of what has become of our society. Nothing in MCD’s menu is fresh and healthy! Nevertheless, it has grown the number of systemwide restaurants from ~30,000 to ~42,000 in the most recent 18 years whereas it took ~33 years to open its first ~10,000 restaurants.

Business Overview

You are undoubtedly familiar with MCD. Nevertheless, I encourage you to (at the very least) review its website and recent SEC filings.

MCD generates ~65% of global systemwide sales from its core menu that includes Quarter Pounders and fries; it has 17 $1B brands!

We know MCD’s menu has little nutritional value. Nevertheless, MCD continually modifies its products to make them ‘tastier’ (more addictive?). Burgers with softer, freshly toasted buns, meltier cheese and more Big Mac sauce are coming to US restaurants by the end of 2024 and most other markets by the end of 2025.

Interestingly, MCD’s chicken sales have reached $25B annually and are on par with beef sales. In order to capitalize on the growth of its ‘chicken’ based products, MCD plans to bring its McCrispy sandwich to nearly all global markets by 2025.

In addition to the beef and chicken items on MCD’s menu, it sells 8 million cups of coffee per day. Management has determined there are significant opportunities to grow coffee sales. Historical growth, however, has been hampered by a fragmented approach. There is currently a plan is to reduce the list of equipment suppliers so MCD’s coffee is more consistent globally.

The following is restaurant information at FYE2023.

CosMc’s

A sizable segment of MCD’s customer base is experiencing financial strain which raises questions about MCD’s future growth. In this regard, one of the most anticipated announcements at its Investor Day in December 2023 was news about CosMc’s (see website).

CosMc’s is a new restaurant format that will offer customizable drinks and treats designed to appeal to afternoon snackers. The plan is to grab sales from competitors like Starbucks and Dunkin’ in what is a $100B category that has superior margins and faster growth than the rest of casual dining.

The rationale for this new format is to address the sales slump MCD’s restaurants experience in the mid-afternoon.

The plan is to open 10 CosMc’s restaurants through the first half of 2024. One will be near the MCD’s headquarters in Chicago and the other 9 will be in Texas. MCD will study the results for at least a year before determining whether to expand.

MCD is also looking to CosMc’s to expand its menu and to improve service times in order to keep up with other fast-growing chains like Starbucks. Starbucks, for example, plans to open 55,000 stores globally by 2030; it currently has ~38,000.

MCD’s existing format caters to budget conscious consumers who are short on time. The complexity of the drinks CosMc’s will offer, therefore, makes it impossible to fit into existing restaurants. It is for this reason that integration with MCD’s existing locations is unlikely.

Financials

Q4 and FY2023 Results

MCD’s Q4 and FY2023 results released on February 5, 2024 are accessible here.

Conditions in the Middle East resulted in a sharp drop in comparable store sales in MCD’s developmental and licensed segment. On the Q4 earnings call, management stated that headwinds are unlikely to abate in that region until such time as the conflict ends.

Despite the substantial decline, that segment represented just 12% of company operating profit in 2023.

Comparable store sales in the US experienced ~4.3% growth. Internationally operated markets (IOM) grew ~4.4%.

Operating Cash Flow (OCF) Free Cash Flow (FCF)

Earnings and cash flows can be distorted/manipulated, and therefore, it is important to fully analyze a company’s financial statements. In addition, investors should never look at quarterly or annual results in isolation.

I typically look at 10 years of earnings and OCF and FCF. If I see significant swings, I try to determine whether significant variances are attributed to normal business operations or whether non-recurring events have significantly contributed to such variances.

The following is MCD’s OCF and FCF for the past 10 years. While there are consecutive years with ~$2B – ~$3B variances, these variances are due to the normal course of business and not ‘manipulation’.

OCF – In FY2014 – FY2023, MCD generated (in billions of $) 6.730, 6.539, 6.060, 5.551, 6.967, 8.122, 6.265, 9.142, 7.387, and 9.612.

FCF – In FY2014 – FY2023, MCD generated (in billions of $) 4.147, 4.725, 4.239, 3.698, 4.225, 5.728, 4.624, 7.102, 5.488, and 7.255.

FY2024 Outlook

Sales growth moderation and ongoing inflationary headwinds are likely to continue to pressure short-term results. MCD, therefore, expects net restaurant expansion in 2024 and restaurants opened in 2023 will contribute only ~2% to system-wide sales growth.

Despite headwinds, management anticipates a mid to high 40% operating margin in FY2024. This will be driven primarily by top line growth and franchise margin performance.

Interest expense is forecast to increase ~9% – ~11% from FY2023’s level due to higher average debt balances and interest rates.

The effective tax rate for the year is likely to be ~20% – ~22%.

On the CAPEX front, MCD plans to spend ~$2.5B – ~$2.7B with more than 50% dedicated to new unit openings across the US and International Operated Markets segments.

Globally, MCD plans to open more than 2,100 restaurants with about 500 of these openings across the US and International Operated Markets segments.

It also expect to open more than 1,600 restaurants in its International Developmental Licensed Markets segment, including ~1,000 in China, where MCD recently completed the acquisition of Carlyle’s 28% stake in McDonald’s China. MCD has now increased its minority ownership to 48% in its second largest and fastest-growing market.

Overall, MCD anticipates:

• ~4% unit growth driven by more than 1,600 net restaurant additions in 2024; and
• free cash flow conversion in the 90% range.

Credit Ratings

Roughly 23 years ago, Moody’s assigned an Aa2 rating and S&P Global assigned an AA rating. Both ratings were the middle tier of the high grade investment -grade category.

Over the years, MCD’s priorities changed and a decision was made that lower credit ratings were acceptable in order to meet these changes. Striving to have one of the highest credit ratings was no longer a priority. Now, the current ratings are 5 tiers lower than shortly after the turn of the century.

MCD’s domestic senior unsecured long-term debt ratings are:

• Moody’s: Baa1
• S&P Global: BBB+

Both ratings are in the top tier of the lower medium-grade investment-grade category. These ratings define MCD as having an adequate capacity to meet its financial commitments. Adverse economic conditions or changing circumstances, however, are more likely to lead to a weakened capacity of the obligor to meet its financial commitments.

Despite much weaker credit ratings than a little over 2 decades ago, I do not envision MCD having a problem servicing its obligations.

Dividends and Share Repurchases

Dividend and Dividend Yield

In FY2022 and FY2023, MCD distributed dividends totaling ~$4.168B and ~$4.533B.

MCD has raised its dividend for 47 consecutive years since paying its first dividend on August 15, 1976; its dividend history is accessible here. The firm is a Dividend Aristocrat based on its streak.

On December 1, 2023, MCD declared its first $1.67 quarterly dividend that was distributed on December 15.

Investors can expect 3 more $1.67 quarterly dividends. On December 1, 2024, I anticipate at least a $0.10 increase. Using the current ~$287.50 share price and the next 4 quarterly dividends totaling $6.78 ((3 x $1.67) + (1 x $1.77)), the forward dividend yield is ~2.36%.

Share Repurchases

The weighted average outstanding shares in FY2014 – FY2022 (in millions of shares) is 986, 945, 861, 816, 786, 765, 750, 752, 741, and 727.8 in FY2023.

In FY2022 and FY2023, MCD repurchased ~$3.896B and ~$3.054B.

Stock Splits

Since going public in 1965, McDonald’s has executed 12 stock splits. Its stock split history is accessible here.

Valuation

In FY2023, MCD generated $11.56 of diluted EPS and $11.94 of adjusted diluted EPS. With shares trading at ~$287.50 as I compose this post, the diluted PE and adjusted diluted PE are ~25 and ~24.

It generated ~$7.255B of FCF in FY2023 and the diluted weighted average shares outstanding was 732.3 million thus resulting in ~$9.91 of FCF/share and a P/FCF of ~29.

Based on the currently available estimates, however, MCD’s forward-adjusted diluted PE levels are:

• FY2024 – 36 brokers – a forward-adjusted diluted PE of ~23 using a mean of $12.44 and low/high of $12.06 – $12.88.
• FY2025 – 36 brokers – a forward-adjusted diluted PE of ~21 using a mean of $13.57 and low/high of $13.11 – $14.27.
• FY2026 – 13 brokers – a forward-adjusted diluted PE of ~19 using a mean of $14.87 and low/high of $14.25 – $15.64.

MCD targets a FCF conversion rate in the ~90% range. Taking 87% – 93% of the $12.44 mean FY2024 forward-adjusted diluted EPS, we get ~$10.8 – ~$11.57. Using the current ~$287.50 share price, the forward P/FCF range is ~25 – ~27.

Final Thoughts

On June 25, 2012, I initiated a position in MCD @ ~$88 in a retirement account for which I do not disclose details; I subsequently occasionally added to my exposure. I hold no shares in the FFJ Portfolio and it was not a top 30 holding when I completed my 2023 Year End FFJ Portfolio Review.

MCD has succeeded in convincing billions of people to shell out money for inexpensive and unhealthy food while passing on higher costs in the form of higher prices. When your primary target market consists of budget conscious consumers, however, there is a point when consumers will push back. This is exactly what has happened thus leading to MCD stating that some prices will be lowered.

Recognizing that a huge segment of its customer base is experiencing financial strain, MCD is rolling out its new CosMc’s concept; it really needs to capture a customer base that will not be so resistant to price increases.

It makes sense that MCD keep CosMc’s separate and distinct from its typical MCD outlets. There is no way someone ordering a Happy Meal will want to wait several minutes for someone’s Mocha Chocolata order to be filled beforehand. In addition, the consumer being targeted by CosMc’s will not want to be around a bunch a screaming kids in a MCD’s Playland.

It will certainly be interesting to see how the CosMc’s concept fares, however, I think MCD really has its work cut out to make CosMc’s a success.

In my opinion, MCD is fairly valued. This lowers the odds of a significant share price appreciation over the next few years. As a result, I don’t like the probability of generating an attractive investment return.

I think we are experiencing a period of irrational exuberance. The odds are reasonable for a sudden broad market decline, and therefore, I am not making any meaningful purchases.

I wish you much success on your journey to financial freedom!

Author Disclosure: I am long MCD. I disclose holdings held in the FFJ Portfolio and the dividend income generated from the holdings within this portfolio. I do not disclose details of holdings held in various tax-advantaged accounts for confidentiality reasons.

Author Disclaimer: I do not know your circumstances and do not provide individualized advice or recommendations. I encourage you to make investment decisions by conducting your research and due diligence. Consult your financial advisor about your specific situation.

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