Natalia Kuzina/iStock Editorial via Getty Images
The best investments are often premium at a discount, but premium brands and well run companies aren’t often discounted for long. Markets can be irrational for extended periods of time, but traders and investors don’t miss out on many good investments forever, and markets tend to correct themselves over the long term.
There are few brands in the US or worldwide that are better known than McDonald’s (NYSE:MCD).
McDonald’s is headquartered in Chicago and the company operates worldwide in 122 different countries. McDonald’s is the definition of a global brand.
The stock has also had a huge run over the last 30 years, and also just in the last 5 years as well. The stock has recently gone from $127 a share in 2015 to today’s share price of nearly $257 a share. McDonald’s biggest revenue drivers over the last 5 years have been restaurant sales and franchising fees. The company did well during the pandemic and recently reported very strong third earnings even compared to 2019 comps before the pandemic. McDonald’s has beaten earnings expectations for three straight quarters now.
McDonald’s third quarter earnings report was impressive, and the strong recent report showed impressive comps across the company’s various business both compared to 2020, as well as compared to 2019. The company performed very well during the pandemic, with revenues dropping less than 25% despite an over 40% drop in same store traffic in 2020. McDonald’s recently reported for the third quarter that global sales were up 12.7%, and U.S. sales were up 9.6%.
The company’s franchising business was strong too as international operated markets segments were up 14% from 2020 and 9% from 2019. The company’s international developmental licensed segment was up 16.7% from last year and 5% from 2 years ago. McDonald’s third quarter comps were impressive across the board compared to both the restaurant’s 2019 and 2020 sales. The company reported that margins for the full year were an impressive 44%, and management does not see margins falling significantly below this number moving forward despite obvious issues like a labor shortage and supply chain issues.
Still, one of the biggest drivers of revenue for McDonald’s over the last 5 years has been the franchising of most of the restaurants. About 93% of McDonald’s capacity is franchised now, which is close to the company’s goal of 95%. Franchising restaurants was very successful strategy that McDonald’s has used to leverage earnings in particular over the last 5 years. The company already operates across 122 countries, and management isn’t likely to open a significant amount of new stores anytime soon.
With nearly 93% of McDonald’s restaurants franchised now, the company will likely have to look for new revenue drivers moving forward if this industry leader wants to continue to report double digit growth in the highly competitive fast food restaurant industry.
This is why valuation does not look cheap. McDonald’s currently trades at 26x trailing earnings estimates and just over 25x consensus earnings estimates for next year. Even though earnings estimates have been low the last several quarters, the stock still does not look cheap trading at around 25x earnings estimates. McDonald’s has industry leading margins at 44%, and the company obviously also has a recession resistant business model, but a key recent revenue driver of franchising the company’s restaurants isn’t likely to be as strong of a growth factor moving forward. The company also struggled to maintain a double digit growth rate prior to 2015.
McDonald’s certainly should be trading at a premium to industry peers for a number of reasons, but the stock is currently trading at a significant premium to competitors despite signs of decelerating growth. The company does see growth comps slowing in the back half of next year. Margins also will likely face at least some pressure as labor costs continue to rise and supply chain issues continue.
McDonald’s has also seen earnings growth slow significantly for extended periods of time even more recently over the last 15 years.
This is a chart of McDonald’s quarterly earnings over the last almost 15 years.
Source: Macrotrends
McDonald’s recent earnings growth accelerated significantly around 2015 as the company began to accelerate franchising, but that revenue growth driver isn’t likely to be as strong moving forward since nearly 93% of the company’s restaurants are now franchised.
As Franchising fees likely slow moving forward McDonald’s will likely return to a mid to high single digit growth rate like we saw from 2010 to 2015, and a slowing growth rate should of course lead to multiple contraction. Even though the company has industry leading margins of over 40%, a premium brand, and a recession resistant business model, the market isn’t likely to pay nearly 25x forward earnings for single digit growth. Also, well currency moves didn’t materially impact this company past year earnings, forex moves can have a noticeable impact on the company’s earnings as well.
Management recently announced a new growth strategy called Accelerating the Arches, a growth strategy most focusing on driving digital sales, but the company has already successfully developed online market tools that enabled the business to succeed during the pandemic. Digital sales could also hurt McDonald’s too if customers decide to buy the company’s products online instead of at the store, and McDonald’s has to pay delivery companies such as door dash or grub hub, or customers who aren’t in the restaurant spend less.
McDonald’s is a very well run company with a premium brand. The company has industry leading margins and a recession resistant business model. Still, the stock currently trades at nearly 25x forward earnings estimates even though growth moving forward is likely to be more difficult. McDonald’s has already franchised nearly 93% of the company’s capacity and organic growth from same store sales will likely be in the mid to high single digits in the US and overseas moving forward. If McDonald’s growth rate slows even slightly, the company’s growth multiple will likely contract, and the company could easily see share prices trade at least 15-20 percent below current elevated levels.
