McDonald's price target upgraded by UBS. Why?

The marginal benefit of the McCafe is most likely a much greater contributing factor to their success than we thought, especially with Starbucks coming in hot.

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McDonald's (MCD) is the largest quick service restaurant (QSR) firm in the world by sales with over 39,000 restaurants in 120 countries. Its business is about 93% franchised with only the rest operated by McDonald itself. The food menu is relatively uniform across the board with obvious variations in taste and quality depending on the restaurant's location. McDonald’s run through covid-19 speaks volumes of its operational capacity for change and consumer brand preference, situating it in favorable terms for the coming year though some suggest its mature status might hinder further success.

Context

The covid-19 pressure to adapt to take-out and home delivery has challenged McDonald’s competitive breakfast division to change, as well as competitors Starbucks, Dunkin’ Donuts, Chipotle Mexican Grill and others. Though McDonald’s breakfast division captures a large 30% market share, Starbucks’ acquisition of La Boulange in 2012, and newer technology firms has helped bolster its presence in the breakfast market posing threats to long term success at MCD (Starbucks coming out on top, see chart). Covid-19 has forced many lockdowns in major markets across the globe pushing restaurant businesses to adapt and incorporate home delivery solutions and take-out-only operations. While there was a 2.2% decrease in company revenue due to the pandemic, McDonald’s US segment, which weighs on about 40% of its share price, increased 4.6%, a good sign.

 

Starbucks vs MCD

Graph MCD

 

Competition Price Target

Starbucks poses an actual threat to McDonald’s dominance in the QSR space in the US and abroad. It has over 32,000 locations and plans to expand aggressively in China which would hedge its US market push come to shove regarding covid-19 control. Starbuck's market cap is second only to MCD’s $157.9B at $121.3B and it is a younger firm by 20 years and has more growth potential as it continues to acquire more technology from its Tech savvy Seattle region. Starbucks' price performance relative to the Hotels, Restaurants and Leisure industry has been greater not to add that it recently surpassed MCD in early October; MCD has underperformed relative to the index recently, see below. Starbucks' price to earnings ratio is higher than MCD meaning investors are willing to pay more for the stock (or could also signal an overpriced stock). Starbucks also competes with MCD on dividend offerings, they offer a lower, but also very steady dividend yield to shareholders.

 

Starbucks on top

Graph Starbucks vs MCD 

Adaptation

Since 2018 McDonald’s has been revamping its stores to incorporate automated processes such as self-serving kiosks in order to streamline its operations. The firm’s process is called ''Experience of the Future'' or ''EoTF''. Moreover, the firm’s mobile ordering, and payment system has been implemented in over 20,000 joints, and over 11,000 McDonald’s have partnered with UberEats for delivery solutions. Delivery represents about 10% of total sales while drive-thru takes the lead at 70-90%. MCD has also acquired technology firm Dynamic Yield, and AI firm Apprente to enhance its customer service performance and position itself as a top player in the use of technology in the restaurant industry.

Some Fundamentals analysis

McDonald’s year over year financial statements show a strong performance relative to industry averages despite covid-19 interference in 2019-2020. Continuing operations are more profitable than those of other firms in its peer group such that operating margins, gross profit and profit margin are all far above industry performance. MCD’s Q3 2020 last earnings report showcased a reported earning per share of 2.22 or, 16.52% higher than consensus estimates for the quarter suggesting investors were generally ready to pay a sizable premium to own the stock. Net income dipped in 2020 from 2019 however, MCD has shown resilience after a hard Q2 converted its Q3 back to previous 2019 levels.

 

Bulls

    1. Defensive business model

Strongly positioned to navigate pandemic-related headwinds due to customer loyalty and embrace of technology and innovation in its stores. Mobile, drive-thru and delivery are all well implemented by MCD. MCD’s focus on customer loyalty and continued marketing efforts reinforce its position as an industry leader and brand name. Revenue has only slightly dipped since 2017 to around $21B while net income has increased from 2017 levels of $4.5B to $6B today. MCD global average unit volumes and new restaurants cash-on-cash returns are ahead of most of its competitors.

    1. Dividend support

MCD’s current dividend yield is roughly 2.43%. MCD’s annual dividend yield has consistently been above 1.80% at least since 2015 while the industry average is at 1.36%. This indicates that as MCD further matures it promises to continue attracting investors and showcases its ability to support payments to shareholders day in day out. This type of dividend support is attractive for investors looking for exposure to global middle-class consumer growth and as we exit covid-19 this could prove to be worthy.

 

Bears

    1. Bankruptcies

Bankruptcies among QSR franchisees might escalate either due to further regulations, or due to slowdowns in vaccine deliveries and public acceptance of the vaccine. This is especially true of pressured franchisee economics, or overleveraged locations.

    1. Competitive US Market

The QSR industry is a highly competitive sector known for its price wars, and as the industry enters a recovering phase of the covid-19 era, competition for market share will start to squeeze MCD’s marketing budget potentially away from R&D or acquisitions. We are starting to see an upswing in the QSR industry which suggests future challenges for an incumbent leader who as we saw above is struggling to keep up with Starbucks.

 

Takeaways

MCD suffered from covid-19 lockdowns as shown in their Q1 and Q2 2020 financial statement figures: the premium investors were willing to pay to own stock, earnings per share, lowered, and operating income margins dipped with revenue losses from previous periods. However, financial statements also indicate losses from rough macroeconomic climate were not due to poor management, or MCD economics, but rather due to externalities, and structural misalignments. We are now seeing a strong recovery to pre-covid levels which is a sign of brand loyalty, strong consumer habits, and well managed profitability, and return on invested capital.

While McDonald’s faces a challenging climate in terms of competition, its rating was also recently upgraded from neutral to buy from UBS yesterday adding a new price target exceeding high mid-October levels. Until recently MCD outperformed for the greater part of the year its peer group of Hotels, Restaurants and Leisure. Naturally, due to a structural change in restaurant management, and adoption of delivery technology the increased price performance of the peer group has undoubtedly led to a shrinking MCD market share and could contribute to a bearish sentiment.

Sources

Trefis report on MCD

Returning to familiar brands like MCD during hard times

MCD Upgraded by UBS 

BoA Global Research:

 - MCDONALDS BoA Global Equity Report

 - STARBUCKS BoA Global Equity Report

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