McDonald’s: växer via app och McDrive

We're also encouraged by the three pillars of McDonald's 2020 "Accelerating the Arches" plan, which include (1) optimizing its marketing approach; (2) focusing on its core menu; and (3) doubling-down on digital, drive-thru, and delivery efforts. We've seen signs of progress on each pillar already, including the use of social media to market celebrity meal promotions in the U.S. to offset some of the COVID-19-related comp weakness stemming from lost morning daypart transactions (impacted by the decline in morning commuters). McDonald's 2020-21 core menu plans--including a U.S. launch of a premium crispy chicken sandwich, testing a McPlant burger in some markets, and McCafe bakery additions--should also help to keep near-term comps in the mid-single-digit range. We also expect positive contribution from its digital/drive-thru/delivery strategies, including an overhauled digital loyalty program (MyMcDonald's), increased drive-thru capacity (side-by-side lanes and third windows, utilization of Dynamic Yield menu board predictive ordering, and voice ordering), and examining hybrid first- and third-party delivery models in some international markets.

While it must contend with pandemic-related guest traffic pressures, aggressive industry promotional activity (limiting near-term pricing opportunities), and wage increases across many global markets, we believe McDonald's technology, value, marketing and franchisee advantages will allow it to sustain normalized low- to mid-single-digit system sales growth and high-single-digit operating income growth over longer horizon, implying operating margins improving to the mid-40s over the next five years.

Economic Moat | Nov 16, 2020

Nonexistent switching costs, intense industry competition, and low barriers to entry make it challenging for restaurant operators to develop an economic moat. Although McDonald's faces increased competition, an uneven macro environment, evolving consumer views about menu composition and in-restaurant experience, and pandemic-related changes in consumer behavior, we believe it possesses a wide economic moat. Our moat rating is based on a mix of structural and intangible competitive advantages, including a widely recognized brand, a franchisee system aligned on driving unit-level productivity improvements, and meaningful economies of scale. These qualities were instrumental in helping McDonald's to build the largest restaurant chain in the world (based on systemwide sales) and resulted in leading market share in most countries in which it operates, with the notable exception of China. McDonald's generated $100 billion in sales at its company-owned and franchised restaurants during 2019, representing almost 4% of the estimated $2.3 trillion global restaurant industry. This almost doubles Yum Brands' systemwide sales of $53 billion in 2019 (including Yum China) and dwarfs Restaurant Brands International ($34 billion) and Subway ($12 billion). We also believe these qualities will help McDonald's compete for market share ceded by smaller independents that are unable to survive extended periods of coronavirus-related restaurant regulation and guest traffic declines, though we acknowledge its recovery may be uneven due to its dependence on the morning daypart and reduction in morning commuters.

With strong brand awareness, consistent customer experience, convenient restaurant locations, and a uniform value-priced menu balancing core menu items with locally relevant options, McDonald's is among the few restaurant chains to enjoy success globally. McDonald's normalized average annual sales of around $2.5 million per restaurant trumps the quick-service restaurant industry average of just over $1 million per location. Additionally, we believe exterior and interior restaurant decor upgrades, more-efficient kitchen and drive-through 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) can assist with management's velocity growth plans and drive restaurant productivity metrics higher over an extended horizon.

Menu innovation has historically played an important role in enhancing McDonald's intangible asset moat source. Management has cited executional and complexity issues with its menu over the past several years, so we're encouraged by ongoing menu rationalization efforts, a more streamlined value menu offering, and efforts to better promote core menu items (including celebrity meal promotions in the U.S. in 2020). We view these decisions as prudent, but also acknowledge that future menu changes will require a careful balance between rationalization and incorporating local preferences, something that could take additional time and resources (capital, labor, data analytics) to fine-tune. To that end, we find management's three-prong approach to rebuilding guest traffic commendable. This includes: (1) a focus on family oriented products/experiences and the breakfast daypart to retain current customers; (2) convenience/value improvements to regain lapsed customers; and (3) an emphasis on coffee/snacking and operational consistency to convert casual customers (accentuated by stand-alone McCafe kiosk/pastry counters in certain locations). We're also intrigued by management's emphasis on creating a customer Experience of the Future flexible enough to accommodate the demographic, competition, taste, and franchisee permutations across its different operating regions while incorporating input from local and regional decision-makers. This is most apparent in McDonald's big five international markets (Australia, Canada, France, Germany, United Kingdom), where innovations in each country are establishing a blueprint for more sustainable growth across the entire system.

Although migrating innovations from international markets to the U.S. will take time to implement, given the company's size and industry competition, we're becoming more constructive about McDonald's opportunity to sustain comparable sales growth in the mid-single-digit range as it benefits from coronavirus-related closures across the restaurant industry. Our confidence stems from the recipe changes utilizing higher-quality ingredients and incremental labor investments and training, driving improved speed of service and order accuracy metrics and helping boost comparable sales in the U.S. and helping to improve McDonald's brand perception among consumers even before the successful launch of all-day breakfast, each of which reinforces our wide moat rating. While all-day breakfast exceeded management's expectations and helped to bring back guest traffic, we continue to believe the more important takeaway is that the program went from a single test market to nationwide rollout in just about six months. This implies McDonald's is overcoming its recent supply chain execution hurdles while demonstrating a greater level of coordination across the system, which we believe portends a more seamless rollout for new products (including the launch of a premium crispy chicken sandwich and testing a McPlant burger in some markets in 2021), promotions, and other in-store innovations in the future.

We've been encouraged by how much thought has gone into seamlessly integrating McDonald's mobile order and pay and plans for the Experience of the Future initiative, which will be rolled out across most of the U.S. system by the end of 2021 (aided by franchisee co-investment incentives). It's clear that management has put considerable time and resources into developing the platform to scale and adapt to evolving consumer preferences, including new kitchen configurations that can accommodate additional capacity from mobile/delivery orders (through partnerships with UberEats and DoorDash) and an innovative mobile ordering/payment platform that uses geofence virtual-perimeter technology to facilitate customers’ mobile order when they are nearing any U.S. location. Mobile order and pay capability has been rolled out at all U.S. locations and more than 8,000 locations across Canada, the U.K., and other international markets. While we don't expect the U.S. Experience of the Future rollout or mobile order and pay to have the same immediate impact as the all-day breakfast, we believe the combination of ordering flexibility (including counter, kiosk, web, and mobile ordering), menu customization (including the ability to custom-build burgers, chicken sandwiches, and salads), customer experience (including a blend of front counter, table service, and curbside delivery), and future loyalty program/targeted marketing opportunities will collectively have a more sustained impact than a platform like all-day breakfast, giving us comfort in our post-pandemic U.S. comparable sales targets in the mid-single-digit range.

McDonald's $300 million acquisition of personalization and decision logic technology company Dynamic Yield is also noteworthy from a strategic standpoint. Most of the headlines regarding the transaction are focused on the benefits to McDonald's drive-thrus, including menu suggestions based on daypart, weather, restaurant traffic, and purchase trends. With roughly 70% of U.S. sales coming from drive-thrus, Dynamic Yield's technology has clear average ticket implications, especially if it can deliver the 10%-15% lift in average revenue per customer that the company has cited in previous case studies. That said, we believe that there may be more significant upside as this technology is integrated into McDonald's kiosks and mobile app. Here, we believe McDonald's can drive more consistent transactions from existing customers while potentially lowering the acquisition cost for new and lapsed customers (via Dynamic Yield's reported reach of 600 million unique monthly visitors), potentially strengthening the brand intangible asset behind its wide moat. We also see two other potential positives from this transaction. One, improved personalization and targeted marketing capabilities has been a recurring theme among other high-frequency restaurant chains in recent years, and this move can put McDonald's several steps ahead of its QSR and specialty coffee chains as the industry continues to shift toward mobile order and delivery transactions. Two, Dynamic Yield has previously stated that it works with over 200 global brands, which could unlock new potential cross-marketing or other partnerships.

We also believe McDonald's solidified its position as a technology leader in the QSR space with the acquisition of Apprente, a voice-based conversational AI platform. The immediate focus of the Apprente team will be improving the customer experience at the drive-thru, which accounts for 70% of U.S. system sales, focusing on speed of service, order accuracy, and peak-hour throughput benefits. However, it's not hard to see McDonald's acquired technologies (which will be part of the new McD Tech Labs that will work closely with its Chicago Innovation Center) as also the foundation of Experience of the Future 2.0. McDonald's has spent several years modernizing its in-store experience, so it's not surprising that its 2019 acquisitions have focused on the drive-thru. However, we believe its acquired technologies offer other benefits, including improved in-store kiosk/mobile ordering functionality, comprehensive targeted marketing efforts, more flexible store labor models, and automated back of the house operations--each of which could benefit the brand intangible asset and cost advantage sources underpinning our wide moat rating. As the company has time to integrate and digest the data from its recent acquisitions, we would not be surprised to see new smaller-format, digital/drive-thru/delivery-oriented McDonald's restaurant formats developed in the years to come (something management alluded to at its 2020 investor day event).

While McDonald's full transformation will take time, we're comforted that the company's brand intangible asset moat source is backed by a cohesive franchisee and affiliate system, which collectively operated almost 93% of the chain at the end of 2019 and will likely own 95% over a longer horizon through additional refranchising efforts. This structure allows the company to expand its brand reach with minimal corresponding capital needs while providing an annuitylike stream of rent and royalties, even during challenging economic times. As a result, McDonald's currently generates returns on invested capital (excluding goodwill) in the high teens, with our model forecasting growth to the low 20s over the next five years. These results are even more impressive when considering that the firm owns 55% of the land for its restaurants (around $6.0 billion in land assets) and approximately 80% of the buildings for its restaurants, meaning that the returns are generated on a higher invested capital base than most franchised restaurant chains. We believe these assets provide an additional competitive buffer that most other restaurant firms cannot match.

We also appreciate McDonald's aspirations to be a more agile organization, particularly with respect to making more menu and marketing decisions at the local and regional levels. Although we consider McDonald's size and scale to be a key competitive advantage--the foundation of our cost advantage moat source--questions about the agility of its supply chain have surfaced in recent years, especially in a restaurant industry experiencing changing taste preferences at local and regional levels, a more pronounced consumer shift toward healthier foods, and some fast-casual players reaching critical mass (which we believe have captured a share of McDonald's previous middle- to upper-middle-income consumers). There have been instances when competitors have been able to bring new products to market more rapidly than McDonald's because of raw material procurement constraints, but we are hopeful that impressive speed-to-market for the all-day breakfast launch in the U.S. paired with localized menu decisions will help to alleviate some bottlenecks in the system and level the playing field somewhat.

Fair Value and Profit Drivers | Nov 16, 2020

We're raising our fair value estimate to $235 per share from $225 reflecting a modestly more optimistic near-term sales outlook due to management's new "Accelerating the Arches" plan focused on optimized marketing efforts, emphasizing the core menu, and doubling-down on digital, drive-thru, and delivery efforts. Our fair value estimate implies 2021 price/earnings of 27 times, enterprise value/EBITDA of 18 times, and a free cash flow yield of almost 3%, which is higher than historical norms but also reflects recovering fundamentals throughout 2021.

Based on third-quarter trends, our model now assumes a 7% decrease in systemwide sales growth during 2020--up from previous forecasts calling for an 8% decrease--as the contribution from 350 net new restaurant openings worldwide is offset by a 10% decline in global comps. Our model calls for a nominal comp increase in the U.S. segment, 14% decline in the international operated markets segment, and a low-double-digit decline in the international developmental licensed segment.

Management's various marketing, menu, and digital/drive thru/delivery initiatives give us confidence in average annual systemwide sales growth of almost 8% from 2021-25, putting our estimates slightly ahead of guidance calling for mid-single-digit system sales growth in 2021 (versus the $100.1 billion posted in 2019) and mid-single-digit growth again in 2022. We also expect average annual unit growth of 2.5%, weighted toward international markets and the back half of our five-year forecast period (incorporating guidance calling for 1.5%-2.0% unit growth in fiscal 2022). We still see consolidated comp growth in the mid single digits as a realistic goal over the next five years through new menu innovations, digital/drive-thru/delivery efforts, and inflationary price increases.

We believe coronavirus-related store closures and franchisee investments will result in a high 20s decline in adjusted operating income in 2020, implying 35%-36% operating margins for the full year (versus 38% a year ago). We expect company-owned restaurant margins will decrease by 270 basis points to 14.9% in 2020, due to coronavirus-related expense deleverage, elevated payroll costs, and other investments. Over the next five years, our model assumes consolidated restaurant margins rebound and remain between 17% and 19% because of increased operating leverage, with adjusted operating margins moving to the mid 40s due to the impact of sales leverage and SG&A optimization.

Risk and Uncertainty | Nov 16, 2020

Restaurant chains are susceptible to cyclical headwinds, including increased consumer unemployment rates and commodity, labor, and occupancy cost volatility. We expect QSR companies including McDonald's, Restaurant Brands International, Inspire Brands, Chick-fil-A, and Yum Brands, to increasingly compete against one another on price and product differentiation while also facing encroaching competition from fast-casual chains. If competition were to cause a decline in restaurant productivity metrics, it could signal impairment of the McDonald's brand intangible asset and negatively affect its intrinsic value. On top of competitive pressures, McDonald's must also strike a balance between growth initiatives and unit-level profitability, which can occasionally result in tension between management and its franchisees.

With 60%-65% of total operating profits coming from outside the U.S., McDonald's is sensitive to economic fluctuations across the globe, including currency movements, minimum wage hikes, and negative publicity tied to food quality concerns. Additionally, we believe the company will face more intense competition from earlier-stage rivals as they develop scale and expand. We also expect coronavirus-related restaurant closures and changes in consumer behavior will have a lasting impact on the industry and drive operating volatility.

While its size affords McDonald's scale advantages, questions about the agility of its supply chain have occasionally surfaced as it has expanded. Although we agree with management that the company possesses an "infrastructure positioned for growth," there have been instances when rivals brought new products to market more rapidly because of McDonald's raw material procurement constraints. We are starting to see signs of improved speed to market through better communication with its key vendors and franchisees and giving local and regional decision-makers more autonomy but believe further supply chain improvements are possible.

Stewardship | Nov 16, 2020

The termination of Steve Easterbrook as McDonald's CEO in November 2019 was a surprise, but we ultimately believe that current CEO Chris Kempczinski is well positioned to lead the company. Easterbrook, who separated from McDonald's "following the board's determination that he violated company policy and demonstrated poor judgment involving a recent consensual relationship with an employee," had been instrumental in the company's turnaround efforts since 2015. This includes a successful global segment reorganization, refranchising more than 4,000 locations, and eliminating $500 million in annual SG&A expenses. During that period, McDonald's also undertook several "velocity growth accelerators," including (1) an Experience of the Future layout, which features a combination of ordering flexibility, customer experience, and a more streamlined menu; (2) mobile ordering and payments; and (3) delivery alternatives.

When Easterbrook was appointed CEO in January 2015, he was also tasked with adding outside perspectives that would help to develop new growth strategies that capitalized on McDonald's key strengths: its brand, its franchisees, and its scale (also the key components behind our wide moat rating). Kempczinski was one of key hires during this period, joining McDonald's in September 2015 as executive vice president of strategy, business development and innovation following leadership positions at Kraft and Pepsi. Kempczinski had been actively involved with the velocity initiatives--including digital and delivery--and worked with franchisees to adopt these platforms since becoming the head of McDonald's U.S. in January 2017. We also believe Kempczinski's focus on menu innovation (including the rollout of fresh beef burgers), restaurant operations, and international expertise (from his time at Kraft) make him a strong CEO.

We've assigned McDonald's a Standard equity stewardship rating based on past execution struggles--most notably the inability to keep pace with evolving consumer tastes and a competitive global restaurant landscape--but we would consider an Exemplary equity stewardship rating if Kempczinski can capitalize on new "Accelerating the Arches" growth plans while maintaining its commitment to returning cash to shareholders. We like that McDonald's capital-allocation plans continue to balance global expansion efforts, reinvesting in new restaurant openings/renovations/technologies, and returning cash to shareholders. This includes capital structure optimization efforts, refranchising activities outside the U.S., and selling, general, and administrative cost reductions, which could lift longer-term shareholder returns. We're also encouraged that top executives are expected to hold a multiple of their individual base salary in company stock, which provides them with incentive to increase shareholder value. With 10 nonexecutive board members out of 11, we view the board as sufficiently independent, though we would prefer additional outside perspective and declassified terms.