POST OF THE DAY
Liquid Lounge
McDonald's

Format for Printing

Format for printing

Request Reprints

Reuse/Reprint

By Mithrophon
February 2, 2006

Posts selected for this feature rarely stand alone. They are usually a part of an ongoing thread, and are out of context when presented here. The material should be read in that light. How are these posts selected? Click here to find out and nominate a post yourself!

I suspect that most people assume the MCD investment case is pretty much played out. After all, the stock has been a huge winner and really, how much better can the U.S. operations get? I'm making the somewhat contrarian argument that MCD stock still has good upside from here.

McDonald's Path to Higher Earnings and Multiple Expansion
1) Fix the U.S.
2) Fix Europe
3) Allocate capital wisely
4) Re-franchise company-owned units
5) Demonstrate Chinese growth potential
6) Grow total number of restaurants

1) Done. 32 consecutive months of positive comps. Since 2002, operating margins are up from 30.9% to 44.5% and sales have risen 28%, while total number of U.S. restaurants grew only 1.8%.

2) Underway, but still early. 22 of the past 30 months have seen positive comps, vs. only 6 of the prior 30 months. Current margins are 29.0%, and I think 33%+ is doable.

3) The cutting of capex and increasing of the dividend have been well documented. However, $1.2 billion in 2005 share repurchase did nothing but offset options (which primarily came into the diluted share count via the treasury method of accounting as the stock rose). 2006 should see the beginning of significant share count reduction, and I expect $3.5 billion of share repurchase through the end of 2007.

4) Management addressed this issue in the latest earnings call, announcing that 1500 of their company-owned units with either low returns or limited-growth locations will likely be sold over the next 3 years to various existing market-level franchisees. In this set-up, the franchisee will own the land and fixtures, paying MCD a fee (4%-5% of sales) for use of the brand. This should reduce SG&A by some amount (with little data I'm estimating between $45-$110 million), adding ~$0.03-$0.07 of ongoing EPS (netted against MCD taking a $600 million loss on the original investments in these lower return units). Significant additional re-franchising should occur once the British and German markets improve.

5) MCD has been very deliberate about expansion in China as they feel the infrastructure doesn't support rapid growth without risking food quality/safety issues. I believe MCD is making long-term investments timed to highlight the real unit-growth potential of this market in conjunction with the Beijing Olympics.

6) No one is talking about MCD unit expansion, but with total system restaurants only up from 31,108 in 2002 to 31,886 in 2005 (0.8% annual growth), the company will have an additional trench of revenue growth at some point in the future. Management already acknowledges pent-up demand in many parts of the U.S., and once European operations and Chinese infrastructure issues are fixed, I expect this to become a broad theme.

Certainly as U.S. investors, we're most cognizant of the domestic turnaround, and that lever has already been pulled. I expect MCD's record comp streak to come to an end, which could put pressure on the stock. But overall there are many remaining drivers for sales growth, margin expansion, and a higher multiple. McDonald's generates a high-quality stream of earnings, deploys cash smartly, and has an enormous economic moat. I think the stock is going into the $50's over the next 2-3 years.


Become a Complete Fool
Join the best community on the web! Becoming a full member of the Fool Community is easy, takes just a minute, and is very inexpensive.