Recession-Resistant McDonald’s Offers Attractive Restaurant Exposure Amidst Tough Times

Business Strategy & Outlook:

As the leader in global food-service sales, McDonald’s is taking adequate steps to adjust to an evolving competitive landscape, leveraging its scale to invest heavily in digital acuity and menu innovation en-route to compelling unit economics. A turbulent couple of quarters amidst a quickly deteriorating macroeconomic environment (and a stubbornly persistent global pandemic), and encouraged by management’s vision for the business, which should enable McDonald’s to maintain its edge. The firm has widely embraced customer centricity and technological prowess since its 2015 turnaround, and while the processes have evolved since then, the firm’s focus on the customer experience has not. Recent initiatives, including the loyalty program launch, a large breast chicken sandwich line, and test-marketing a McPlant burger, attest to a more finely tuned sense of market demands. Though the velocity growth plan laid the groundwork for better products and unit-level performance, that management’s new “Accelerating the Arches” framework better capitalizes on the firm’s cost advantages in marketing and technology investments. The plan focuses on a unified marketing approach, a commitment to the core menu, and an emphasis on the three D’s: delivery, digital, and drive-thru.

With nearly a third of orders now coming through digital channels, that the pivot is warranted and see long-term upside through labor efficiency, improved order accuracy, and suggestive selling, particularly following a year that saw mid-teens labor cost inflation in the industry. With the notoriously slow-moving restaurant industry forced to make widespread investments in technology in 2020 and 2021, omnichannel ordering capabilities to become a required offering from larger players. McDonald’s mobile application, loyalty program, and recent efforts toward order automation and suggestive selling represent steps in the right direction, with customization, targeted promotions, and increased penetration of the delivery channel offering alluring opportunities to the operators able to get ahead of the curve.

Financial Strengths:

McDonald’s financial strength as sound, with the firm maintaining an investment-grade credit rating and reasonable leverage relative to its competitive set. Debt/EBITDA clocked just north of 3 turns at year-end 2021 (within the long-term guidance range of 3-3.5 times). Solid free cash flow generation (averaging 42% of revenue through 2024) and high EBIT coverage of interest payments (nearly 8 times for 2022) should be more than sufficient to meet near-term obligations while leaving investment plans and dividends untouched. While they acknowledge differences in financing philosophies with private equity ownership, McDonald’s sports substantially lower leverage than Restaurant Brands International and Yum Brands, two of its largest peers in the QSR space, which operate with around 5-6 times debt/EBITDA. The company’s commitment to maintaining an investment-grade credit rating strikes us as prudent, with corporate strength tending to correspond to more attractive franchisee borrowing rates (and increased unit-level profitability), bolstering the brand intangible asset. Finally, the firm maintains substantial cash flow flexibility, with clearly demarcated priorities of growth capital investment, payment of common stock dividends, and share buybacks. The forecasted total returns to shareholders of $19.9 billion between 2022 and 2024 and recognize that $6.5 billion in modeled share buybacks during that period provides a healthy cushion that could easily be repurposed to meet debt service or pursue attractive investment opportunities. With stability of cash flows driven by an increasingly franchised model and well-matched future minimum rent receipts and debt service payments.

Bulls Say:

With 65% of global stores featuring a drive-thru and more than 80% of stores offering home delivery, McDonald’s is well positioned to take advantage of evolving ordering habits.
Technological investments and the ongoing rollout of the firm’s loyalty program leverage McDonald’s scale and could positively drive average check and brand affinity.
As the low-cost operator in the space, input cost inflation and consumer pressure offer McDonald’s a chance to gain share in key markets.

Company Description:

McDonald’s is the largest restaurant owner-operator in the world, with 2021 system sales of $112 billion across more than 40,000 stores and 119 countries. McDonald’s pioneered the franchise model, building its impressive footprint through partnerships with independent restaurant franchisees around the world. The firm earns more than 60% of its revenue from franchise royalty fees and lease payments, with the remainder coming from company-operated stores across its three core segments: the United States, internationally operated markets, and international developmental/licensed markets. McDonald’s owned 55% of the real estate and 80% of the buildings in its franchise system as of the end of 2021, offering it substantial leverage in maintaining quality standards and consistency.

(Source: Morningstar)

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