McDonalds recently released their second quarter result announcing $6.1 billion revenue for the quarter and a 6.1% increase in comparable sales. At $59.77 McDonalds is trading at the upper end of their 12 month range ($46.64 – $63.69) and are currently rated a buy or strong buy by 11 of 17 analysts aggregated by Yahoo Finance.
We have assumed McDonalds revenues will grow to $25 billion in 2010 representing an annualised growth rate of 3.14% over the next three years. This growth will be driven by a combination of organic growth of existing stores and the ongoing opening of new stores.
EBITDA margins are projected to grow from 31.5% in 2008 to 33.5% in 2010 reflecting Mcdonalds’ strategy of focusing on franchised and affiliate stores. “Margins” derived from franchise operated stores for the first half of 2008 averaged 81.9% versus 17.1% for company operated stores. McDonalds re-franchised 300 stores in the first half of 2008 and plans re-franchise 1,000 to 1,500 by 2010.
We have assumed a constant capital expenditure of $2 billion per annum over the next three years consistent with McDonalds’ 2008 guidance. In 2008 this capital expenditure will be split 50/50 between the opening of 1,000 stores (net 600 stores) and reinvesting in existing stores.
A WACC (discount rate) of 8% has been used and terminal growth rate of 3% has been applied to McDonalds ongoing cash flows beyond 2010.
Our analysis incorporates the cash and debt on the MCD balance sheet – Valuecruncher calculates a net debt number.
Our analysis gives a valuation of $62.50 per share which is 4.6% above the current share price of $59.77.
The current share price is consistent with our analysis but McDonalds faces a number of challenges that limit the share price’s upside potential. These challenges include:
- Pressure on margins from increased food and labour costs (e.g. chicken and beef costs are expected to increase by between 5% and 9% in 2008) are ongoing issues facing the industry.
- Sustaining U.S. sales growth is a challenge in an extremely competitive industry exposed to changing customer tastes. Growth drivers in the key U.S. market have been chicken, breakfast, beverages and convenience. The breakfast and beverage markets are extremely competitive as major industry participants see this as a key growth area in a saturated restaurant market.
- International expansion in markets such as China and Russia has been a key driver in McDonalds growth with over 50% of the company’s operating income being derived outside the U.S. in the first half of 2008. The reported growth of McDonalds international business has been amplified by currency movements. Adjusting for currency movements McDonalds revenues decreased slightly in the first half of 2008. The company’s share price is exposed to currency movements (approximately 50% of the company’s debt is denominated in foriegn currencies) and dependent on maintaining their strong growth in international markets.
- McDonalds sees itself primarily as a franchisor and a key driver in our projected margin expansion is the focus on re-franchising restaurants. This re-franchising and the continuing opening of new stores rely on the economic viability of the individual restaurants. A potential economic slow-down and cost inflation will impact on the viability of the individual stores flowing through to both the revenue and margin growth assumptions.
With over 31,000 stores worldwide and approximately $63.5 billion in total system sales in 2007 McDonalds is the global leader in convenience restaurants that won’t be disappearing anytime soon. This scale combined with McDonalds plans to return $5.6 billion to $7.6 billion to shareholders over the next 18 months may make the company a safe haven despite the “limited” upside share price potential.