McDonald's Corp. (MCD, Financial) released its fourth-quarter 2023 earnings report on Feb. 5, causing a sell-off. And yet, at the time of writing, the stock was up 5.50% on a three-month basis even after a 3.73% drop.
When we zoom out even further, the stock is up more than 200% over a 10-year period. The earnings drop could be justified as a mere technical retracement and profit trimming. Indeed, there is nothing in the earnings report that could directly or indirectly point to corporate mistakes or strategy errors. My investment thesis is the share price is now at an interesting entry point for prospective investors who missed the end of year stock rally given the unjustified stock drop, the attractive forward valuation, the new CosMc concept and the exciting implementation of artificial intelligence in the business.
Pullback Due To Earnings: An Opportunity To Jump On The Trade At The Last Hour
Let us dive into the reported earnings. The earnings per share (EPS, which is the company's profit or net income per outstanding share) beat the Street's expectations by $0.13 to reach $2.95. This is an impressive 18% year-over-year (YoY) increase, especially for a corporation this large. The reason for the stock drop was the revenue disappointment: revenue missed expectations by $40m. That is a 0.6% miss considering the $6.41B revenue (up an impressive 8.1% YoY as well). Wall Street can be picky and the markets don't forgive even a slight miss. As mentioned, the miss is minimal from a quantitative perspective and couldn't possibly justify the erasal of $6bn of market cap; the nature of the miss may actually be of greater concern. Indeed, McDonald's is an international business with presence all-over the globe. Its ability to adapt its menus to local cultures has truly been the key to the business expansion on all continents, and support the continued growth of the company. Therefore, events outside of the U.S. could potentially have material impacts on the financials. When I looked into the quarterly same-store sales figures in the various regions, the U.S. saw an increase of 4.3% versus 4.45% expected while for the international figure the expectation was higher (4.79%) and missed severely by attaining only 3.4%. The international sales miss is what caused the stock to drop, and the main point of concern is the reason for international sales to drop: the situation in the Middle East, in particular the Israel-Hamas conflict.
McDonald's Israeli franchisee caused large controversy on social media after announcing its plans on Instagram to provide thousands of free meals to Israeli soldiers amidst the conflict with Hamas. The announcement was surprising because McDonald's has shown neutrality in conflicts over the years, key to being able to implement itself all around the globe with over 41,000 locations in more than 100 countries. The decision caused large boycotts in Muslim countries with large populations and growing markets, namely Malaysia and Indonesia. The boycott waves reached one of the largest and most profitable market as well, France.
The markets sold off the stock for a reason that is, in my opinion, a short-term circumstance and a short-lived event. Even if the boycotts were to continue, there is limited downside as it is unlikely they would intensify going forward (the peak of the boycotts were the days following the controversy). More importantly, McDonald's revenue depends less on its food sales than its real estate business and therefore, further downside from boycotts are mitigated. Harry J. Sonneborn, an early insider in McDonald's, once said, “We (McDonald's) are not technically in the food business. We are in the real estate business. The only reason we sell fifteen-cent hamburgers is because they are the greatest producer of revenue, from which our tenants can pay us our rent.”
McDonald's is a real estate business first and foremost. Out of the 41,000 plus locations I mentioned earlier, only slightly over 2,000 are operated by the company itself (the remaining ones are operated by franchisees). The company provides the franchisees with the product that the latter will sell to pay the rent to the company. Rental income in 2021 exceeded one third of the total revenue and represented the main source of revenue of the fast-food chain. This is the real moat of the business in relation to its competitors. The premium valuation reflects the quality of the business.
A great business with an attractive outlook reflected by a rich valuation
Compared with the wider fast-food industry, where competitors like Yum Brands (YUM, Financial), Chipotle (CMG, Financial) and Starbucks (SBUX, Financial) operate, McDonald's is rather richly valued. Based on trailing multiples, the stock keeps getting valued more and more richly over time.
Source: TIKR.com
Ten years ago, the stock was valued at a total enterprise value of less than 4 times last 12 months revenue and around 10 times Ebitda. We are now at around double, meaning the stock has become twice more expensive than a decado ago. The reason for the growing valuation lies in its moat we discussed earlier. The company has successfully managed to mitigate the cyclical nature of its food business by the fixed part of revenue coming from the rental income of its franchisees. The company's growth prospects have also improved over the years, leading to a premium valuation on the multiples of revenue, Ebitda, earnings and free cash flow, which are all above the sector median.
Source: TIKR.com
The rich valuation is, in my opinion, also justified by exciting innovations. McDonald's has launched a new concept that has been implemented in a few locations in the U.S. and is named after a little-known mascot of the company from the 1980s: CosMc. This new chain, CosMc, is focused on beverages and snacks and clearly aims to become an undeclared competitor to Dunkin' Brands (DNKN, Financial) and Starbucks. The latter has been repeatedly criticized amidst a high inflationary environment to hike prices in an unbearable manner. CosMc has proven to be a huge success in its first open locations: the store has seen the triple amount of visitors per square foot than an average McDonald's restaurant.
Last but not least, another exciting innovation is underway with regard to artificial intelligence. McDonald's announced in December a partnership with Alphabet's (GOOG, Financial) Google to gradually roll out an AI system throughout 2024 in the U.S. For now, the project is rather secretive with little publicly available information on the project. McDonald's has so far only declared that the aim is to provide to its customers “hotter, fresher food” and help managers “quickly spot and enact solutions to reduce business disruptions”. We can assume the AI system will help with orders, perhaps faster processing of orders and also in some ways cover for missing staff. It is not impossible that the implementation of AI could reduce the number of employed workers, leading to increased profitability. These innovations are still in the implementation phase and their positive impact could take months or even years to be reflected in the financials. What is certain is the revenue growth prospects and earnings per share growth estimates continue to improve, as shown below.
CosMc and AI are likely to boost revenue growth with a significant outperformance relative to the trendline.
The earnings per share is also expected to outperform the 10-year trendline.
These events could invalidate my bull case
Despite these great prospects and the fundamentals, my bullish case could be invalidated if McDonald's turns too political. Indeed, the business has been able to expand its presence, making it an unmatched brand - except perhaps by Yum's KFC - because of its ability to adapt to local cultures and consistently brushing off any involvement in geopolitical discussions.
Additionally, the new CosMc pilot project and the Google AI partnership are too uncertain to model any increase in cash flow projections in 2024. If they turn out to not be profitable, one or both projects could be a source of increased expenses in 2024.
Bottom line
McDonald's is a great business that is valued at a premium to the restaurant industry. In my view, the earnings do not justify the drop the stock has suffered, and therefore presents an excellent opportunity to initiate a position or continue accumulating shares. Despite the cyclical nature of the business, the continuous growth of the number of franchisees and the rental income stemming from them provide a reliable base to the financial health of the company. Exciting pilot projects like CosMc and the Google AI partnership provide comfort that the stock will likely continue being valued richly and the business will continue growing in the years to come.
