Legendary investing guru Warren Buffett (Trades, Portfolio) has often said, "It's far better to buy a wonderful company at a fair price than a fair company at a wonderful price."
McDonald's Corp. (MCD, Financial) is a wonderful company that I believe is currently trading at a fair price. While the guru does not hold the stock today, Berkshire (BRK.A) (BRK.B) owned a large position in the 1990s and Buffett has said he regrets selling the stock.
Company overview
The company is a leading franchisor and operator of fast casual restaurants globally with roughly 41,822 locations across more than 100 countries. Roughly 95% of McDonald's restaurants are franchised, though the format varies across locations.
Approximately 55% of the company's locations are operated under a conventional license, in which the franchisee is responsible for investment in equipment and operating the restaurant. Franchisees receive operating profits from the locations they own. McDonald's is responsible for the building and real estate and collects rent and royalties from the franchise operators.
Approximately 20% of the company's locations are operated under a development license. Under this arrangement, the franchisee is responsible for investments in equipment, buildings and real estate. McDonald's receives royalties from these operators, but does not receive rent and does not own the real estate for these locations.
Roughly 20% of its locations are operated under the foreign affiliated model, which is similar to the development license model. But McDonald's also receives equity in earnings based on the company's ownership percentage of these locations.
Finally, the remaining 5% of locations are fully owned and operated by McDonald's.
While the company generates a significant portion of its revenue from company-owned locations, the vast majority of its profits are derived from franchised locations as operating margins are very high in this part of the business.
High-quality business model and competitive advantages
One of McDonald's biggest competitive advantages is its strong global brand, which consumers have grown to love and trust. Additionally, the company benefits from its massive scale. As one of the largest restaurant operators globally, it is able to benefit from economies of scale. Key benefits include strong negotiating power with suppliers, global advertising capabilities, best-in-class operational know how and significant capital resources for research and development and other efficiency initiatives.
While the company operates a significant number of restaurants, the profit engine is really the royalties and rent income it receives from franchisees. The result of this business model is that McDonald's is able to capture the most valuable part of restaurant business value chain while having less exposure to more volatile operating results. Additionally, it also benefits from a recession-resistant business which has allowed the company to enjoy steady cash flows even during economic downturns.
Evidence for the high-quality nature of McDonald's business model can be seen in its high profit margins and ability to consistently generate very high returns on invested capital.
Growth prospects
In addition to being a high-quality recession-resistant business, McDonald's also has solid growth potential. The company expects to accelerate the pace of new restaurant openings to between 4% and 5% and plans to reach a total system restaurant count of 50,000 by 2027, up from roughly 41,822 currently. New restaurant openings are expected to contribute 2% growth to 2024 total system sales and 2.50% annually over the long term.
In addition to sales growth driven by new restaurants, McDonald's believes it can improve operating margins going forward. For 2023, the company reported adjusted operating margins of roughly 47% and expects to improve them after 2024.
Consensus estimates currently call for the company to grow revenue by mid-single digits over the next few years. Earnings per share is expected to grow by a high single-digit percentage over the next few years. Given the company's plans to accelerate new restaurant development and improve operating margins, I view these targets as conservative given the company has grown adjusted EPS by a nearly 9% annual rate over the past decade.
Reasonable valuation
Currently, McDonald's trades at roughly 21 times consensus 2024 earnings per share. Comparably, the S&P 500 trades at roughly 22 times consensus 2024 earnings. Thus, McDonald's is trading at a market multiple.
Historically, the S&P 500 has grown earnings at a high single-digit annual rate and thus, I believe that over the medium to long term, McDonald's has similar growth prospects to the broader market. That said, I still believe the stock could trade at modest premium valuation relative to the broader market given the recession-resilient nature of the business. The stock's historical beta serves as evidence of the fairly defensive nature of the company's business. Over the past 10 years, McDonald's has realized an average three-year rolling beta of roughly 0.62.
In addition to trading at a reasonable valuation versus the broader market, the stock is also trading at a reasonable valuation in comparison its own historical norm. Over the past 10 years, the stock has traded at an average forward price-earnings ratio of roughly 26, which is well above the stock's current forward price-earnings ratio of 21.
The company has been a fairly aggressive repurchaser of its own stock. For 2023, it repurchased roughly 11.11 million shares for $3.10 billion, implying an average purchase price of roughly $279 per share, which is modestly above the current share price. This activity suggests to me that management views shares as reasonably attractive at current prices.
Risks to consider
One key risk to consider is the potential for GLP-1 weight loss drugs to lead reduced consumption of some key products sold by McDonald's, such as soft drinks or french fries. While increased usage of GLP-1s has not significantly impacted McDonald's business so far, the ultimate impact remains highly uncertain.
Another key risk to the bull case is that the company experiences brand issues in certain countries due to stance or lack of stance on certain political issues. McDonald's recently drew criticism in Arab countries after franchises in Israel began offering discounts to soldiers. While the company was quick to point out this was an individual and private act by the franchisee, it did little to fix the fallout in Arab countries. In an attempt to stabilize the situations, earlier this month, McDonald's announced a deal to acquire all of its Israel franchise restaurants. While the impact from this event is relatively limited, there is potential for other more significant political issues to emerge, which may result in brand challenges for McDonald's globally and risk alienating certain customer groups various parts of the world.
Conclusion
McDonald's is a wonderful company with a long history of delivering solid results to shareholders. The company benefits from its strong global brand and massive scale, which allows it to enjoy certain competitive advantages.
While the company owns a small percentage of its restaurants, the majority of its income is generated from its asset-light franchise business model. McDonald's has historically generated very strong returns on invested capital, which I expect to continue going forward.
While the stock is not cheap, I believe the valuation is reasonable compared to the broader market given the relatively defensive nature of the business and its solid growth prospects. Moreover, the stock's valuation is also reasonable relative to its own historical averages.
For these reasons, I believe McDonald's is a wonderful company trading at a fair price and thus represents a solid investment opportunity.
