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Economy, Stocks  | March 28, 2019

Shares of fast food titan McDonald's Corporation (MCD) continue to have a stellar year, vastly outperforming the S&P 500. With shares near all-time highs at $187 per share, the stock has reached a valuation that is significantly higher than its historical norms. While we like the company's move to a more profitable business model, organic growth can be difficult to come by in the years ahead. In addition, the balance sheet is becoming stretched. With such a lofty valuation, we feel that the stock is bound for range-bound trading over the coming years as the company's intrinsic value catches up to the share price.

Becoming More Cash Flow-Efficient

McDonald's has been steadily re-franchising its stores over the past several years. Revenues have dropped in favor of higher profitability and a much more asset-light business model.

This has made the business much more "efficient" at generating free cash flow. The company's conversion rate of revenue to free cash flow has soared from 15% (already a good rate) to just over 20%. By franchising its stores, McDonald's becomes a virtual branding and real estate company. The company feeds its intellectual property and brand to franchisees, while the franchisees incur most of the overhead and costs of running its stores. In addition, McDonald's charges back royalties and rent fees in exchange for its resources.

Distributing Cash To Shareholders

Generating cash flow so efficiently has allowed the company to be very generous to its shareholders. McDonald's is a Dividend Champion with 43 consecutive years of raising its payout. The most recent dividend raise of 14.9% is a further sign of management's commitment to rewarding investors.

Additionally, McDonald's has been very aggressive in using stock buybacks to push EPS growth. The company has ramped up its buyback programs over the past five years, spending billions of dollars over that time frame. The share count has dwindled to just 765 million from almost a billion five years ago. This has played a huge part in boosting the company's EPS.

If we take approximate EPS (2018 net income of $5.924 billion / 765 million shares) of $7.74 and strip out the buybacks (divide by 1 billion shares instead), the EPS today would only be $5.92. Based on the current P/E ratio, this would mean a stock price of $143. Although these are rounded estimates, it illustrates how much of an impact buybacks can have on a stock.

Cash Distributions Aren't Sustainable

The problem that begins to stand out with this is that this spending pattern isn't sustainable for McDonald's over the long term.

We can see that for some time, management's spending has easily outpaced the company's organic cash flows. The dividend alone eats up roughly 77% of cash flows, meaning that these tens of billions have largely been executed by taking on debt. The problem with this strategy is that this is short-sighted decision making. Shareholders are happy with the cash benefits, but the business eventually becomes bogged down with a levered-up balance sheet.

This process has advanced over the past five years, with McDonald's doubling its total debt over the past five years. The company now carries a cash-to-debt ratio of 35:1, and the balance sheet is levered at 3X EBITDA. This is beyond our benchmark of 2.5X that indicates a company is beginning to take on too much debt. While McDonald's size and cash flow will buoy the company, even with this much debt it's becoming clear that this drastic level of borrowing cannot go on for much longer. This will ultimately put pressure on the company to grow organically - not just to pay down the balance sheet, but to move EPS higher without the help of large buyback programs.

Where Is This Growth Going To Come From?

This challenge becomes the long-term headwind that investors face in McDonald's. The company is certainly stable, and the cash will continue to come in (people will always eat at McDonald's). However, it becomes more difficult to make the leap from "stable" to "outperformance".

The company's comparable store sales have been largely driven by pricing rather than true foot traffic. Traffic growth has wavered back and forth between -4% and +2% yearly, and is virtually even over the past several years. In fact, 2018 marked the first time since 2012 that global guest count growth was positive two years in a row. This places the onus of growth primarily on the company's ability to milk more from each transaction. This has largely worked for some time, as comparable sales have been growing at a low- to mid-single digit rate consistently.

This growth pattern is what can enable McDonald's to consistently deliver to investors over the long term. Ideally, the company can manage 0-1% traffic growth, 2-4% pricing growth, and increase the store count by 1% every year. If the company can grow by 4-6% annually and buy enough stock to boost EPS another 2%, the stock's earnings can grow 6-8%.

This scenario represents an approximate "peak performance" level for McDonald's over the long term. The company doesn't have the financial resources to artificially accelerate EPS growth rapidly like it has in the past. Given that even ideal operating results equate to modest EPS growth, valuation is ultimately important for investors. This is where the real danger comes into play.

The Dangers Of P/E Compression

We have briefly mentioned P/E compression in this article. Let's flesh this out to illustrate the specifics and to chart a course of action moving forward. Below are analyst estimates for the upcoming/current fiscal year, as well as 2020 and 2021.

Based on the current price of approximately $187 per share, the stock is trading at the following earnings multiples:

  • FY 2019 EPS: 23X
  • FY 2020 EPS: 21.5X
  • FY 2021 EPS: 20X

Over the past 10 years, McDonald's stock has traded at a median P/E ratio of 18.27X earnings. In other words, the stock is currently above historical valuation levels, even if you extrapolate out three years of earnings growth.

It is almost a certainty that McDonald's will retreat from these current valuation levels. The company's decade-long median P/E ratio is a reflection of an almost completely bullish stock market and years of excessive buybacks pumping up growth. The long-term 6-8% growth the company will generate doesn't justify such a premium valuation.

So, What Is A Reasonable Price?

The tone of this article reflects bearish sentiment on McDonald's. We must emphasize that we like the company's business model. However, there is a large disconnect between the state of the business and the valuation of its stock.

Given the stretched balance sheet and the limitations it will eventually put on management's buyback policy, we view a P/E ratio of 16X-17X earnings as a reasonable vantage point. This would assign a target price of $129-137 per share to the stock.

Wrapping Up

McDonald's transformation into a high-margin, asset-light business is attractive from an investment standpoint. The company's massive scale, brand power, and history of innovation give it continued staying power in a competitive industry. However, the large gap between the fundamentals of the business and the price of the stock are red flags to us. For those reasons, we cannot consider McDonald's at this time.

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