McDonald’s: Betting On The Fastest Expansion Phase In The Company’s History (NYSE:MCD)

Thesis Introduction

Over the past few months, I have gradually warmed up to the idea that McDonald’s stock (NYSE:MCD) deserves a “Buy” rating. Compared to my previously held “Equal-weight” thesis, which has been published in February 2023, there were two major variables that prompted my rating reassessment: Firstly, I acknowledge that rates are slowly falling, with markets pricing about 150 basis points worth of rate cuts through 2024. If the consensus trading projection is correct, than the lower rate environment would take off pressure from valuation concerns. Secondly, I understand that the McDonald’s franchise may have significant untapped penetration upside in emerging market in LATAM and APAC. In fact, by end of 2023 McDonald’s management projected plans for the fastest stores expansion in the company’s history, aiming to open 10,000 new stores by 2027. On that note, I highlight that McDonald’s growth is highly value accretive to investors, with McDonald’s operating on negative book value and generating about 29 cent of free cash flow for every incremental dollar of revenue, most of which is distributed to shareholders. Adjusting my numbers for cost of equity and EPS growth projections, I update my EPS estimates for McDonald’s through 2026; and I now calculate a fair implied share price of about $317.

For context: Since the start of the year 2024, McDonald’s’ stock performance has been relatively weak, with shares under performing the broader U.S. equity market. In fact, YTD McDonald’s shares have gained only about half a percent, compared to a value appreciation of about 6.7% for the S&P 500 (SP500).

McDonald’s: Still A Growth Story

I am increasingly gaining confidence in the assessment that McDonald’s international expansion may have further upside ahed, despite the fast food chains already established global position. During McDonald’s most recent Investor Update (dated December 2023), management outlined strategic initiatives to super-charge its global momentum and increasing market share. Specifically, the update highlighted annual compounded store growth expectations of approximately 4% in 2024 and between 4-5% for the years 2025 to 2027. In absolute numbers, McDonald’s projects to open approximately 10,000 new stores worldwide by 2027, of which about 900 locations are planned in the US, about 1,900 in the International Operated Markets (IOM), and roughly 7,000 in the International Developmental Licensed markets (IDL), with over 50% of these openings planned for China. If McDonald’s growth target would be achieved, I point out that the next 4-5 years would mark McDonald’s most rapid expansion phase in the company’s history.

Conceptually, McDonald’s aggressive internationalization push is supported by penetration data: I point out that across the United States McDonald’s currently operates on a people to outlet ratio of approximately 25,000 to 1. And while this number jumps to about 45,000 – 60,000 to one for Western Markets like France, United Kingdom and Germany, it surges to 280,000 and 2,900,000 for China and India, respectively. Admittedly, the increased exposure to China may be a risk for McDonald’s, mostly due to geopolitical rather than cultural concerns. On that note, however, investors should consider, that McDonald’s operates quite successfully in China already. Moreover, McDonald’s strategy will anchor on a franchise system, which transfers most of the commercial risk to the franchise operator.

Meanwhile, McDonald’s membership in the active loyalty program is projected to surge to 250 million by 2027, generating $45 billion in system sales, up from the current 150 million members and $20 billion as of 2023. On that note, McDonald’s aims for a sharper focus on personalization, leveraging its extensive customer data for more targeted promotions. This improved target backdrop may be particularly useful in the context of a weaker economic environment.

Growth May Be Highly Value Accretive To Investors

Profit-wise, McDonald’s highlighted the conviction to maintain an anticipated mid to high 40% operational margins for 2024 and through 2027 which should ease concerns that the incremental growth may be dilutive to McDonald’s exceptional profitability. In fact, management suggested its that operating profit to free cash flow (FCF) conversion is expected to remain around 90%. On that note, I highlight that most of McDonald’s free cash flow is distributed directly to shareholders. For the trailing twelve months for example, McDonald’s generated approximately $7.4 billion of unlevered free cash flow, of which the company distributed $8 billion (>100% FCF payout), $4.5 billion in form of dividends and $3.5 billion in form of buybacks.

On that note, McDonald’s recent Q4 reporting supports the bull thesis on the commercial momentum. For the fourth quarter, McDonald’s exceeded expectations with higher menu prices, enhanced digital sales, and increased guest counts contributing to its success, despite facing inflation pressures. Specifically, the company saw an increase in same-store sales, revenue, and adjusted earnings per share, outperforming Wall Street’s predictions. The reported figures are as follows:

Fourth Quarter Earnings:

• Revenue: $6.41 billion, only slightly below the $6.45 billion expected by Wall Street.
• Adjusted EPS: $2.95, exceeding the $2.82 estimated by analysts.

As I see it, the negative initial buzz surrounding MCD’s Q4 results related mostly to headwinds relating to geopolitical tensions and the war in the Middle East, which impacted sales negatively.

Raise TP To $317

Reflecting on McDonald’s strong commercial momentum and projection for an additional 10,000 stores by 2027, I update my EPS projections for MCD stock in alignment with the latest analyst consensus estimates: For FY 2024, I now estimate that MCD’s EPS will likely fall within the range of between $11.7 and $11.9 (non-GAAP). For FY 2025, and FY 2026 I set my EPS expectation at $12.5 and $13.6, respectively. In addition, I update my terminal growth rate input to about 3%, which I think is still conservative give that the EPS CAGR for the S&P 500 constituents over the past decade was more than double this rate. Lastly, I reduce my cost of equity assumption by 75 basis points, to 7.25%, mostly as a consequence of falling benchmark interest rates. Moreover,

Against the backdrop of the adjustments highlighted above, I now calculate a fair implied stock price for McDonald’s stock equal to $316.88, suggesting that MCD shares may be trading at a slight discount to fair value.

Below also the sensitivity table, which tests different assumptions for the cost of equity (row) as well as terminal growth rate (column).

Investor Takeaway

McDonald’s enterprise value trades at approximately 22 times the company’s estimated operating income for 2024. While such a valuation multiple is not cheap for the average stock, I also point out that for McDonald’s the multiple may be attractive, reflecting on the company’s resilience, fast-paced store growth through 2027, and strong shareholder distribution. In fact, anchored on a residual earnings model based on analyst consensus EPS and arguably reasonable cost of equity and terminal growth rate assumptions, I calculate that McDonald’s stock may be trading at a slight discount to fair value (which I see around $316.88/ share). “Buy”.