McDonald’s (MCD): Inflationary Pressures, Limited Upside Overshadow Long-Term Prospects

Investment Thesis

McDonalds (MCD) had a poor quarter but a great year. The company continues to generate healthy margins and healthier cash flows without compromising on its Capex spending and digital initiatives. The company is also well positioned to capitalise on the pent-up demand brewing in China.

In this article however, I demonstrate how the inflationary pressures in the medium term and its valuation, as evidenced from my DCF analysis, puts the stock in the ‘Hold’ category for now.

The Fourth Quarter Shows a Painful Immediate Future

While McDonalds missed expectations on both the top and bottom lines in Q4, it was not all doom and gloom for the company. For instance, the company managed to generate operating margins of a little over 43% for FY21. Free cash flows for the year grew to $7.1 billion, which represents an increase of nearly 25% over pre-pandemic levels, and, more importantly, free cash flow conversion, the ability of a company to convert its income into free cash flow, came in at a very healthy 94% for 2021.

However, while the company had a great year overall, Q4 results in general, and the expenses in particular, gave a glimpse of the pain that lies ahead. Overall operating costs and expenses rose by 14% in Q4, and food and paper costs rose by 4% in FY21. The unfortunate news is that these costs are only going to worsen as the company’s management now expects its FY22 food & paper costs to nearly double both in the U.S. and in its international markets. Wage inflation is also expected to be persistent going into next year. As a result, operating margins are expected to come under significant pressure in the coming year, with the company now expecting FY22 figure to be in the low-40s.

With inflation unlikely to subside anytime soon despite the Federal Reserve’s aggressive plans of tightening, one can expect these commodity and wage pressures to be significant headwinds for the foreseeable future. Although the price increases made by the company to counter the rising costs did not affect its FY21 sales as badly as one would have imagined, it is highly unlikely that this strategy would be sustainable in the future.

Capex Spending and Digital & Drive-Thru Channels Keep the Long-Term Story Intact

While inflationary pressures are likely to affect the company’s margins in the medium term, from a long-term perspective, the story hasn’t changed much. The company continues to dominate an industry that is expected to grow at a CAGR of 4.6%, according to a report by Grand View Research, Inc.

Furthermore, the growth in the company’s digital business continues to remain strong, with digital channels accounting for 25% of the overall business. In FY21, MCD’s top 6 markets generated $18 billion in sales through the digital channels, which represented a year-over-year increase of 60%. The company also saw a higher percentage of sales in the drive-thru segment compared to pre-pandemic levels. An important factor that is driving such sales could be the surge in popularity of its Rewards program. MyMcdonalds Rewards, the company’s loyalty program, attracted over 30 million loyalty members till date, 70% of whom continue to remain active and earn rewards.

The headwinds, mentioned previously, have not had any adverse effect on MCD’s investment plans. The company now expects capital expenditures to be in the range between $2.2 billion and $2.4 billion in FY22. More than 1,800 restaurants are expected to be opened, including roughly 800 in China, where there is a lot of pent-up demand brewing as the Chinese government tightens restrictions as part of its “zero-Covid” policy. The company’s investments in China, therefore, allow it to be well-positioned to capitalise on this demand once restrictions are eventually lifted. It is also encouraging that even after planning such a massive outlay, the company still expects a free cash flow conversion of over 90% for 2022 and has not suggested any cuts to its dividend policy or share repurchase program for next year.

So, overall, while it is going to be a painful 2022 from a cost perspective, MCD’s investment plans and its continued focus on digital initiatives together with its China strategy leaves its long-term growth story firmly intact.

Valuation

DCF Analysis was conducted to estimate the target price of MCD’s stock. Free cash flows to the firm were used in the model and a five-year horizon was selected.

The following were the key assumptions made in the analysis:

Source: Company’s Q4FY21 Earnings Call and Author’s calculations

As mentioned previously, the total revenue of global fast-food market is expected to grow at a CAGR of 4.6% until 2028. Therefore, I assume the sales of McDonalds to grow at this rate. The management, during the recently concluded fourth quarter earnings call, expected operating margins to be in the range of low-to-mid 40s for FY22. I adopted a conservative measure and maintained the operating margins to be 40% during my investment horizon.

The growth rate used to calculate the Terminal Value was set to 1.5%, keeping in mind that traditional DCF models use a growth rate lower than historical long-term GDP growth rates of the country where the company is headquartered.

The company expects the capital expenditures to be $2,200 million during the first year of forecast. For the remaining years, I used the average capex/total revenue ratio over the last five years, which amounts to 9.1%. I assumed the company’s effective tax rate to be 22%, which is the effective tax rate that the company expects for the first year of forecast.

For the calculation of Weighted Average Cost of Capital (OTCPK:WACC), I use a risk-free rate of 2%, an after-tax cost of debt of 1.095% (calculated based on the company’s outstanding long-term debt), a beta of 0.6, and an equity risk premium of 7.11%, retrieved from Aswath Damodaran’s website. Based on these figures, the company’s WACC equals 5.49%.

I used a share count of 747.25 million, which is the number of shares outstanding as per the Refinitiv database.

Based on these assumptions, the DCF model yields a share price of $283.14, which represents only a 9% upside to the February 07^th closing price of $259.85.

Risks

In addition to the pressures of wage inflation and rising commodity costs, the other main risk that MCD currently faces is its debt levels, which stand at 114.83% of the total capital, according to Refinitiv. Although the interest coverage ratio, the metric that suggests how easily the company can pay its interest expense, remains healthy, it declined significantly in the fourth quarter, compared to the third quarter. A period of consistent declines in this metric would make the already elevated debt levels riskier.

Finally, while the pandemic is steadily transitioning into an endemic in most regions, one can never rule out the threat of a new, more dangerous variant, which could cause significant disruptions in the company’s major markets.

Concluding Thoughts

Overall, MCD remains a stellar company, one with strong fundamentals. The company continues to invest in new stores and continues to have a strong focus on its digital initiatives. It also continues to have a loyal customer base not just in the U.S. but across the globe and remains well positioned to capitalise on the pent-up demand in China.

However, in the medium term, inflationary pressures continue to be a headwind. Commodity costs are expected to double and wage inflation remains persistent going into next year. The company’s debt levels also remain significantly high. Finally, from a valuation standpoint, the stock only offers a limited upside, with the DCF analysis implying a price target of $283.14, a 9% upside to the closing price on February 07^th.

So, while the long-term story remains intact, given the medium-term headwinds and the steep valuation, for now, it would make more sense to add the McChicken to your basket and the stock to your watchlist.