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McDonald’s Improving But Serious Hurdles Remain

publication date: Jul 30, 2020
author/source: Callum Turcan

Image Shown: Shares of McDonald’s Corporation are richly valued as of this writing, especially when considering the headwinds facing its business in the near-term and its hefty net debt load.

By Callum Turcan

On July 28, McDonald’s Corporation (MCD) reported second quarter 2020 earnings that beat consensus top-line estimates but fell short of consensus bottom-line estimates. As expected, the ongoing coronavirus (‘COVID-19’) pandemic took a large bite out of its performance last quarter with global comparable sales down 23.9% versus the same period a year-ago. McDonald’s reported that its global comparable store sales trajectory improved throughout the second quarter as the decline shrank from -39.0% (negative 39.0%) in April 2020 to -12.3% (negative 12.3%) by June 2020. Shares of MCD sold off modestly during normal trading hours on July 28, and we caution that McDonald’s still appears to be generously valued as of this writing.

McDonald’s has not yet released its 10-Q SEC filing covering the second quarter of 2020 as of this writing. The firm did not readily provide its balance sheet or cash flow statements in its earnings press release or the related 8-K SEC filing. We will have more to say on the name as additional information becomes available.

Capital Allocation Priorities

While we appreciate McDonald’s pivoting towards a franchise-heavy business model over the past few years, the company’s near-term outlook is still contending with serious headwinds due to the ongoing pandemic. Considering McDonald’s carries a hefty net debt load, the firm has limited financial flexibility to navigate the storm. Management mentioned during the company’s latest earnings call that the firm would “look to reduce debt in the near-term to lower our elevated leverage ratios.”

For reference, McDonald’s exited March 2020 with a net debt load of $33.8 billion (inclusive of $1.1 billion in short-term debt). Its $5.4 billion cash and cash equivalents position at the end of March 2020 provided the firm with ample liquidity, though the company will need to retain quality access to capital markets at attractive rates going forward to refinance maturing debt. Deleveraging activities are not the top priority, however, as McDonald’s also mentioned that its “top priorities remain the same. First investing in the business for growth and second prioritizing dividends to our shareholders” with deleveraging taking precedence after those considerations.

Quarterly Update

The firm’s performance in the US held up much better than its company-wide performance last quarter as its domestic comparable store sales were down just 8.7% year-over-year. Additionally, that trajectory improved through the quarter just as it did for its international operations. McDonald’s reported that its US comparable store sales were down 19.2% year-over-year, which improved to a year-over-year decline of just 2.3% in June 2020.

Drive-thru operations were key to enabling McDonald’s to continue meeting demand during the pandemic. The company was able to cut drive-thru times by 15-20 seconds due to operational improvements during the early phase of the pandemic according to management. McDonald’s noted that drive-thru sales were quite strong in Canada, the UK, Germany, Australia, and France last quarter as ~70% of its restaurants in those markets offer drive-thru options. In the US, drive-thru options are available at ~95% of its restaurants and drive-thru sales represented ~90% of its total US sales during the second quarter. Home delivery and digital sales were also cited as being quite strong last quarter.

We appreciate that McDonald’s appears to be entering the third quarter on the rebound, though we caution that the potential for a resurgence of COVID-19 infections and hospitalizations in US and elsewhere continues to cloud over the firm’s near-term outlook. As of the end of June 2020, McDonald’s had reopened “nearly all” of its global locations, though in-store dining options were limited or not available at plenty of those restaurants (locations with limited or no in-store dining options pivoted towards drive-thru and delivery options).

In the second quarter of 2020, McDonald’s reported that its GAAP revenues dropped by 30% year-over-year with weakness reported that both its company-owned and franchised locations. The company’s GAAP operating income tumbled 58% year-over-year as the 11% year-over-year drop in its total operating costs and expenses only modestly offset the financial pain caused by smaller revenues. Management noted that McDonald’s would accelerate the closure of US stores this year that were previously planned to close in future years, over half of which are “low volume” locations in Walmart Inc (WMT) stores.

McDonald’s continues to roll out its “Experience of the Future” program which includes adding kiosks to its restaurants that take customer orders and more closely integrating digital operations into its traditional processes (such as delivery operations). The company expects to spend $1.6 billion on capital expenditures this year, down from $2.4 billion previously, with a large chunk of that going towards rolling out the Experience of the Future program in the US. Additionally, McDonald’s intends on opening 350 net stores this year.

Possible Stake Reduction

One thing that really caught our eye during the company’s latest earnings call was a comment noting that McDonald’s intended to sell down its stake in its Japanese operations held via McDonald's Holdings Co. Japan Ltd. (MDNDF). Here is what management said during the call (emphasis added):

Consistent with enhancing financial flexibility and our franchising strategy, we're planning to divest a portion of our stake in McDonald's Japan. As a result of the strong performance of the McDonald's Japan business over the past few years, and our confidence in the local management team, we believe it's the right time to gradually reduce our ownership stake in the market. This will take some time because of the low trading volume of McDonald's Japan shares. As a reminder, we currently own about 49% of the business, and we will retain at least 35% ownership. This decision provides us with additional financial flexibility to execute our capital allocation strategy, while also demonstrating our commitment to our Japanese business.

It is possible that those proceeds could assist McDonald’s in paying down some of its debt load. Management noted that selling off this equity stake would be a slow process. One thing working in the company’s favor is that its Japanese operations reported positive comparable store sales growth last quarter.

Concluding Thoughts

At the top end of our fair value estimate range we value McDonald’s at $173 per share, well below where shares are trading at as of this writing. Though shares of MCD yield a nice ~2.6% as of this writing, we are not interested in shares of McDonald’s at this time given its premium valuation and the downside risks posed by the ongoing COVID-19 pandemic and the company’s large net debt load.


Restaurants - Fast Casual & Full Service: BJRI, CAKE, CBRL, CMG, DENN, DIN, DRI, EAT, RRGB, RUTH, TXRH

Restaurants - Fast Food & Coffee/Snack: ARCO, DPZ, DNKN, JACK, MCD, PZZA, SBUX, WEN, YUM



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Callum Turcan does not own shares in any of the securities mentioned above. Vanguard Consumer Staples ETF (VDC) is included in Valuentum’s simulated High Yield Dividend Newsletter portfolio. Both the simulated Best Ideas Newsletter and Dividend Growth Newsletter portfolios include a SPDR S&P 500 ETF Trust (SPY) put option holding with a $295 per share strike price that expire on August 21, 2020. Some of the companies written about in this article may be included in Valuentum's simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.

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