Below is an excerpt from a report on one of the companies from our Fall 2018 Quarterly Focus Buy List. This list is designed to highlight 5-7 new buy ideas every quarter that are attractively priced and have a clearly identifiable short-term catalyst. Our analyst team delivers a short report on each name as well as a custom model to help our clients with fresh buy ideas that have been researched and vetted.
Overview: McDonald’s is the world’s leading fast foodservice retailer with over 37,000 locations in over 100 countries. Over 90% of McDonald’s restaurants worldwide are owned and operated by independent local franchisees. The company has three major reporting segments: US, the company’s largest segment which currently generates ~40% of operating income; International Lead Markets – established markets including Australia, Canada, France, Germany, the U.K. and related markets, which currently generates ~40% of operating income, High Growth Markets – markets believed to have relatively higher expansion potential including China, Italy, Korea, Poland, Russia, Spain, Switzerland, the Netherlands and related markets.
In 2015, McDonald took steps to reset its business and restore growth. With a new CEO in place in Q1, management in May announced the steps of a turnaround plan, beginning with a worldwide restructuring in July. This resulted in a reorganization from a geographically-focused structure to segments that combine markets with similar characteristics and opportunities for growth. This new operating structure is designed to sharpen the focus on the customer, drive greater accountability, and remove distractions and bureaucracy. In addition, the company refocused on restaurant fundamentals by providing – hot and fresh food, fast and friendly service, and a contemporary restaurant experience at the value of McDonald’s. Management also announced plans to optimize the company’s restaurant ownership by refranchising ~4,000 restaurants through 2018 to reach a franchise mix of 95%, and deliver net annual G&A savings of about $500 million, with the vast majority of the saving to be realized by the end of 2017.
Since then, the company’s operation has achieved broad based momentum, prompting management to transition from turnaround to growth. In 2017, McDonald shifted its focus to delivering long-term growth via a strategy named the Velocity Growth Plan. This plan aims at driving sustainable guest count growth, by focusing on three pillars – Retaining existing customers by focusing on where the company has a strong foothold in the “informal eat out” category, including family occasions and food-led breakfast; Regaining lost customers by recommitting to food taste and quality, convenience and value; Converting casual to committed customers by building stronger relationships with customers, via efforts such as elevating and leveraging the McCafé coffee brand and enhancing snack and treat offerings. Very importantly, the company has also been aiding the growth strategy through tools such as – Experience of the Future (“EOTF”), Digital and Delivery, which include restaurant renovation, equipping restaurants with global mobile app, self-order kiosks and technology-driven models that enable table service and curb-side pick-up. Further, delivery services with third party partners have been offered and expanded.
Catalyst: The US is in its first year of executing the 3 year Velocity Growth plan. Rolling out this ambitious plan has created a fair amount of challenges to operations, ie, free beef burger has delayed take out wait time, and the EOTF initiative has created disruption to normal operation. In addition, the company launched its $1 $2 $3 Dollar Menu in January, which has stimulated strong competitive reaction. In 18Q2, though US comparable store sales grew 2.6%, foot traffic was down 0.3% year over year. Separately in mid July, Department of Health said it is investigating a potential case of food-borne illness linked to McDonald’s salads, after more than 100 people have fallen sick from the cyclospora parasite in Illinois and Iowa since mid-May.
The salad drama will likely have passed and the disruption from the aggressive EOTF efforts will likely see the headwind peak in the coming quarters. What is important is, EOTF is proven to be a strong operation lifter as it has consistently improved comparable store sales in mid single digit in the international lead market which is further along the way in implementing the initiative. In addition, the $1 $2 $3 Dollar Menu offering should gain more traction as it just finished rolling out in May in the US and it takes time to raise awareness. As importantly, the company is working hard to create supplemental value offerings on the meal side to fight off competition, and its digital and delivery offerings are generating strong incremental sales. Overall, we expect to see tangible benefits from Velocity for Growth in the US to more than offset disruptions in the coming quarters. Separately, we commend MCD’s recent 15% dividend hike, which put its stock yield at an attractive 2.8%.