McDonald’s: Solid Business Regardless Of Russian Exposure (NYSE:MCD)

McDonald’s (NYSE:MCD) has presented solid first quarter financial figures. The firm’s global comparable sales were up by 11.8%, mainly driven by a strong growth of more than 20% in the international operated markets segment and an increase of 14.7% in the international developmental licensed market segment. The U.S. segment has also exhibit growth, however to a much smaller extent, growing by only 3.5%. We believe that such a growth rate in the long term may not be sustainable.

On the other hand, MCD’s financial performance is slightly overshadowed by the temporary suspension of its operations in Russia and Ukraine. $127 million of costs are associated with the suspension, which includes employee salaries, lease, and supplier payments and also inventory.

In our view, McDonald’s financial results are strong, however there is too much uncertainty surrounding the operations in Russian and Ukraine. In our view, the stock is currently a “hold”. More clarity is needed on the duration of the suspension of the operations and on potential further losses due to the geopolitical tension before we can recommend to buy the stock.

Let us look at McDonald’s business to decide, whether it could be a good investment once the uncertainty decreases. First, we need to understand MCD’s exposure to Russia and Ukraine, then we need to take a look at the firm’s growth potentials and risks, and last but not least its value.

Exposure to Russia and Ukraine

As of 31.12.2021, MCD had 847 restaurants in Russia 84% of which was company operated. The firm also had 108 restaurants in Ukraine, which were all company operated. These figures may seem high, but McDonald’s is the global market leader in foodservice retail with more than 40,000 locations in more than 100 countries.

For 2021, Russia and Ukraine sales combined represented only 2% of the system wide sales, however as much as 9% of the revenue, due to the high number of company-operated restaurants in the region. The operating income from these two countries represent only 3% of the total.

We believe that the temporary suspension of operations in Russia will not have a significant long-term impact on MCD’s business. However, in the short-term significant uncertainty exists, including the possibility of reopening the restaurants and also further potential losses.

Financials and strategy

First quarter results

The firm has reported a significant increase in comparable sales compared to the year ago quarter.

In the U.S., the main drivers of the sales growth were the increases in menu prices and also the growth in the digital channel.

In our view, both of these elements are important in the current inflationary environment. The increase in menu prices, together with the growth in sales, proves that McDonald’s is able to pass over the increased input costs to its customers. Further, the digital channel also benefitted from MCD’s launch of “MyMcDonald’s Rewards” last year by enhancing customer loyalty.

In the international operated markets, the impressive performance growth was primarily enabled by the easing of Covid related government restrictions. Operations in France and the United Kingdom contributed significantly.

We believe that once all the restrictions are lifted, these growth figures are not likely to be sustained. Therefore, such growth figures are not suitable to build are investment thesis on.

In the international developmental licensed market, the leaders of growth were Japan and Brazil, offset by sales in China due to the new government restrictions introduced because of the Covid-19 outbreak.

In terms of diluted EPS, a decline of about 28% could be observed Y/Y.

The drivers of this decline are costs associated with the temporary suspension of the business in Russia and Ukraine, and a reserve set aside for an international tax matter. The impact of these on a per share basis were $0.13 and $0.67, respectively.

Strategy

In late 2020, the firm has defined its new strategy. In MCD’s annual report they define their three pillars of growth as: maximising marketing, committing to the core and doubling down on the 3D’s: digital, delivery and drive thru.

MCD aims to maximise marketing by communicating their values and the story of their brand in a unique, culturally relevant way. Their commitment to the core means focusing on the chicken, beef, and coffee offerings on their menu.

We believe that these two pillars of growth are not particularly strong and we do not see significant growth potential based on these. On the other hand, the digital expansion, with increasing number of deliveries and drive thru sales could be the driver of growth for the firm, as in 2021 the sales through digital channels were over $18 billion, representing more than 25% of all systemwide sales in their 6 largest markets. Further, the strength of their digital initiatives is proven by the fact that they have more than 30 million users registered in their MyMcDonald’s Rewards, from which 21 million are actively loyalty members.

Value

Price multiples

McDonald’s is trading at significantly higher multiples than its peers. Although these multiples may be slightly distorted due to the significant diluted EPS decline in the first quarter, we believe they are not justified. Both in terms of P/E and EV/EBITDA the firm is trading at over a 100% premium compared to the sector median. We do understand that MCD is a market leader and one of the most recognised brands in the world, but its growth potential is limited. Further, increasing competition and a global change towards healthier lifestyles may create headwinds for the firm.

By looking at the EPS estimates, analysts expect the earnings in the next four quarters to be in the range of $9.05 – $10.61. Actual earnings per share in 2021 were $9.28, indicating that there is not much growth foreseen.

In our view, the firm is currently overvalued and there are much better alternatives in the market with higher growth, and trading at lower multiples. If you are looking for growth at a reasonable price, check out our previous article on Crocs, Inc. (CROX).

Share buybacks

MCD has been consistently buying back its shares in the last decade, reducing their number of outstanding shares by more than 30%.

In our opinion, share buybacks are always a great way to return value to the shareholders in the long term. MCD proves its commitment through its continuous share buyback programs.

Dividend

In the first quarter, the company declared a quarterly dividend of $1.38 per share. The current dividend yield of the MCD is slightly above 2%.

MCD has a strong track record of returning value to its shareholders in the form of dividends. Their payouts have been continuously increasing in the last 10 years.

However, McDonald’s has a payout ratio of more than 50%. Compared to the firm’s 5-year average of 75% payout this seems low, however it’s more than double the sector median of about 25%.

In our view, a payout ratio over 50% is too high. There are other firms, which have the similar dividend yields and growth as MCD, but having a much lower payout ratio. If you are looking for sustainable dividends, there are better alternatives in the market. If you are interested in an alternative, check our previous article on Tyson Foods, Inc. (TSN).

Risks

Finally, let us highlight some of the risks that we believe are crucial to understand, before investing in MCD’s business. An extensive list of the risks can be found in McDonald’s annual report.

1.) Change of customer preferences

We believe that currently many people are aiming for a healthier lifestyle, which may create headwinds for MCD, at least in certain segments of the population. On the other hand, we believe that MCD is constantly growing its offerings to try to accommodate these trends e.g. by partnering with Beyond Meat (BYND) to offer meat free burgers in a number of restaurants.

2.) Highly competitive market

Although MCD is one of the largest and most recognised brands in the world, changing trends and newly appearing restaurants can eat away market share from MCD.

Our takeaways

McDonald’s had solid financial figures in the first quarter of 2022, regardless of the impact by the geopolitical tension in Eastern Europe.

The successful implementation of the strategy is key for future growth. Promising signs in digital can be already seen.

MCD appears to be overvalued based on several metrics and its dividend payout ratio of 50% is too high for our taste.

Wait for a drop in price before starting a new position.