McDonald's Serves Up a Wide Moat

With the market bracing for soft results in light of sluggish industry trends,

McDonald's MCD delivered a better-than-expected third quarter on both the top and bottom lines. With respect to top-line growth, the highlight was comparable sales growth across all regions, including 1.3% growth in the U.S. (just ahead of market estimates of around 1%) as well as 3.3%, 1.5%, and 10.1% in McDonald's international lead, high growth, and foundational market segments, respectively. The U.S. results were particularly noteworthy, as they represented an acceleration of two-year comps compared with the second quarter (2.2% growth versus a 0.2% decline), which we attribute to the McPick 2 value platform as well as residual benefit from the all-day breakfast menu. On the bottom line, while solid comp results and refranchised efforts were the primary drivers of the 260-basis-point increase in operating margins to 33.3%, it's clear that McDonald's is also benefiting from improved restaurant efficiencies.

While the third-quarter results reinforce the brand intangible asset behind our wide moat, McDonald's investors must be prepared for U.S. comps to dip into negative territory the next two quarters as it overlaps last year's all-day breakfast launch. That said, we believe there are other drivers that could mitigate these headwinds, including ongoing restaurant-level improvements, the margin benefit of recent refranchising, and the announcement of a new three-year capital return program sometime in the first half of 2017.

We're not planning material changes to our $128 fair value estimate, as the better-than-expected third-quarter results will be offset by a slight reduction to our near-term comp outlook amid limited near-term pricing opportunities. We view shares as undervalued and remain comfortable with our five-year targets calling for 4%-5% annual systemwide sales growth and operating margins in the low 40s (driven by refranchising activity and other operational improvements).

CEO Ordered Major Improvements, Including Reorganization, Refranchising
McDonald's CEO Steve Easterbrook set in motion a major turnaround in 2015, including reorganizing the company into four segments based on the maturity and competitive position of its different markets, plans to refranchise 4,000 locations by the end of 2018 (and targeting longer-term franchisee system ownership of 95%), and targeting $500 million in net annual selling, general, and administrative expense reductions. McDonald's is also committed to a more streamlined menu (but one still allowing for personalization), making decisions closer to the customer at the local and regional level, and adopting consumer-facing technologies. In our view, each of these initiatives should make McDonald's a more agile organization that is better aligned with evolving consumer restaurant preferences.

Nonexistent switching costs, intense industry competition, and low barriers to entry make it challenging for restaurant operators to develop an economic moat. Although McDonald's has faced increased competition, self-inflicted product pipeline, pricing, and marketing issues, a tepid macro environment, and evolving consumer tastes in recent years, we believe it still possesses a wide moat. Our moat rating is based on a mix of structural and intangible competitive advantages, including a widely recognized brand, a franchisee system focused on driving unit-level productivity improvements, and meaningful economies of scale. These qualities were instrumental in helping McDonald's to build the largest restaurant system in the world (based on systemwide sales) and leading market share in the majority of countries in which it operates, with the notable exception of China. McDonald's generated $83 billion in sales at its company-owned and franchised restaurants during 2015, representing almost 4% of the $2.4 trillion global restaurant industry (using Euromonitor estimates). This almost doubles

Yum Brands' YUM systemwide sales of $44 billion and dwarfs

Restaurant Brands International QSR ($24 billion) and Subway ($12 billion).

With strong brand awareness, consistent customer experience, convenient restaurant locations, and a uniform value-priced menu balancing core menu items with locally relevant options, McDonald's is one of the few restaurant concepts to enjoy global success. McDonald's average trailing 12-month sales of around $2.3 million per restaurant trumps the quick-service restaurant industry average of just over $1 million per location. Additionally, we believe exterior and interior restaurant decor upgrades, more-efficient kitchen and drive-through configurations, and an Innovation Center (a 38,000-square-foot facility where the company can simulate new restaurant prototypes across a wide range of configurations, technologies, dayparts, and guest count volume) can assist with management's turnaround plans and drive restaurant productivity metrics higher over an extended horizon.

Coffee, Snack Wraps Enhance Intangible Asset Moat Source
Menu innovation has historically played an important role in enhancing McDonald's intangible asset moat source with introduction of several margin-accretive products like snack wraps and the McCafe beverage platform. Management has cited executional and complexity issues with its menu over the past several years, but we're encouraged by ongoing menu rationalization efforts, a reduction in the number of Extra Value Menu offerings, and placing less emphasis on variations of core products in 2015. We view these decisions as prudent, but also acknowledge that the composition of McDonald's menu will require a careful balancing act between rationalization and incorporating local preferences, something that could take additional time and resources (capital, labor, data analytics) to fine-tune. We're also encouraged that recipe changes using higher-quality ingredients appear to be resonating with consumers, which, when combined with incremental labor investments and training (improving speed of service and order accuracy), are helping improve McDonald's brand perception among consumers, reinforcing our wide-moat rating.

We're also intrigued by management's emphasis on creating a customer "Experience of the Future" flexible enough to accommodate the demographic, competition, taste, and franchisee permutations across its different operating regions while incorporating input from local and regional decision-makers. This is most apparent in McDonald's international lead segment (Australia, Canada, France, Germany, United Kingdom), where innovations in each company are establishing a blueprint for more sustainable growth across the entire system. In particular, we're intrigued by the "full restaurant" model rolled out in France in 2015, which is perhaps the best example of a McDonald's format fully integrating ordering flexibility (including counter, kiosks, web, and mobile ordering), menu customization (including the ability to custom-build burgers, chicken sandwiches, and salads), and customer experience (including a blend of front counter, table service, and curbside kiosks). Innovations like these--which have also been successful to some degree through the Experience of the Future rollouts across each of the other international lead markets--contribute to our expectations for positive same-store sales across all regions through the first half of 2016, though international lead markets will face more difficult comparisons as 2016 progresses.

Changes Won't be Fast-Food Instantaneous, but Worthwhile Long-Term
Although we acknowledge that adapting innovations from international lead markets will take additional time to implement in the U.S. given the region's size and competitive set, we're becoming more constructive about the longer-term opportunity for the company to return to sustainable comparable sales growth in the low- to mid-single-digit range. Our confidence stems from a combination of recipe changes utilizing higher-quality ingredients and incremental labor investments and training, driving improved speed of service and order accuracy metrics and helping boost comparable sales in the U.S. even before the successful launch of all-day breakfast last October. While the rollout of all-day breakfast has exceeded management's expectations and brought U.S. transaction counts to positive territory in the fourth quarter, we continue to believe the more important takeaway is that the program went from a single test market in May to nationwide rollout in October. This implies McDonald's is overcoming its recent supply chain execution hurdles while demonstrating a greater level of coordination across the system, which we believe portends a more seamless rollout for new products, promotions, and other in-store innovations in the future (including a revamped national value platform emphasizing bundling in 2016 and digital menu boards that automatically adapt using consumer data).

While McDonald's transformation will still take time, we're comforted that the company's brand intangible asset moat source is backed by a cohesive franchisee and affiliate system, which collectively operates 83% of the chain (a metric expected to grow to 95% over a longer horizon through refranchising efforts). This structure allows the company to expand its brand reach with minimal corresponding capital needs while providing an annuitylike stream of rent and royalties, even during challenging economic times. As a result, McDonald's generates excellent free cash flow and returns on invested capital in the mid- to high teens. These results are even more impressive when considering that the firm owns 45% of the land for its restaurants (around $5.6 billion in land assets), meaning that the returns are generated on a higher invested capital base than most franchised restaurant chains. We believe considerable land assets provide an additional competitive buffer that most other restaurant firms cannot match.

We also appreciate McDonald's aspirations to becoming a more nimble organization, particularly with respect to making more menu and marketing decisions at the local and regional level. Although we consider McDonald's size and scale to be a key competitive advantage--the foundation of our cost advantage moat source--questions about the agility of its supply chain have surfaced in recent years, especially in a restaurant industry experiencing changing taste preferences at a local and regional level, a more pronounced consumer shift toward healthier foods, and fast-casual players reaching critical mass (which we believe have captured a share of McDonald's previous middle- to upper-middle income consumers). There have been instances when competitors have been able to bring new products to market more rapidly than McDonald's because of raw material procurement constraints, but we are hopeful that impressive speed-to-market for the all-day breakfast launch in the U.S. paired with localized menu decisions will help to alleviate some bottlenecks in the system and level the playing field somewhat.

Early results of the initiatives have been promising, with positive comps across all operating regions in the back half of 2015 and early 2016. More important, we're encouraged that the sales improvement hasn't been a function of a single factor, but rather a combination of recipe changes using higher-quality ingredients and incremental labor investments and training (improving speed of service and order accuracy). Additionally, the rapid rollout of all-day breakfast in the United States implies that McDonald's is overcoming its supply chain and execution issues and portends a more seamless rollout for new products. When coupled with learnings from international markets, we're confident that McDonald's can return to normalized low- to mid-single-digit system sales growth and mid-single-digit operating income growth over time.

That said, McDonald's could be positioned for a more difficult back half to 2016. Additions to the all-day breakfast and McPick 2 value platforms are positives, but we don't identify a U.S. sales driver over the next several months with the same potential as the initial all-day breakfast launch last year. Coupled with widening food at home/food away from home price gap (limiting near-term pricing opportunities) and wage increases across many global markets, it sets the stage for flat to modest comp declines and increased margin pressures over the near future.