April 16, 2015 - 6:57pm EST by
2015 2016
Price: 95.67 EPS 4.86 5.28
Shares Out. (in M): 961 P/E 19.7 18.1
Market Cap (in $M): 91,948 P/FCF 21.1 19.1
Net Debt (in $M): 12,912 EBIT 7,430 7,947
TEV ($): 104,860 TEV/EBIT 14.1 13.2

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  • Management Change
  • Turnaround
  • Refranchising
  • Quick Service Restaurant (QSR)
  • Brand
  • Dividend
  • Potential Buybacks
  • Dividend yield
  • Food and beverage
  • Real Estate


Investment Thesis

  1. MCD is a high quality business (mid 30s EBITDA margin, 16% ROIC) trading at a discount, with a margin of safety provided by its significant scale advantages and strong brand value in a defensive, growing end market

    1. Largest restaurant with one of the most recognizable, iconic brands in the world.  MCD restaurants generate $2.5mm of sales / unit (2x competition) and $450k of profit / unit (4x competition).  MCD has significant scale advantages i.e. MCD spends more on advertising (~$5bn) than rest of industry combined

    2. Predictable, stable cash flow stream given franchised business model and real estate ownership.  75% of EBITDA from royalty and rent. MCD owns 45% of the land underneath its restaurants and 70% of the buildings for its 36K restaurants.  Owns best real estate in the business given first mover advantage in most markets

  2. Disappointing operational execution and a suboptimal company structure over the past two years have led to material underperformance compared to peers (stock down 3% in LTM vs. +15% for S&P) and a sector-low valuation (11x 2016 EBITDA vs. 14x for peer group), but these issues are self-inflicted and fixable.  A fresh, experienced new CEO and cooperative Board is now leading the company with a sense of urgency and is both willing and able to enhance shareholder value through a operational turnaround.  He has referred to himself as an “internal activist” and is committed to moving faster and keeping all value creation options on the table.

    1. Value Creation Levers.  There are a number of levers that management could easily pull to drive profitability, cash returns and a multiple rerating.  These include (in order of value creation): (i) refranchising à moving franchise mix from 81% to 90% or 95%, (ii) leveraging balance sheet (currently 1.3x vs. franchised peer group at 2x to 5x) and (iii) SG&A cuts (spends $70k / systemwide restaurant vs. peer group at $12k to $40k).  Finally, MCD could potentially monetize its real estate through a REIT structure, shielding taxes and benefiting from a multiple bump on a meaningful portion of its earnings.  However, I believe this is highly unlikely and  last resort.

    2. Operating Turnaround.  I also believe there is a reasonable probability of an operating turnaround in the next 12 to 18 months given upgraded leadership (plus shareholder pressure) and excited franchisee base.  In the coming year, I expect MCD to eliminate fringe menu items to improve service time and accuracy, address its price architecture, improve ingredient quality in very public way, advertise ingredient quality and food prep (i.e. crack eggs for breakfast vs. peers that reheat frozen food), innovate in core burger category and test customized burgers, improve labor relations and perception of MCD as an employer and create a more decentralized organization to enable local product development.  Comps get very easy in June.

      1. Important to keep in mind that Burger King, Wendy’s, Sonic, Jack in the Box, Taco Bell, KFC, Domino’s, Papa John’s, Dunkin Donuts, etc. are all generated at least +LSD comps

  3. Attractive up / down asymmetry

    1. Under a conservative base case scenario, MCD should trade at 12.5x FY17 EV/EBITDA in line with higher-franchised peers, which represents a $113 price target at the end of FY15 (18% upside from today’s $96 share price)

      1. While a mid/high teens return may not seem compelling to those on VIC, I believe it is a very compelling risk/reward considering the minimal downside / large margin of safety, combined with various value creation levers and an increasingly engaged shareholder base which can drive significantly more upside beyond my $113 target
    2. Downside based on 10x EBITDA (significant discount to peer group) results in $88 stock price, or < 10% downside.  Realistically, downside protected by enthusiasm for new management and understanding that turnaround will take at least a year.  Also, weak operating results will increase pressure to pull value creation levers.
    3. I believe one can earn a good return if MCD simply pulls refranchising / leverage / SG&A levers and can earn a great return if coupled with an operating turnaround.


Company Overview

Mcdonald’s Corporation (MCD) is the world’s largest franchisor and operator of fast-food restaurants.

  • Market-share leading quick service restaurant (QSR) with over 36,000 restaurants, $88bn systemwide sales, and $27bn revenue globally

  • Dominant player in largest QSR sub-category: burgers

  • Geographically diversified – in terms of EBIT:

    • 44% U.S.

    • 41% Europe

    • 15% Asia

  • Majority (~82%) of MCD’s restaurants are operated by franchisees which pay MCD via two earnings streams:

    • Brand royalty = ~4% of sales

    • Rent = ~9% of sales (in cases where MCD owns the underlying real estate)

    • Royalties and rent contribute to ~75% of total EBITDA


Why is MCD a Good Business?

MCD is a very high quality business with a irreplaceable brand, market leading position in a growing, defensive category, significant scale advantages and a highly stable business model that generates > 75% of its earnings from royalties and rent.


Highly Recognized, Iconic Brand with Market Leading Position

  • Decades of heritage and billions of dollars of advertising spend have created one of the most valuable brands in the world

  • Enables MCD to attract the best franchisees and partners around the globe

  • Brand recognition contributes to strong unit economics and productivity per store at roughly twice the level of peers

Market Leader in Stable, Defensive QSR Industry

  • MCD has 5% market share in the United States restaurant industry and 15% share in the QSR segment

  • Restaurant sales grow at ~ 4% p.a.

  • MCD achieved strong SSS through the downturn (7% in 07, 7% in 08, 4% in 09)

Scale Advantages

  • McDonalds spends more on advertising than rest of industry.  While not a guarantee of success, advertising muscle amplifies an on-target, trend right message.

  • Best real estate in industry given scale, unit economics and first mover advantage in most markets

  • Supply chain that is unrivaled; global reach and capabilities

Franchised Business Model + Real Estate Ownership Create Stable Earnings Profile

  • 80% franchised business model creates stability through royalty stream and enables Company to grow in capital light manner.  Limited exposure to commodities, labor costs, etc. as that risk and volatility is borne by franchise base

  • Owns 45% of land and 70% of buildings for its 36K restaurants.  The Company is the landlord for its franchising, charging ~ 9% of sales.  Again, creates a stable, low-risk cash flow stream and attracts great franchisees.  


Recent Underperformance

  • Over the past decade, MCD has generated 6% system sales growth (2% stores, 4% SSS) and 8% EBIT growth

  • Coupled with share buybacks, total EPS growth has compounded at a low teens rate before dividends (currently 3.5% yield)

  • However, after a fantastic decade long run, MCD sales growth and profit margins began to decline in 2013 / 2014

  • See Valuation and Risk/Reward section for historical financials


Industry Growth and MCD Performance

  • The United States restaurant industry is expected to grow at ~ 3% going forward (vs. ~ 4% over last four years).  While fast casual is experiencing explosive growth, it currently only accounts for 4% of US foodservice


  • MCD has substantially underperformed the peer group in the last two years after a period of outperformance.  Other legacy QSR companies with a reputation for unhealthy food have been able to generate positive low to high single digit SSS growth


Historical Market Share (United States)

  • MCD has ceded market share after a period of strong market share gains




What is Driving Growth at Peer Group?

  • While it varies across companies, other “unhealthy” QSR chains have done a much better job at executing around their core, menu innovation and marketing improvement

  • They have also focused on upgrading their asset base

    • BKW (#4 QSR chain) à under new management team, upgraded the menu, revamped marketing (no more King character, advertised the food and compelling value), invested in asset base

    • WEN (#5 QSR chain) à under new CEO, WEN returned to focusing on premium sandwiches with successful items such as the Bacon Pretzel Cheeseburger.  Focused on unique buns and cheeses that were differentiated in the marketplace.  Invested in remodel program.

    • DPZ (#15 QSR chain) à under new CEO, admitted that food quality and service had become problems, made a public mea culpa and advertised their improvement with great success.

    • Taco Bell (#6 QSR chain) à menu innovation (Doritos taco) + improved customer perception of ingredients (cantina bell) + new breakfast day part

    • Jack (#17 QSR chain) à menu innovation (Siracha burger) and memorable, unique advertising

    • Sonic (#12 QSR chain) à menu innovation + unique, memorable marketing (two guys sitting in a car) with more of an emphasis to national TV (64% in 2014 vs. 48% in 2012)


But What About Fast Casual?

  • Fast casual is certainly a headwind for McDonald’s and other legacy fast food players.  But fast casual only accounts for 4% of the industry and is expected to compound at a HSD rate (vs. +LSD for traditional QSR concepts)



  • It is also important to keep in mind that MCD and Five Guys are not truly substitutes for most MCD customers given significant price point differential:


Operational Diagnosis

McDonald’s challenges are mostly self-inflicted due to disappoint operational execution – relative lack of innovation, less effective advertising, declining quality scores, and weakening value proposition.


  • While the broader burger category continued to generate positive same store sales (SSS) in 2013-2014, MCD’s SSS turned negative as a result of strategic misdirection, operational inefficiencies, and disenfranchised franchisees

  • These issues are self-inflicted, as MCD customers have not stopped eating burgers – they are just looking elsewhere within the traditional fast food category

  • Conversations with franchisees and former MCD executives suggest that these issues are already being addressed, which should allow for a return to positive SSS over time

Relative Lack of Innovation

  • After nearly a decade of sales building through new products – culminating in the McCafe launch – McDonald’s innovation pipeline seems to have dried up

  • The single biggest product introduction in the last two years – the Mighty Wings limited time offer (LTO) in 2013 – had disappointing results, while flagship products from Burger King (e.g. Chicken Fries) and Wendy’s (e.g. Pretzel Bacon Cheeseburger) were massively successful

Less Effective Advertising

  • National advertising campaigns, such as the “Our Food, Your Questions” initiative, have been largely reactive to consumer concerns about MCD’s health and food quality, rather than being proactive in promoting the steps the company is taking toward healthier, higher-quality ingredients

  • Menu marketing has been centralized at the national level, rather than allowing localized decisions to be made by franchisees closer to the end customer

Declining Quality Scores

  • MCD’s food quality scores have been on the decline, as its complicated menu and lack of proper employee training have weakened food prep quality.  Menu proliferation (100 items added over last decade) has hurt order speed (doubled order time in many stores) and order accuracy

  • Asian meat supplier scandals and MCD’s historical sourcing of preservative-filled ingredients have driven negative perceptions about its food quality

  • People are not eating fewer burgers – they’re eating exceedingly higher quality burgers, caring more about ingredient sourcing and food preparation



Weakening Value Proposition

  • Customers have historically anchored to MCD’s Dollar Menu, and as Food Away from Home Inflation (FAFH) has risen, MCD has had to raise prices on most of its premium burgers and other menu items to offset the higher costs without losing its large Dollar Menu-focused customer base

Turnaround Plan

New CEO Steve Easterbrook and his team have a clear plan to turn around the company’s operations, the components of which are already being implemented.  There is significant overlap with his highly successful turnaround plan at MCD UK.  


Menu simplification and innovation

  • Reduce menu board complexity.  There are too many items (have added 100 items in last decade), which is creating customer confusion and kitchen complexity, hurting service time, order accuracy and employee morale.  Many of these items are low turning (i.e. complex variations of snack wraps) and have easy substitutes on the menu.  Approximately 80% of sales come from a handful of core and value items.

  • At the same time, get back to innovating, particularly around burgers.   MCD has ceded this ground to WEN.  Company plans to launch third pound sirloin burgers soon and also introduce premium toppings (i.e. guacamole) later this year.  Innovation has been borderline non-existent over last two years

    • Create Your Taste – higher price point, customized burger platform based on in-restaurant kiosk ordering system.  Unclear if this makes sense and can generate returns as only 30% of sales is inside the restaurant.  In test mode and management has been non-committal.  Launching across Australia (800 store market) this year, which should provide valuable lessons.  Should improve brand perception.

  • Decentralize the organization to enable faster and more regional approach to menu innovation.

Modify price architecture

  • Reduce the price gap between Dollar Menu and More and core items (i.e. Big Mac).  This has already started and is part of the reason for weak compares in recent months.

Improve health and wellness perception

  • Advertising campaign around the quality and integrity of the ingredients and kitchen prep

  • High profile changes to supply chain (i.e. plan to eventually eliminate antibiotics in chicken).  MCD receivers a lot of free press for these types of changes though they can’t be implemented overnight given size of the supply chain

    • Could MCD move to fresh beef or eliminate all preservatives?  Inventory turns 100x per year.  Opportunities to transition to “fresher” supply chain

Emphasis on improving customer experience

  • Technology – will introduce their first mobile app by end of year, eventually enabling mobile ordering, mobile payment, loyalty program, customized marketing

  • Emphasizing culture of hospitality

    • Raising minimum wage and benefits at company owned stores.  Improves perception of company and helps them compete, motivate and retain talent

Decentralize the Organization

  • Enables faster and more locally relevant innovation and improved marketing

  • Empowers franchisees and incorporates their best ideas more rapidly and effectively


Background on New CEO

MCD’s new CEO Steve Easterbrook is credited with successfully turning around the McDonald’s UK business in the mid / late 2000s, an effort which entailed addressing many of the same issues that plague McDonald’s globally today.



  • On March 1st, 2015, the Board of Directors hired British-born Steve Easterbrook as President and CEO

  • Since joining McDonald’s in 1993, Easterbrook has held numerous leadership roles, including CEO of McDonald’s UK, President of McDonald’s Europe, and most recently, Global Chief Brand Officer

  • In addition to his more than 20 years with McDonald’s, Easterbrook’s time leading two UK-based restaurant chains in 2011-2013 – PizzaExpress and Wagamama – equips him with an outside perspective to make radical changes to issues that have fatigued MCD’s historical “promote from within” culture


McDonald’s UK Turnaround

  • In the 2000s, McDonald’s faced a sales downturn in the UK, driven in part by concerns about its food quality and its treatment of employees

  • Easterbrook, promoted to head that business in 2006, dealt with the brand’s battered image head on

  • He boosted sales by modernizing restaurants with a cleaner look, revamping the menu, and working to portray McDonald’s as environmentally friendly

  • He was also a fierce defender of the brand, starting a petition to change the dictionary definition of “McJob” as a dead-end job and installing a website to answer questions including its working conditions and animal welfare

  • At the same time, Easterbrook showed an interest in adding healthier-menu options and an appreciation for the importance of marketing to moms as well as its core male consumers

  • Easterbrook went on television channel BBC in 2006 to debate Eric Schlosser, an industry critic and author of “Fast Food Nation” – a debate which he won

  • Under Easterbrook, McDonald’s UK market share, after declining to 12% in 2006, rose each year to 15.7% in 2013, despite continuing declines in global market share



Checks on Steve Easterbrook are unanimously positive and suggest that he is both willing and able to take the necessary steps to turn around the brand perception and company performance with a strong sense of urgency:


Feedback from Former MCD Executives

  • “He was the best and only choice.  They did the right thing bringing him back.  He is an extremely bright, driven, exciting leader.  I loved working with him.  And he does listen, too.  He doesn’t surround himself with yes people.  He will surround himself with people that will challenge him, which I think is one of the things that had been a challenge for Don [former MCD CEO].”

  • “He has shown a willingness to make some bold hiring choices from outside the organization.  Especially on the brand and marketing side.”

    • Former Global HR Director at McDonald’s

  • “From what I read and hear, Easterbrook is doing the right things, versus what I’ve heard in the past.  It’s all about the advertising; it’s all about the fundamentals; and it’s all about getting the consumer experience of the people who are coming into the store right.”

    • Former Chief Marketing Officer at McDonald’s Germany

  • “Easterbrook is good at simplifying complex situations by remaining focused and not impulsively taking action in many different directions.  He also is good at communicating his strategy to both management and store owners.”

  • “The chief difference between Don Thompson’s strategy and that of Steve Easterbrook is that Thompson was very focused on a centralized  approach, which never worked globally.  By contrast, Easterbrook has seen the benefits of a decentralized approach and empowering local operators.  Easterbrook is likely to push for more decentralization at McDonald’s.”

  • “He [Steve Easterbrook] was an instrumental part of the changeover of the British business, because the British business was sluggish and didn’t perform very well for six or seven years.  He took the job, and then they started to change, together with McDonald’s Germany.  He was Marketing VP at that moment.  His main focus was really on the execution in the restaurants, the revitalization of the brand, and very strongly in communication.”

  • “I expect Steve to empower people around the globe.  He will empower more management and more people locally to do business better.  He’s a financial person, so if he can understand what is going on with franchising and re-franchising in the ailing markets, and then put in developmental licensing, that will have an impact.  Steve understands that they need to cut the centralized things first and then streamline.”

    • Former President and CEO at McDonald’s Germany and West Division in Europe

  • “The new CEO is a great leader and decision maker…he doesn’t wait to get everyone onboard before making decisions, he is very confident in his strategic views and moves swiftly to implement them, even if there’s tension.”

  • “Steve stands up both internally and externally to defend and support his vision in a very smart way…which sometimes can be perceived as a little bit cold, but it is usually effective.  He is capable of this turnaround but it will be slower than his prior turnaround because of the scale of the global operations he is now dealing with and because he needs time to built and mold the new senior management team surrounding him.”

    • Former SVP and Franchising Development Officer, McDonald’s Europe


Feedback from Former MCD Franchisees

  • “Management has changed a lot over the last 35 years, and a lot of the company’s issues have been self-inflicted.  But I’m pretty positive on the new CEO Steve Easterbrook.  But his sense of urgency and ability to execute on a global scale has not yet had enough time to bee seen.”

    • Current McDonald’s Franchisee (13 locations in Florida)

  • “Steve Easterbrook did a turnaround in the UK which is pretty similar to what’s going on now.  But the learning curve may be steeper because the global franchisee structure is different than what he had to deal with in the UK.”

  • “There is some low-hanging fruit over the next 12 months, like menu simplification and localization.  McDonald’s today can change much more quickly than it has been able to in the past because of the recent management changes.  There is finally some sense of urgency…in the next 90 days we’ll start to see changes.  60-75% of the strategic plan can take place within the next nine months.  Image perception will probably take longer to change.”

    • Current McDonald’s Franchisee (12 locations in Illinois)

  • “I’ve never met Steve Easterbrook or Mike Andres [President of McDonald’s USA] but I’ve heard good things given Steve’s UK experience.  McOpCo executives have been much more amenable to change and seeking franchisees’ perspectives lately.”

  • “I think we are 9-18 months away from turning around the business.  Sales should get back to flattish within the next 12 months.  Given his branding experience, Steve can probably get advertising and marketing changes made pretty quickly, but product and supply chain changes will take more time.”

    • Current McDonald’s Franchisee (9 locations in Pennsylvania and New Jersey)


Value Creation Opportunities

Three primary drivers of potential value creation indicate ~26% upside to MCD’s current $96 share price at a 12.5x EV/EBITDA multiple at the end of 2016, or a 17% two-year IRR.


  1. Restaurant Refranchising

    1. MCD is currently ~81% franchised

    2. Plans to refranchise at least ~1,500 units by FY16 (~85% franchise mix)

    3. Under new CEO’s plan, MCD could potentially move to ~90% franchised

    4. I assume 90% franchise mix across all regions by end of 2017, with proceeds to fund $3bn share buyback


  1. Increased Leverage / Share Buyback

    1. MCD is currently under-levered

      1. 1.3x Net Debt/FY14A EBITDA

      2. 2.4x Adj. Net Debt/FY14A EBITDAR

    2. Peers are levered at 2.3x Net Debt with a 90% franchise mix, suggesting that MCD can support higher leverage by increasing franchise mix (stable CF’s)

    3. I assume an increase to ~2x net debt / FY15E EBITDA at 4% int. rate in 1Q16, with proceeds funding $4.6bn buyback


  1. SG&A Reduction

    1. MCD has ~2x more SG&A/store than peers

    2. With 90% franchise mix + corporate G&A cuts, MCD should be able to cut more than its guided G&A savings of $100mm

    3. I assume an SG&A reduction of 7.5% (~$200mm) in FY16

Restaurant Refranchising

MCD has an opportunity to become a more asset-light model by refranchising some of its nearly 7,000 company-owned units, which would likely result in both higher profit per unit and a higher earnings multiple.


  • MCD considers itself primarily a franchisor with company-operated restaurants playing a smaller role in the McDonald’s system

  • Of the three initiatives MCD said it was considering at a March 2014 conference (i.e. looking at capital structure, evaluating SG&A spend, and considering refranchising opportunities), the only one that it ended up making a meaningful change on was refranchising

    • Announced plans in May 2014 to sell at least 1,500 stores in APMEA and Europe through 2016, taking its franchise mix up from 81% to ~85%

  • The Street estimates that MCD would receive roughly ~$1.5bn in proceeds from selling the 1,500 international company-operated stores to franchisees, assuming conventional franchise deals

    • Proceeds could be higher if the refranchising is done in developmental licensing deals in which MCD would sell any owned land and buildings along with the business

  • However, more aggressive refranchising is a possibility

    • MCD has a franchise mix of ~81% vs. larger-cap multi-national QSR peers at 92% and the overall peer average of 90%

    • By refranchising more aggressively, MCD would create value from cutting SG&A and using the proceeds to buy back shares



  • I assume ~3,000 restaurants are refranchised from 2014-2017, bringing MCD’s franchise mix to ~90%

    • Assumes $350k EBITDA per store per year, each sold at a 5x multiple with the proceeds taxed at 32%

    • Generates $3bn in proceeds from 3Q15 through 2017, which are used to buy back shares at an 8.5% cost of equity


WEN Case Study on Refranchising

  • At the end of last year, WEN management indicated they were considering increasing their franchise mix.  In early February 2015, they officially announced their intention to move from an 85% franchised system to a 95% franchised system by middle 2016

  • The Company also announced its intention to take balance sheet leverage from 3x to a target of 5x to 6x

  • Finally, the Company announced cost cutting actions to reduce SG&A to $230mm (13% reduction relative to LTM levels of $265mm)

  • The stock was up nearly 40% from initial hints about refranchising to the final announcement

  • Given the new asset-light business model, the stock re-rated from 10x EBITDA to 13x EBITDA within four months