• McDonald’s trades around 3% year-to-date lower
• Company set to report Q3 earnings on Monday
• Revenue growth seen slightly weaker than in Q2 2023
• McDonald’s hikes charges on some franchisees
• A look at 3 valuations models
• Stock bounces off the lower limit of the Overbalance structure

McDonald’s (MCD.US), one of the world’s largest and most famous fast food chains, is trading around 3% lower year-to-date. Company is scheduled to report earnings for June – September 2023 period on Monday before the opening of the Wall Street session. Let’s take a look at what the market expects from the release, recent changes in McDonald’s franchisee charges as well as the company’s valuation.

McDonald’s to report earnings on Monday

McDonald’s is expected to report a 11% YoY increase in Q3 revenue, a slightly lower than 13.6% YoY growth reported in Q2 2023. However, if those expectations are met, a trailing 4-quarter revenue growth (T12) would improve from 2.5% YoY in Q2 2023 to over 6.5% YoY in Q3 2023 – the highest since Q2 2022. Operating profit as well as net income are expected to climb around 10% YoY each while margins are expected to deteriorate slightly compared to a year ago quarter.

Q3 2023 expectations

• Revenue: $6.52 billion (+11% YoY)
  • Same-store sales: +7.7% YoY vs +9.5% YoY a year ago
• Number of locations: 41 185 (+3% YoY)
• Operating profit: $3.05 billion (+10.5% YoY)
• EBITDA: $3.55 billion (+10% YoY)
• Net income: $2.17 billion (+9.7% YoY)
• EPS: $2.98 vs $2.68 a year ago
• Gross margin: 58.5% vs 58.69% a year ago
• Operating margin: 46.9% vs 47.1% a year ago
• Net margin: 33.4% vs 33.7% a year ago

Annual growth rates for McDonald’s 12-month trailing revenue and operating income. Source: Bloomberg Finance LP, XTB

Franchises to be charged more

McDonald’s announced that it will hike charges on some franchisees. Company informed operators and employees that the monthly royalty fee charged on franchisees in North America will be increased from 4% to 5% of gross sales, starting from 1 January, 2024. A new, higher fee will apply only to new restaurants as well as restaurants that were owned by McDonald’s and later taken over by franchisees. Restaurants outside North America are already being charged 5% in most cases.

On one hand, this change means that McDonald’s will earn more. On the other hand, things may not be so simple. The increase will add strain to franchisees who are already experiencing elevated costs in a high-inflation environment and, given that higher charges will apply to new restaurants, it may discourage opening of new franchised restaurants. Moreover, McDonald’s has been struggling to grow its business as of late and a hike – the first in 30 years – may mean that it is running out of options to boost growth.

Franchised revenue still accounts for over 60% of McDonald’s total sales but this share has dropped slightly in recent quarters. Source: Bloomberg Finance LP, XTB

Valuation

Let’s take a quick look at McDonald’s valuation with 3 often used valuation methods – DCF, multiples and Gordon Growth Model. We want to stress that those valuations are for presentation purposes only and should not be viewed as recommendations or target prices.

Discounted Cash Flow method

Let’s begin our look at McDonald’s valuation with the most in-depth of the three aforementioned models – Discounted Cash Flow method (DCF). This model relies on a number of assumptions. We have decided to take a simplified approach and base those assumptions on averages for the past 5-years. Detailed forecasts for 10 years were made with terminal value assumptions being set as follows – 2% terminal revenue growth and 6% terminal weighted cost of capital (WACC). Such a set of assumptions provides us with the intrinsic value of McDonald’s shares of $286.94 per share – over 10% above current market price!

A point to note is that the intrinsic value obtained via DCF method is highly sensitive to assumptions made. Two sensitivity matrices are provided below – one for different sets of Operating Margin and Revenue Growth assumptions and the other for different sets of Terminal WACC and Terminal Revenue Growth assumptions.

Source: Bloomberg Finance LP, XTB Research

Source: Bloomberg Finance LP, XTB Research

Multiples

In order to value McDonald’s using stock multiples, a peer group needs to be constructed. We have chosen 4 US companies that operate fast-food restaurants and have a similar business model as McDonald’s – Chipotle Mexican Grill (CMG.US), Yum! Brands (YUM.US), Domino’s Pizza (DPZ.US) and Wendy’s (WEN.US). We have taken a look at 6 different valuation multiples – P/E, P/BV, P/S, P/FCF, EV/Sales and EV/EBITDA. 

As we can see in the table below, there is quite high volatility in multiples for different companies. As such, we have decided to base calculations of McDonald’s valuation on medians rather than means. A point to note is that Yum! Brands, Domino’s Pizza and McDonald’s have liabilities exceeding assets, meaning that their book value is negative and therefore price-to-book ratio cannot be calculated. Taking a look at the 5 remaining multiples and valuations obtained from them, we can see that they are as low as $115.62 for EV/Sales and as high as $301.30 for EV/EBITDA. Taking a trimmed mean of the 5 valuations, that excludes the highest and the lowest valuations, we are provided with an intrinsic value for McDonald’s shares of $214.16 – or around 17% below yesterday’s closing price.

Source: Bloomberg Finance LP, XTB Research

Gordon Growth Model

Last but not least, let’s take a look at McDonald’s valuation using the Gordon Growth Model. As McDonald’s has a long track record of paying dividends, the company is suitable for valuing using this method. We have assumed a 6% dividend growth rate as well as 8% required rate of return based on averages and trends for the past 5-years. Running a model with such assumptions leads us to an intrinsic value of $299.98 per share. This is over 15% above yesterday’s closing price.

As it is usually the case with valuation models, the Gordon Growth Model is also highly sensitive to assumptions made. Sensitivity matrix for dividend growth and required rate of return assumptions is provided below. Green tiles show combinations that result in above-market valuation and red tiles show combinations that result in below-market valuations.

Source: Bloomberg Finance LP, XTB Research

A look at the chart

Taking a look at McDonald’s (MCD.US) chart at D1 interval, we can see that the stock dropped around 18% between late-July and mid-October. However, downward move was halted at the $245.50 support zone recently. This zone is important not only because it is marked with previous price reactions but primarily because it is marked with the lower limit of the Overbalance structure and a break below would hint at a bearish trend reversal. However, no such downside breakout occurred, signaling that the uptrend is still in play. Stock began to recover from recent declines and has climbed to $260 resistance zone which has not been breached yet. A break above this resistance would pave the way for a test of the $270 resistance zone, marked with 50-session moving average (green line).

Source: xStation5