EUR 850.00 For Business Accounts Only

Morningstar | McDonald's Velocity Drivers Intact, Should Help to Placate Franchisee Questions Heading Into 2019

Our positive outlook for McDonald's remains in place following its third-quarter update, as recent operational improvements continue to lift global comps (up 4.2%) and refranchising efforts pushing operating margins to the mid-40s (45% for the quarter, with expectations of 43% for the full year). While we recognize U.S. franchisee concerns about the efficacy of Experience of the Future (EOTF) investments and margin pressures from value platforms--the strength of the McDonald's franchisee system is one of the intangible assets behind our wide moat rating--we see several indicators that suggest top-line momentum as we head into 2019 that haven't been fully appreciated by the market.

We identify multiple sources of top-line growth over the medium term. The first are its various velocity drivers such as EOTF, mobile order, and delivery. While EOTF haven't yet delivered meaningful transaction growth--especially relative to advanced EOTF international markets like the U.K., France, Australia, and Canada--we believe McDonald's U.S. comparable ticket and traffic trajectories compare favorably with other restaurant technology-based transformation efforts (most notably, Panera's 2.0 initiative from 2014-16). We also share management's views about opportunities to improve speed of service and order accuracy as new technologies are implemented and expect contribution from classic meal deal and breakfast daypart additions to the $1-$2-$3 menu. Taken together, we forecast U.S. comps of 2%-3% range in the fourth quarter, with acceleration to the 3%-4% range as 2019 progresses.

We're not planning changes to our $190 fair value estimate and see shares as undervalued even after the post third-quarter rally. While we still see McDonald's velocity accelerators as its top investment consideration, we believe the stock offers an attractive capital allocation play (even as refranchising efforts wind down) as well as one of the industry's more recession-resistant names.

While valuations have contracted across the industry as refranchising activity has wound down and transaction growth has remained elusive, McDonald's remains one of our top industry investment ideas. As we discussed in our Oct. 2 piece, "The Restaurant Industry Is Evolving—Your Key Performance Benchmarks Need to, Too," we believe McDonald's is at the top of the list at understanding its position in an evolving industry landscape, with recent menu, operational improvements, and technology enhancements positioning the company to maximize convenience and throughput, which in turn should be additive to the brand intangible asset behind our wide moat rating.

While transformational investments will weigh on near-term margins, we also see McDonald's 2020 targets as achievable. Our model is aligned with these goals, which include 3%-5% system sales growth, operating margins growing to the mid-40s (we forecast 43% this year and 45%-46% in 2019), high-single-digit EPS growth, and total shareholder returns in the low double digits.