Everyone wants to buy a great company at a cheap price. Unfortunately, those opportunities are few and far between. Most of the time, when you find a company that is the undisputed leader in its industry, highly profitable, and growing, the stock will trade at a significant premium.
Investors should jump at the opportunity to buy the dip (13% over the past three months) in this restaurant stock. The company’s earnings miss is the result of accounting distortions – identified by our “novel dataset” featured in “Core Earnings: New Data and Evidence”. The recent upheaval of the executive team is also overblown, and we expect this company to continue to deliver strong results. McDonald’s Corporation (MCD: $194/share) is this week’s Long Idea.
GAAP Earnings Mislead Investors
MCD trended lower beginning in August 2019 due to concerns over increased competition. Those concerns seemed valid when the company reported third quarter earnings per share of $2.11 on October 22, missing consensus expectations of $2.20. MCD has missed expectations in all three quarters of 2019.
However, our research shows that these disappointing earnings results don’t tell the whole story. While MCD’s GAAP net income declined through the first nine months of 2019, its after-tax operating profit (NOPAT) continues to rise. See Figure 1.
Figure 1: MCD’s GAAP Net Income and NOPAT: 2018-TTM
Sources: New Constructs, LLC and company filings
The decline in TTM GAAP net income is primarily attributable to the change in MCD’s “Asset dispositions and other (income) expense, net,” disclosed on page 27 of its latest 10-Q. Through the first nine months of 2019, MCD has $38 million in asset disposition and other expense. Through the first nine months of 2018, it earned $45 million in income from this line item, primarily due to sales of restaurant properties in the U.S. and Australia.
The change in this non-operating line item decreased MCD’s pre-tax income by $83 million year-over-year through the first nine months of 2019. Using MCD’s cash tax rate of ~25%, that equates to a $62 million hit to GAAP net income, or 111% of the decline in GAAP net income between 2018 and the TTM period.
Investors who rely on reported earnings will believe that MCD’s profits are declining, when the core earnings are growing.
Growing Same-Store Sales
In addition to our forensic accounting adjustments, MCD’s accelerating same-store sales growth shows that the decline in GAAP earnings does not accurately reflect the fundamentals of the business.
MCD reported that same-store sales grew by 5.9% year-over-year through the first three quarters of 2019. MCD has improved its same-store sales growth in every year but one going back to 2015, as shown in Figure 2.
Figure 2: MCD’s Same-Store Sales Growth
Sources: New Constructs, LLC, and company filings
MCD drives same-store sales growth through constant innovation in its restaurant design and menu.
Always An Innovator
Over the past two years, the company, along with its franchisees, invested heavily in remodeling its locations through its “Experience of the Future” (EOTF) redesign. The redesign emphasizes a modernized aesthetic, digital kiosks for more rapid ordering, and a more convenient layout that makes delivery and mobile ordering easier.
Delivery, in particular, has been a major driver of growth. On the 3Q19 earnings call, the company projected that delivery will drive $4 billion of sales in 2019, or 4% of global sales. Delivery sales have quadrupled from just $1 billion three years ago.
Meanwhile, MCD continues to drive growth across a wide variety of markets through constant menu innovation. The company continues to grow and expand its market share in countries like Japan, Portugal, and Russia by combining its core menu with items that appeal directly to local tastes.
MCD also continues to innovate in its menu presentation. The company spent $300 million in March to acquire Dynamic Yield, which uses machine learning to personalize the customer experience. MCD has already implemented Dynamic Yield technology in the majority of its U.S. drive-thru locations, and plans to roll it out across the entire country by the end of the year.
These constant innovations have helped MCD’s maintain its dominance in the fast food industry for decades, and we see no reason to expect that dominance to diminish.
Refranchising Strategy Pays Off
In addition to its store redesign, MCD has emphasized refranchising its locations over the past several years in order to maximize its cash flows. The percent of MCD locations run by franchisees has increased from 81% in 2013 to 93% currently. See Figure 3.
Figure 3: Percent of All Locations Franchised
 Harvard Business School features the powerful impact of our research automation technology in the case New Constructs: Disrupting Fundamental Analysis with Robo-Analysts.
This article originally published on November 6, 2019.
Disclosure: New Constructs
Disclosure: David Trainer, Kyle Guske II, Sam McBride, and Andrew Gallagher receive no compensation to write about any specific stock, style, or theme.
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