MCD is on the Hedgeye Restaurants Best Ideas list as a LONG.
A widely popular McDonald’s survey released last week, articulated how dissatisfied McDonald’s franchisees are with the current environment in which they operate. We don’t disagree with the conclusions of that survey; in fact, the survey sheds light on some alarming concerns that we highlighted in our recent Black Book.
Our thesis on McDonald’s is that the company is broken and is in the process of being fixed and there are other issues to consider when analyzing the health of the McDonald’s franchise system. In addition, most of the broader opinions in that survey are backward looking.
Taking the other side of this debate and looking at it from a different perspective, there are two critical metrics to consider:
- Franchisee profitability
- Franchisee EBITDA valuations
MCD is far from fixed and there are problems within the franchise system that still need to be addressed, but the company and franchisees are healthy. From the franchisee perspective, the MCD concept is one of the best quick service restaurants to own and we remain confident McDonald’s management is taking the right steps towards returning the business to prosperity.
In fact, the same survey that says the company is broken makes the same point we are. As one operator in the survey said:
“…We have the best cash flow in the industry driven by our higher sales and guest counts…Operators will need to evaluate the lifestyle they currently live and determine if five or less stores will generate enough cash to support their habits and complete investments necessary to keep the brand strong.”
Below is a chart that looks at McDonald’s Franchise system sales and margin performance. This chart makes the point above that the McDonald’s concept has the best cash flow in the industry.
According to our data, Franchisee EBITDAR margins peaked in 2010 at 25.3%. We would note that this is the same year MCD made its big push into beverages and launched the “cold” side of its McCafe strategy. With the big push into beverages and expanding the afternoon day-part, average unit volumes peaked two years later in 2012 at $2.6 million.
Since their respective peaks, by 2014 margins had fallen 260bps and average unit volumes had fallen by $62K. It’s also important to note that in 2014 MCD EBITDAR margins although down remained strong at 22.7%.
After 3-4 years of declining margins its only normal for franchisee anxiety to be at peak levels and it also makes for great press as MCD is an easy target.
What is even more challenging is taking the other side (being LONG) and convincing people that there are plans in place that are going to help franchisees and shareholders be better off.
Clearly, some of the concerns and negativity from franchisees are warranted, but management is working hard on improving the business and alleviating these concerns. Change will not happen overnight.
Another issue the company faces is that there are a significant number of McDonald’s franchisees, and management is not going to make everyone happy. The largest MCD franchisee owns 60 stores, with the top ten largest franchisees owning a total of 409 stores in the U.S., representing 2.9% of the system. The implications are that there are thousands of franchisees that all have an opinion on how things should be run!
Another important metric to consider is franchisee valuation trends. Looking at the data from Restaurant Research, the data on valuation trends also point to a very healthy system.
The chart below displays the unit level EBITDA multiple valuation trend for MCD, which peaked in 2014 at 5.75x, +16% higher than the segment average.
The demand for MCD restaurants among new and existing franchisees remains very healthy, despite the issues the company faces.