McDonald's Continues to Execute Well Despite Challenging Restaurant Macroeconomic Environment

Equity Analyst

Sean Dunlop

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As the leader in global food-service sales, McDonald's is taking adequate steps to adjust to an evolving competitive landscape, in our view, leveraging its scale to invest heavily in digital capabilities and menu innovation as it leans into its MCD strategic framework. While we expect a turbulent couple of quarters amid a soft macroeconomic environment, we're encouraged by management's vision for the business, which we believe should enable McDonald's to maintain its edge.

More concretely, the firm's focus on relevant marketing, core menu development, and the four D's: digital, drive-thru, delivery, and development, strikes us as cogent, and appears to be effectively meeting the evolving needs of today's restaurant consumer. We believe that this approach capitalizes well on the firm's core competencies, with strong marketing engagement and brand affinity continuing to drive positive guest traffic despite a pronounced transaction slowdown industrywide. McDonald's investments in its core menu have resulted in the development of a strong, incremental chicken sandwich platform, and an emphasis on constant operational improvement suggests that the world's largest restaurant company by systemwide sales isn't resting on its laurels. Elsewhere, the burger chain continues to execute well on its four D's, with digital sales now comprising nearly 40% of systemwide sales in the firm's top 6 markets, attributable to the combination of growth in the delivery business, a successful global loyalty program launch, and pilots of smaller format stores which could unlock heretofore inaccessible trade areas. We expect further details on the firm's development targets later in the year, but note that McDonald's has returned to unit growth in its home market for the first time since the mid-2010's, a positive sign and reflective of improving franchisee cash flow dynamics and strong recent results.

We foresee market share gains as par for the course in the near-term, with the largest global restaurant chains best positioned to defray required investments in omnichannel ordering, loyalty programs, and restaurant modernization across a larger base of systemwide sales, in our view.

Business Strategy & Outlook

Low barriers to entry and minimal switching costs render the restaurant industry very competitive, making it difficult for most operators to develop an economic moat. Those who are able to do so, as we see it, focus on generating pricing power through a substantially differentiated and recognizable brand or by developing structurally lower operating costs, generally supported by scale-driven pricing advantages and leveraged systemwide investments in marketing and technology, while spreading administrative expenses over a larger revenue base. In our view, McDonald’s boasts a wide economic moat, with pricing power, a healthy network of franchisees, and successful international replication underpinning its brand intangible asset. We also believe that McDonald’s benefits from a durable cost advantage, with its dominant global scale allowing it to procure food and paper at favorable prices, to leverage marketing and technology investments across its global footprint, and to secure lower rates from third-party delivery aggregators. Our wide moat rating implies the assumption that the firm can continue to earn positive economic returns for the next 20 years. To this point, the firm has earned an average return on invested capital (inclusive of goodwill) of 20% over the last five years, against a weighted average cost of capital (as we calculate it) of 7%. Our 10-year forecast sees an average adjusted ROIC of 28%, with our 2032 projection of 32.5% outstripping the firm’s prepandemic average due to positive operating leverage and modest refranchising. The strength of recent technological investments, the company’s strong performance during a trying 2020—during which its ROIC of 14.5% still outperformed its cost of capital—and ongoing success in international markets leave us confident that McDonald’s will continue to earn excess returns over an extended horizon.

With respect to intangible assets, we cite the firm’s ability to pass through food and labor cost inflation to customers, its competitive restaurant-level margins and impressive unit volume, and number-one quick-service restaurant market share by sales volume in every major market in which it operates (with the notable exception of China) as the pillars underpinning our wide moat rating. To the first point, McDonald’s U.S. and international developmental/licensed segments saw their average check increase roughly 5% per year during 2016-19, faster than food inflation (1.3%) and increases in food-away-from-home pricing (up 2.7%, per USDA data) during that period. While the firm suspended its reporting of that figure due to temporary store closures during the initial surge of COVID-19, we view 6%-7% annualized same-store sales growth and market share gains between 2019 and early 2023 as reflective of a competitively advantaged brand, despite margin compression amid an unprecedented surge in input costs, and expect a full (if protracted) recovery to prepandemic profitability. The firm's ability to increase its industry traffic share despite 10%-plus price increases in 2023 further validates our view.

Turning to restaurant-level economics, we believe that the attractiveness of a brand to franchisees is driven by average unit volume, restaurant-level margins, systemwide stability, and franchise return on investment. McDonald’s scores well across the board, with average sales per U.S. franchised restaurant of $3.6 million in 2022, meaningfully outperforming publicly traded peers in the hamburger space (Burger King saw $1.4 million, Wendy’s $1.9 million, and Sonic $1.6 million, per Restaurant Business' 2022 top 500 report and our calculations). Given that restaurants feature high incremental operating margins, we estimate that higher sales lead to meaningfully better store-level operating income than many of McDonald’s direct competitors, a view corroborated by franchise disclosure documents after adjusting for measurement comparability. We conservatively estimate that McDonald’s franchisees earn midteens cash on cash returns (annual operating income as a proportion of total cash outlay), with category peers earning midsingle digits to midteens, underpinning the firm's unit development aspirations and increasing its allure in the eyes of franchisees.

Finally, with its systemwide sales of $116 billion in 2022, we estimate that McDonald’s attracted roughly 4% of global consumer food-service sales, approximately doubling closest competitor Yum Brands’ share and illustrating the firm’s success in international concept replication. With a footprint spanning 115 countries and a 55-year international operating history, McDonald’s has demonstrated brand strength across geographies, tastes, and cultures. While hiccups along the way have led to philosophical changes in approach, we’re impressed by McDonald’s ability to transfer winning innovations across the system, as seen with the introduction of Spicy Chicken McNuggets, which were initially developed in the Chinese market. The pace of innovation should only accelerate moving forward as the firm has migrated its international franchisees onto a more homogeneous technology stack, and we view investments in digital innovation, loyalty, new format stores, and the firm's chicken platform as evidence that management is taking appropriate strategic steps to position the firm for the ongoing evolution of the restaurant industry.

Turning to the firm’s cost advantage, we believe that McDonald’s commanding scale allows it to benefit from volume discounts in food and paper procurement from food distributors, fixed-cost leverage over general, administrative, marketing and technological expenditures, and from lower rates on third-party aggregator platforms. With respect to procurement relationships, QSR operators primarily value cost and on-time delivery. Larger case volume per store helps food distributors manage delivery costs per case, particularly with expensive last-mile delivery, while in-house technological capabilities offer chains the advantage of paying for food products without added services such as inventory management, marketing strategies, or other consulting offerings. Larger sales volume and geographic reach allow the biggest national restaurant operators to benefit from purchasing leverage, with food distributors willing to accept lower margins in exchange for higher operating income (margin dollars). 

While marketing and technology spending are easy to overlook, the benefits of scale are important when building an international brand. With a 4% marketing royalty and $116 billion of 2022 systemwide sales, McDonald’s advertising cooperatives likely maintain around a $4.6 billion marketing kitty to coordinate promotions, like the firm’s popular Travis Scott and J Balvin “famous” meals, Cactus Cactus Plant Flea Market toys, limited time offers, or top-of-funnel brand marketing through conventional print, radio, and digital advertising (though we note that international master franchisees get to set their own marketing rates, so our calculated figure is just an estimate). More concretely, strong brand awareness help new units achieve normalized average unit sales more quickly, improving cash payback periods and, by extension, lenders' and franchisees' appetites to partner with the burger chain.

On the technology side, the firm has repositioned from technology laggard to leader, piloting AI-enabled drive-thru ordering, signing a series of delivery partnerships with third-party aggregators, and rolling out a global loyalty program, illustrating its renewed digital focus. While McDonald's has not indicated an appetite for further acquisitions (like Dynamic Yield and Apprente, both of which have since been divested), we expect internal investments in mobile ordering, curbside delivery, takeaway windows, and multiple drive-thru lanes in select locations to help the firm increase throughput during key dayparts, and appreciate the longer-term potential of technology on labor efficiency, order accuracy, and guest engagement. The meaningful improvement in drive-thru times despite a surge in off-premises volume and labor pressure over the past few years shows one of the potential benefits of a digital pivot—requiring fewer hours of labor per dollar of sales—which figures to become increasingly important as the industry remains understaffed and as leisure and hospitality wages continue to grow. In our opinion, effective utilization of technology has become table stakes in the restaurant industry as firms begin to cultivate a detailed understanding of customers’ behaviors, leverage machine learning and artificial intelligence to increase customer lifetime value, and provide targeted promotions, but underlying data from customers who order through loyalty programs and white-label online channels offers a potentially enduring competitive edge. As a result, the firm's digital focus, trying to increase its pool of "known" customers (from 5% at the end of the third quarter of 2021 to a targeted level around 40%) strikes us as strategically sound, with data increasingly considered tantamount to a factor of production. 

An underappreciated manifestation of the firm's cost edge is reflected in McDonald's ability and willingness to shore up the health of its franchise system, beyond pure unit economics, in our view. With the firm's commitment to selectively and temporarily shore up franchisee profitability in Europe (to the tune of $100 million-$150 million in 2023) amid an ongoing surge in food cost inflation, we see traces of a competitive advantage that only the largest global restaurant operating companies could replicate, with support serving to avoid costly unit closures and as a proof point that the firm is committed to defending the profitability of its franchisees. It also allows franchisees to invest in long-term customer relationships, underpricing inflation and growing share of industry traffic as consumers increasingly seek value for their money. Rent holidays in 2020 amid the outbreak of COVID-19 served a similar end and helped catalyze the impressive string of subsequent results that have solidified the firm's commanding position in the global restaurant hegemony.

Finally, though restaurants and third-quarter operators are notoriously opaque regarding contract structures, we believe that McDonald’s pays lower commissions (low double digits) to aggregators like DoorDash and Uber Eats than do smaller peers, and far lower than the 30% headline rate. As a relatively early entrant in the space, partnering with Uber Eats in 2017, McDonald’s likely grandfathered in a lower commission, while a subsequent deal with DoorDash in 2019 occurred as pricing competition reached its zenith. Both were renegotiated as global deals in 2021. Management commentary from delivery firms supports this view, with QSR firms widely viewed as loss leaders—necessary to attract new consumers, but materially less profitable than independent restaurants and smaller brands, which rely on the aggregators for demand generation.

Wide

Economic Moat

McDonald's

McDonald's Corp. engages in the operation and franchising of restaurants. It operates through the following segments: U.S., International Operated Markets, and International Developmental Licensed Markets and Corporate. The U.S. segment focuses its operations on the United States. The International Operated Markets segment consists of operations and the franchising of restaurants in Australia, Canada, France, Germany, Italy, the Netherlands, Russia, Spain, and the U.K. The International Developmental Licensed Markets and Corporate segment consists of developmental licensee and affiliate markets in the McDonald’s system. The firm's products include Big Mac, Quarter Pounder with Cheese, Filet-O-Fish, several chicken sandwiches, Chicken McNuggets, wraps, McDonald's Fries, salads, oatmeal, shakes, McFlurry desserts, sundaes, soft serve cones, pies, soft drinks, coffee, McCafe beverages, and other beverages. The company was founded by Raymond Albert Kroc on April 15, 1955, and is headquartered in Oak Brook, IL.

Earnings data Q1 2024

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