McDonald’s Corporation

FNCE 203 – Analysis of Equity investment

Prepared for: Professor Wang Wei Mun

Prepared by: • • • • • DAI Yuchen NI Rui Sha WEI Lai WANG Tenglong YU Xue G3519076M G3528096R G3519070N G3528545N G3528638T

Company profile Company Overview McDonald's is the world's largest chain of hamburger fast food restaurants, serving nearly 47 million customers daily. Each restaurant is operated by a franchisee, an affiliate, or the corporation itself. The revenues of the corporation come from the rent, royalties and fees paid by the franchisees, as well as sales in company-operated restaurants. McDonald's revenues grew 27% over the three years ending in 2007 to $22.8 billion, and 9% growth in operating income to $3.9 billion. In addition to McDonald’s signature restaurant chain, it held a minority interest in Pret A Manger until 2008, and owned the Chipotle Mexican Grill until 2006 and the restaurant chain Boston Market until 2007.

25,000.00 20,000.00 15,000.00 10,000.00 5,000.00 0.00 2004 2005 2006 2007 2008 S les(m a illions )

Business Model McDonald's Corporation earns revenue as an investor in properties, a franchiser, and an operator of restaurants. Approximately 15% of McDonald's restaurants are owned and operated by the Corporation directly. The rest are operated through a variety of franchise agreements and joint ventures. McDonald's business model is slightly different from that of most other fastfood chains. In addition to ordinary franchise fees and marketing fees, which are calculated as a percentage of sales, McDonald's may also collect rent, which may also be calculated on the basis of sales. As a condition of many franchise agreements, which vary by contracts, the Corporation may own or lease the properties on which McDonald's franchises are located.

SWOT Analysis McDonald’s main strength lies in its globalization, with 31,000 restaurants serving 120 countries, which makes McDonald’s the biggest name in the industry. It is increasingly looking for opportunities by continued adaptation to societies needs such as USDA and supersize meal upgrade. Through such innovation opportunities, it may possibly able to overcome its weakness of its advertisements and products that target younger members of the community. The main threat is the current world economic standing. Although the company’s revenue streams are diversified, depending on the length of the recession, it will inevitably be negatively impacted. Industry Analysis Industry Overview Since late 2006, the fast food industry's growth has been slowed by rising food and energy prices. The high prices of commodities, combined with the housing slump and a weakening job market are taking a toll on restaurant spending in the U.S. Fast food restaurants have navigated this difficult landscape with varying levels of success. International players such as McDonald’s and Yum! Brands had the most success as explosive growth in emerging markets has offset rising costs and the slowdown in US market. Other companies like Sonic and Domino's have turned to new marketing campaigns and product innovation to boost growth and profitability. Industry Standing The Fast Food Hamburger Restaurant industry is dominated by McDonald's who possesses approximately 46.7% of the market share. The Fast Food Hamburger Restaurant industry is a $67 billion segment. Burger King is second behind McDonalds with a 13.9% share of the segment. The Fast Food Hamburger Restaurant industry is extremely competitive because each restaurant offers similar menus and prices.

Mark S et hare
26.70% 46.70% 12.70% 13.90%
McDonald's Burger King Wendy's Others

Under current economic situation, the strong international growth is driving sales. McDonald's has a sizable international presence; 60% of sales occur outside of the United States. In addition to developed markets like the U.K., Canada, South Korea and Australia, McDonald's operates in fast growing emerging markets like China, India, Russia and Eastern Europe. By tapping into a growing global middle class, the company's international operations have consistently posted strong same-store sales growth. China is a particularly promising opportunity. In 2007, McDonald's launched the breakfast menu in China, extended store hours to 24 hours in major cities, and implemented drive-thru to capitalize in this huge market. Challenges Consumer preferences that gravitate towards more nutritional food decrease the appeal of eating at McDonald’s. As these consumer trends continue to shift towards the mainstream, public perception of McDonald's becomes increasingly negative. Since McDonald's is the most recognized brand name in the fast food industry, these negative publicity events have widespread impact on its brand equity. Furthermore, because there are many alternatives to fast food, the corporation's sales depend on its ability to maintain its brand name and attract new customers. The introduction of salads and public nutrition campaigns are examples of McDonald's efforts to adapt its business model to changing trends in the market.










as beef, corn, cheese and poultry. Since 2005, food prices have increased substantially, but competition has prevented McDonald's from passing costs along to customers. Thus, increasing input prices have come at the expense of margins. Recent Growth and Performance Sales Revenue McDonald’s revenue grew at a compounded annual growth rate of 6% from 2004 to 2008. The growth is quite slow and steady due to the current economy downturn and the food commodity price increase. Net Income Net income grew at a compounded annual growth rate of 24.7% from $2,278.5 million in 2004 to $3,544.2 million in 2006, but experienced a 32.4% decrease in 2007 to $2,395.1 million. This drop is largely due to the pre-tax operating charges of $1.7 billion ($1.32 per share) related to impairment and other charges primarily as a result of the company’s sale of its business in 18 Latin American and Caribbean markets to a developmental licensee. Normalized Adjusted Net Income Adjustments made to net income comprise investment and of interest income income, and using non net

recurring items. After adjustment normalization margin, the normalized adjusted net income shows a steady growth trend.

3,500 3,000 2,500 2,000 1,500 1,000 500 0 2004 2005 2006 2007 2008

Norm lizedAdjus Net Inc e a ted om (m illions)

Reinvestment Rate The reinvestment rate of this company shows a negative result over the past years. It can be explained by the declining of company’s working capitals, which consist of current assets and current liabilities. Based on firm’s financial reports, we found this company actually had larger current liabilities than its current assets in year 2004 and 2007. Hence, we use an average reinvestment rate over the past five years to replace these two years’ rates respectively. However, we believe this negative reinvestment rate is a temporary phenomenon reflecting volatile working capital. Return on Equity The company’s return on equity has been quite stable over years. Overall ROE during last four years is 27.31%. ROE in 2008 is 28.65%, shows a slowly and steady increasing trend. Marginal ROE The company has been employing a company-operated strategy for growth, which emphasizes more on developing and refining operation standards. With this strategy, the company closed down about 75% of its old investment, comparing to 60% of new restaurant openings from 2006 onwards in major

markets. The ROE of old investments might differ from new ones. Therefore, utilizing marginal ROE may be a better measure of the company’s profitability. Its average marginal ROE is about 19.99%. Parameters Extraordinary growth period Because of the current economic downturn and the price of food commodity such as beef and corn increased since late 2005, we observed the company’s revenue growth is quite steady in the past few years. However, we expect that along with the economy recovery, the growth of restaurant industry will enjoy a rebound. Also, the company is expanse in emerging global markets such as India, Russia and Eastern Europe. With a particularly promising opportunity in China, we expect the company will have an extraordinary growth period of the next five year followed by five years transition phase prior to achieving stable growth. During extraordinary growth period, the cost of equity is 7.51%. The beta used is beta of operating assets calculated based on historical beta of 0.65 which is subjected to Bloomberg formula adjustment. The risk free rate of 2.29% is obtained from 5 years US bond rate. The equity premium is the weighted average premium calculated based on the percentage of revenue from different geographical segment. With an overall marginal ROE of 19.99% and reinvestment rate of 36.38%, we get the growth rate of 7.27%, which is very close to analysts’ expectation of 7.9%. Transition period The growth prospects for McDonald’s will diminish as it expands and reach a stable growth rate when there’s market saturation in emerging markets. Over the 5 years transition period, the growth rate, equity reinvestment rate and cost of equity will change linearly before entering the stable growth phrase. Stable growth period

As the economy fully recovered and the global emerging market matured, the beta will exhibit mean reverting behaviour towards 1. In addition we expect the risk free rate will increase to 4.39% as we believe that the current risk free rate is artificially low due to the global recession. At the long run, equity premium should be the same as that in US, the matured market, which is 5%. And this results in cost of equity of 9.39%. We expect long term growth rate of 5% due to the development of emerging markets. Considering the saturation of the market, we forecast a marginal ROE of 20%. We arrive at the reinvestment rate of 25%.

Valuation Company’s 2008 fiscal year end (31 Dem, 2008) Based on the inputs above, the present value of cash flows that occurred during extraordinary growth, transition stage and stable growth are being summed to attain the value of operating assets. This is then combined with the value of non-operating assets on the same date to obtain the value of equity of $70,187 million, or expected share price of $62.93. Comparing our valuation with the company’s actual share price of $57.07, we found the stock is slightly undervalued and investors should buy. Sensitive Analysis We performed a sensitivity analysis of how the stock price varies with marginal ROE and Beta of operating assets. Within an 80% to 120% range of changes of marginal ROE, the stock price changes from $56.24 to $78.29. When changing Beta of operating assets, we have the stock price changing from $28.95 to $62.93. Moreover, we then took both these two factors into consideration and the fair value of stock varied substantially from $45.23 to $112.09. Compared to the current stock price of $57.07, we believe the stock is now undervalued and we recommend a buy call to investors.


Reference 2008 annual report, McDonald’s Market share, 2009 Technomic Top 500 Chain Restaurant Report Commodity prices, available from Bloomberg

Financial ratios, from the REUTERS,

US economy recovery later this year, Article from: The Advertiser,,22606,25437962-913,00.html Financial Crisis May Offer Retail Opportunities, September 23rd, 2008 Negative reinvestment rates, “Investment valuation: tools and techniques” by Aswath Damodaran US fast food market outlook 2010,