McDonald's Corp



|McDonald's Corp. |(MCD – NYSE) |$165.07 |

Note: This report contains substantially new material. Subsequent reports will have new or revised material highlighted.

Reason for Report: 1Q18 Earnings Update

Prev. Ed.: Mar 8, 2018; 4Q17 Earnings Update

Brokers’ Recommendations: Positive: 72.3% (16 firms); Neutral: 27.7% (6); Negative: 0% (0) Prev. Ed.: 21; 5; 0

Brokers’ Target Price: $186.1 (↑$1.7 from last edition; 21 firms) Brokers’ Avg. Expected Return: 12.7%

Portfolio Manager Executive Summary

McDonald's Corp. (MCD) together with its subsidiaries and franchises operates McDonald's restaurants worldwide. It offers various food items, soft drinks and other beverages. McDonald's’ major markets include Australia, Brazil, Canada, China, France, Germany, Japan, the United Kingdom and the United States.

Of the 22 firms in the Digest group covering the stock, 16 assigned positive ratings and six issued neutral ratings. None of the analysts had a negative stance.

The following is a summarized opinion of the diverse brokerage viewpoints:

Positive or equivalent outlook (72.3%; 16/22 firms): The firms with a positive outlook are optimistic about McDonald's leading position in the fast food industry and strong brand recognition. They believe that the chain’s size allows it to be more convenient to customers and have more advertising clout, thus giving it an edge over its competitors. Robust international comps bode well for the company. Further, the firms remain optimistic about McDonald's sales boosting initiatives especially the rollout of all day breakfast and faster drive thru times. They believe that the company’s sales will continue to improve on the back of menu innovation, digital initiatives, focus on delivery, remodeling of units and marketing measures. These firms are also positive about McDonald's increased cash generation capacity driven by rapid unit growth days and increased emphasis on franchising.

Neutral or equivalent outlook (27.7%; 6/22 firms): The neutral firms appreciate the company’s long-term fundamentals and product pipeline along with comps growth and expense control initiatives. These firms believe that the company’s asset-light model and the operating/financial strategies are commendable. However, they are cautious about cost pressure from higher food, labor and promotional costs, soft consumer spending on food away from home, and cut-throat competition within the U.S. restaurant industry. Moreover, the risks associated with volatility related to global operations and the company’s decline in traffic in the Unites States are worrisome.

May 10, 2018

Overview

Founded in 1948, Oak Brook, IL-based McDonald’s Corp. (MCD), is a leading fast-food chain operating over 37,000 restaurants in over 100 countries. The company mainly operates and franchises quick-service restaurants (QSRs) under the McDonald’s brand. The business is managed as distinct geographic segments.

It is one of the world’s most popular and valuable brands and holds a leading position in the globally branded quick-service restaurant segment of the informal eating-out (IEO) market. McDonald's restaurants serve French Fries, the Big Mac, the Quarter Pounder, Chicken McNuggets and Egg McMuffin. The company’s major markets are Australia, Brazil, Canada, China, France, Germany, Japan (50%-owned affiliated), the United Kingdom and the United States.

Effective Jul 1, 2015, the company began operating under four segments: U.S. (the largest segment), International Lead Markets (mature markets including Australia, Canada, France, Germany and the U.K.), High-Growth Markets (with high restaurant expansion and franchising potential including China, Italy, Poland, Russia, South Korea, Spain, Switzerland and the Netherlands) and Foundational Markets (the remaining markets in McDonald's’ system).

Its website is . The company’s fiscal year coincides with the calendar year.

The firms identified the following factors for evaluating the investment merits of McDonald’s:

|Key Positive Arguments |Key Negative Arguments |

| | |

|The company’s diverse geographic footprint has helped it to garner a |Owing to different sales-driving initiatives, management incurs high |

|leading position in the informal eating-out market. |expenses. Worldwide wage increase also remains a concern. All these |

| |factors, along with an excessive focus on value menu, are putting margins |

| |under pressure. |

| | |

|McDonald’s business model is characterized by a well-structured |Currency headwinds remain a concern since the company has a significant |

|revitalization plan, innovative marketing campaigns, reimaging activities |presence outside the United States. |

|and continuous menu innovation. The steady shift of international units to | |

|a franchised structure will be beneficial over the long term. | |

| | |

|McDonald’s has raised dividends every year since the first payout in 1976. |Soft industry growth in the United States remains a major cause for |

|Share repurchases also boost the bottom line. |concern. Further, the company is grappling with weakness in some parts of |

| |Europe and Asia. |

May 10, 2018

Long-Term Growth

The restaurant industry has been experiencing low consumption over the last few quarters while traffic has been weak too. Moreover, high labor costs and negative currency translation are adversely impacting margins and have added to its concerns. However, this may turn out to be only temporary as the economy remains poised for long-term growth on the back of rising income and solid employment numbers.

Notably, McDonald's is one of the world's largest quick service restaurants in terms of sales. Its large economies of scale allow it to increase spending on advertising, manage general and administrative (G&A) expenses and control costs better than peers.

The company remains committed to its strategic moves, which include menu optimization, modernizing customer experience and broadening accessibility to the McDonald's brand. Over the long term, the firms expect the company to improve its comps driven by new products, limited period offerings, ongoing operational improvements, a broad reimaging program, extended operating hours and aggressive marketing.

Management’s re-franchising strategy involves a shift to a greater percentage of franchised restaurants. At present, 92% of the company’s restaurants are franchised. In fact, the company has achieved its aim of refranchising 4,000 of its restaurants by the end of 2017 with the sale of its China and Hong Kong business.

The reduction in ownership through re-franchising, would weigh on near-term revenues, as it replaces company-operated sales by franchised sales. However, it will reduce the company’s capital requirements and facilitate earnings per share growth and ROE expansion over the long term. The company aims to continue optimizing its ownership mix by refranchising restaurants in a few of its large mature markets, like the United States. Also, it will carry on evaluating other markets to determine whether a developmental license model is the apt model to proficiently grow in those markets.

In fact, owing to re-franchising and stringent spending, the company expects to achieve approximately $500 million in net annual savings on SG&A expenses by 2018. Further, it expects to trim another 5% to 10% from its remaining cost base by the end of 2019.

Moreover, per its cash return target, the company returned $30.0 billion to shareholders over 2014 to 2016 via dividends and share repurchases. This represented an increase of around 80% over the amount of cash returned between 2011 and 2013. Meanwhile, the company expects to return between $22 billion and $24 billion to shareholders for the three-year period ending 2019. 

Meanwhile, the company is largely focused on growing global top-line sales and guest count. As announced by the company’s CFO, “McDonald’s business model supports the company’s ability to achieve and sustain certain long-term, average annual constant currency financial targets, beginning in 2019.” These targets include a system-wide sales growth of 3% to 5%; growing operating margin from the high-20% range to the mid-40% range; EPS growth in the high-single digits; and raising the return on incremental invested capital target from the high-teens to the mid-20% range.

The company expects to reach these targets by enhancing digital capabilities and using technology to dramatically elevate customer experience, redefining customer convenience through delivery as well as focusing on the quality and value of its food. Additionally, accelerated rollout of its Experience of the Future initiative bodes well for long-term traffic growth.

May 10, 2018

Target Price/Valuation

|Rating Distribution |

|Positive |72.7%↓ |

|Neutral |27.3%↑ |

|Negative |0% |

|Average Target Price |$186.1↑ |

|Digest High |$203.00 |

|Digest Low |$160.00↑ |

|Number of Analysts with Target Price/Total |21/22 |

Risks to the target price include macroeconomic weakness, intensifying competition, volatile food or labor costs, impact of overall consumer spending on sales, changing consumer tastes, increase in commodity costs, inability to execute growth plans, food safety, outbreak of any food-borne disease, unexpected pressure on international operations and significant foreign currency exposure.

Recent Events

On Apr 30, 2018, McDonald’s reported its first-quarter 2018 results. Pro forma earnings per share came in at $1.79, surpassing the Zacks Consensus Estimate of $1.67 by 7.2% and increasing 22% year over year.

Total revenues declined 9% year over year to $ 5,138.9 million. However, the top-line figure outpaced the Zacks Consensus Estimate of $4,915 million by 4.5%.

On Jan 16, 2018, McDonald's announced plans to derive 100% of its guest packaging from renewable, recycled and certified sources with a preference for Forest Stewardship Council certification. Management also targets recycling guest packaging at every restaurant.

The company plans to deliver smarter packaging designs and implement new recycling programs. It is also taking up initiatives to establish new measurement programs and educate restaurant crew as well as customers.

Revenues

Revenues of $ 5,138.9 million exceeded the Zacks Consensus Estimate of $4,915 million by 4.5%. Nevertheless, the metric declined 9% on a year-over-year basis. The downturn reflects the impact of the company’s strategic refranchising initiative. At the company-operated restaurants, revenues were down 26% year over year to $2,535.6 million. However, the same at franchise-operated restaurants increased 15% to $2,603.3 million.

Global comps grew 5.5% supported by encouraging guest count across segments.

U.S. Markets

In the United States, comps grew 2.9% in the first quarter owing to increase in average check resulting from rise in menu price and product mix shift. Comps growth, however, was lower than the prior-quarter increase of 4.5%.

In order to boost comps in the United States, which represent about 40% of the company’s business, McDonald’s particularly aims at increasing the focus on growing guest traffic. In this regard, the company is accentuating on operational excellence, product innovation, offering a value menu and rolling out more limited-time offerings.

Also, McDonald’s is leaving no stone unturned to revitalize its McCafe brand. Evidently, it is focusing on new cafe-quality espresso beverages, extended retail offerings and a branding overhaul to gain ground in the battle for the nation's coffee drinkers.

In addition, the company is undertaking digital initiatives to better serve customers, with nearly all of its U.S. restaurants now using digital menu boards. Also, McDonald’s launched mobile order on play capabilities via its app in more than 20,000 restaurants around the world.

Meanwhile, to provide improved convenience to customers, McDonald’s is increasingly focusing on delivery. In fact, it has scaled this initiative by introducing delivery at restaurants across the globe via its partnership with UberEATS. At present, the company’s more than 11,500 restaurants offer delivery.

At the same time, McDonald’s is accelerating Experience of the Future (EOTF) deployment in the United States, building on its success in markets around the world. Currently, McDonald’s has Experience of the Future deployed in 13% of restaurants. Over the next couple of years, this number is expected to increase significantly, with a goal of converting most of the traditional restaurants in U.S. system by 2020.

Moreover, given rising health concerns and increasing awareness on obesity and related diseases, the company has discontinued the use of chicken raised with antibiotics. Also, the company recently replaced margarine with butter in its breakfast sandwiches and removed artificial ingredients from its popular Chicken McNuggets. The company is also set to discontinue the use of frozen patties in favor of fresh beef in all of its popular “Quarter Pounder” burgers across the majority of U.S. restaurants by mid-2018. Additionally, to meet consumer preference for quality food, in September 2015, the company announced plans to shift completely to cage-free eggs for approximately 16,000 restaurants in the United States and Canada over the next 10 years. Such initiatives are expected to drive comps further.

International Lead Markets

Comps at this segment grew 7.8% year over year, higher than a 6% rise witnessed in the last reported quarter. Robust sales in the United Kingdom and Germany along with upbeat results across all other markets drove comps.

High-Growth Markets

Comps grew 4.7%, which was higher than the prior-quarter’s increase of 4%. The uptick can be attributed to strong performance in China and Italy as well as positive results across majority of the segments, partially offset by continual challenges in South Korea.

Foundational Markets

Comps in Foundational Markets grew 8.7% on the back of positive sales performance across all geographic regions. Moreover, the figure came in higher than 8% growth in the last reported quarter.

Outlook

Most firms are optimistic on McDonald’s efforts to boost sales through new, healthy products, investments in technology (mobile ordering and payment), focusing on delivery and faster drive-through times. They expect these efforts to increase capacity and improve traffic in the coming months. However, a soft industry backdrop remains a cause of concern to many.

Please refer to the Zacks Research Digest MCD spreadsheet for more details.

Margins

In the first quarter, total operating costs and expenses declined 18% year over year to $2,995.8 million. However, total operating income increased 5% to $2,143.1 million.

U.S. Markets

Segment operating income increased 5% backed by higher sales-driven franchised margin dollars and increase in sales from restaurant businesses, partially offset by lower company-operated margin dollars.

International Lead Markets

Operating income was up 21%, including the impact of foreign currency translation. At constant currency, the figure was up 9% primarily driven by sales-driven improvements in franchised margin dollars.

Outlook

A couple of firms expect McDonald’s to generate moderate margin growth on SG&A reductions and the transition toward franchising.

Please refer to the Zacks Research Digest MCD spreadsheet for more details.

Earnings per Share

Per McDonald’s, adjusted earnings per share came in at $1.79 in 1Q18, reflecting 22% year-over-year increase. The upside reflects stronger operating performance.

Foreign currency translation had a positive impact of 8 cents per share on earnings in the quarter. At constant currency, earnings grew 16% year over year.

Guidance

Foreign currency translation is expected to drive earnings per share by 8 cents in the second quarter. For 2018, the same is projected in the range of 19-21 cents.

Outlook

In 2018, most of the firms expect earnings to improve modestly on expectations of margin improvement and comps growth. Additionally, they expect a positive impact from foreign currency translations in the near term.

Please refer to the Zacks Research Digest MCD spreadsheet for more details.

May 10, 2018

|Research Analyst |Harendra Ray |

|Copy Editor |Annesha Bhattacharjee |

|Lead Analyst |Harendra Ray |

|Reason for Update |1Q18 Earnings Update |

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May 10, 2018

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