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10 reasons why Morningstar is lovin’ McDonalds

Lex Hall  |  08 Jan 2020Text size  Decrease  Increase  |  
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At McDonald’s in 2020, expect more chicken sandwiches, expect more plant-based meat offerings and expect less fraternising between management and staff.

Despite fierce competition, the world’s biggest and most famous burger joint is Morningstar’s top restaurant pick heading into the new year.

McDonald's (NYS: MCD) is trading at a 10 per cent discount to fair value, according to Morningstar's RJ Hottovy, who is loving the stock for several reasons.

Chief among them is the new chief executive Chris Kempczinski, who took over the job in November last following the controversial ouster of Steve Easterbrook.

But there are other reasons too. The wide-moat company, which this year marks its 65th year, is making it easier and faster to get burgers to customers by investing in new tech – particularly drive-through.

It’s innovating its menu by exploring two fast-food trends it had previously neglected: plant-based proteins, or “fake meat”, and premium fried chicken sandwiches.

And as well as churning out burgers and fries, the “golden arches” is also churning out cash, which Hottovy says helps make it a “recession-resilient” brand.

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And then there’s what Hottovy sees as an underrated management team, now led by Kempczinski.

“Results could be choppy through the management transition in the first half of the year,” Hottovy says, “but ultimately, we believe there are several positive catalysts at the forefront.

“In our view, the shares are enticing, at more than a 10 per cent discount to our valuation.”

And Hottovy's not the only one who likes McDonald’s. It's a well-known favourite of Warren Buffett - the Oracle of Omaha eats Macca's three times a week - as well as his Australian disciple Hamish Douglass, chief stockpicker at Magellan Financial Group.

At last count, the Magellan global ETF (ASX: MGE, rated silver by Morningstar) overseen by Douglass, has a 1.6 per cent holding in Macca's.

Easterbrook’s shock ouster

The fast-food industry is experiencing one of its most disruptive periods in decades, says Hottovy, so it was a surprise to him and other commentators when McDonald’s announced the exit of Easterbrook late last year.

Easterbrook, 52, was fired by the board when it emerged he was in a consensual relationship with an unnamed employee. Easterbrook apologised for conduct that he said violated company values and rules barring employees from dating direct or indirect reports.

Ousted McDonald's chief executive Steve Easterbrook

Former McDonald's chief executive Steve Easterbrook, who cut costs and hired new talent

He had nevertheless been instrumental in the company’s turnaround efforts since 2015, Hottovy says, cutting up to $500 million costs, conducting a successful global segment reorganisation and refranchising more than 4000 locations.

Easterbrook also oversaw two key growth drivers for McDonald’s. The first was the “Experience the Future” layout, which sought to make it faster and easier to order through mobile ordering and payments, as well as more delivery options.

He also reshaped the company’s corporate culture by bringing in outside talent.

New chief burger-flipper’s got talent

Into Easterbrook’s shoes, however, steps a McDonald’s veteran, who Hottovy says is more than capable of leading the company through a tough transition.

Kempczinski, 51, joined in September 2015 as executive vice president of strategy, business development and innovation following stints at other powerhouse consumer brands Kraft and Pepsi.

New McDonald's CEO Chris Kempczinski

New McDonald's chief executive Chris Kempczinski, who joined the company in 2015 

McDonald’s didn’t bother looking for an external candidate, given Kempczinski’s experience and nous in digital and delivery.

And one of his top priorities is menu innovation. That includes revitalising is breakfast offerings – breakfast accounts for about 30 per cent of system sales in the US – new coffee blends and the introduction of the “Chicken McGriddle” sandwich, as well as tests of a “Crispy Chicken Sandwich” and “Deluxe Crispy Sandwich”.

RJ Hottovy’s 10 reasons to consider investing in McDonald's in 2020:

1. It has an unknown yet underappreciated leader

Chris Kempczinski is a more than capable leader who will continue (and build upon) many of the technology initiatives put in place while embracing new menu innovations that alleviate current franchisee concerns.

2. Growth is picking up

With negative comparable transaction growth in 2019, it's not surprising that franchisees and the broader market have called into question the efficacy of what McDonalds calls it “Experience of the Future” investments. But it takes time for consumers to adjust to new technology changes, and we've started to see McDonald's outperform restaurant industry traffic averages the past few months.

3. It is transforming the drive-thru experience

In 2019, McDonald’s acquired Dynamic Yield a company specialising in “personalisation and decision logic technology” and Apprente, a voice-based conversational artificial intelligence platform. These two acquisitions should not only help McDonald's reinvent its drive-thru experience but also unlock new transaction and ticket opportunities through digital and kiosk ordering over the next several years.

4. It is unlocking new restaurant formats

New technologies should enable McDonald's to refine its future real estate strategy and unlock the potential for smaller-format mobile pickup or delivery hub locations. We see several benefits from such a strategy, including more consistent transaction growth and deploying McDonald's own delivery capabilities while reducing its dependence on third-party services (such as Just Eat).

5. It is growing its delivery business

We forecast that McDelivery as a percentage of sales will more than double over the next 10 years, from 4 per cent in 2019 to almost 9 per cent in 2028. As delivery becomes a more meaningful contributor, we expect a positive impact on comparable traffic and ticket trends while potentially allowing McDonald's to explore its own in-house delivery service (and reducing its dependence on third-party aggregators).

6. It is changing its menu

McDonald's largely missed out on the two most significant US menu trends in 2019: plant-based burgers and premium fried chicken sandwiches. While we don't anticipate the same level of comp benefit that Burger King and Popeyes enjoyed from new product launches in 2019, we believe McDonald's will see contribution from new product launches in these categories in 2020.

7. It is growing its presence in China

McDonald's has had uneven results in China, but we believe the sale of its assets in China and Hong Kong to a consortium led by CITIC and Carlyle has greatly improved operations in the region. With stores generating stronger unit economics, improved digital capabilities, a loyalty program of more than 100 million members, and opportunities for smaller-format locations, we expect China restaurant openings to steadily increase over the next 10 years.

8. It is recession-resistant

We're not forecasting a recession in the US in 2020, but we believe it's reasonable to expect a deceleration in industry growth trends amid difficult comparisons and the potential for asset market volatility. McDonald's tends to outperform in periods of slower economic growth, and we believe that will be the case again in 2020.

9. It is reasonably priced

With the restaurant industry fairly valued at current levels and facing potentially slowing growth rates in 2020, investment opportunities are scarce. Nevertheless, we believe McDonald's offers the best risk/reward profile in our coverage list on top of unique technology, menu, and capital allocation catalysts.

10. It is investing in itself

As it successfully wraps up its 2017-19 cash return goals of US$22 billion-US$24 billion, we believe McDonald's management will unveil new capital allocation plans in early 2020. While we don't expect the company to quite reach the same level of cash return over the next three years, we expect an acceleration in dividend per share growth to the low double digits over the next few years, which should satisfy income-oriented investors.

For tips on how to buy international shares, see the Prem Icon Morningstar Guide to International Investing

is senior editor for Morningstar Australia

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