McDonald’s (NYSE: MCD) is neither a growth stock nor a value stock. But a quality title – where I define quality as the ability to generate attractive profit margins, predictable and stable revenue, and a strong competitive moat. Quality stocks are often supported by a recognizable brand image and a non-cyclical industry. As a result, these stocks are doing very well in a recessionary macro environment and at a time when investors are becoming risk averse.
Given a very challenging market environment – which arguably needs no further explanation – I like the relative risk/reward ratio of investing in McDonald’s versus the broader market.
McDonald’s is arguably the most recognizable fast food chain in the world, selling food and non-alcoholic beverages since 1940. Since December 2021the company marketed more than 40,000 restaurants worldwide, more than 90% of which were operated under a franchise agreement.
McDonald’s operates globally in more than 140 countries and generates more than 50% of total sales outside the United States.
What does quality look like
Personally, I define a quality stock with three dimensions: (1) steady and stable revenue growth, (2) high profit margins on those revenues to generate attractive revenues, and (3) a strong competitive moat to defend the accumulation of value. McDonald’s scores very well on all of these characteristics.
Steady and stable revenue growth
From 2018 to 2021, McDonald’s revenue grew at a compound annual growth rate of approximately 2%, which roughly matches nominal GDP growth. As a result, over the past 3 years, McDonald’s has added approximately $1.8 billion in sales, reaching $22.8 billion in 2021.
Over the same period, however, the company has managed to grow its gross profit at a much faster rate: from $10.8 billion in 2018 to $12.6 billion in 2021. These include at a CAGR of around 8%, and indicates that McDonald’s could increase its profitability in the context of bargaining power with suppliers and improving resource efficiency.
Perhaps the strongest argument for defining the McDonald’s business franchise as high quality is based on the observation that despite a very challenging macro environment, the business has managed to grow. For the past twelve months, McDonald’s revenue was $23.2 billion and gross profit was $13 billion.
High profit margin
In my opinion, net profit margins above 20% indicate a quality business. And McDonald’s net profit margin has been consistently above 25% for the past decade.
Notably, for the last twelve months, McDonald’s managed to claim a gross profit margin of 55.3%, which is more than 50% higher than the industry median of 36%. Additionally, the company’s EBIT margin is 43% and net income margin is 25.7%, a 425% premium to the industry median and a 340% premium respectively.
Referring to the table below, readers can see that McDonald’s TTM’s profit margin is in line with the 5-year average, indicating that the company is able to maintain high margins against the competition.
Strong competitive moat
What protects McDonald’s high margin against competition? As with any successful business, it’s the strong competitive gap. A gap can be supported by many different qualities, such as better technology and human capital. But for McDonald’s, I argue that it’s the globally recognized and loved brand (I love it).
According to InterbrandMcDonald’s is ranked the 9th most valuable brand in the world, with $45.9 billion in brand equity.
In addition, investors should also take into account that McDonald’s operates restaurants in prime locations, usually well laid out around the downtown area. This makes the franchise exposed to strong traction and easily accessible for a “quick” meal. And from a competitive point of view, this real estate advantage is difficult to replicate for new entrants, given the enormous capital intensity.
McDonald’s stock is not cheap. Of course not, given the company’s highly rated quality aspects. According to data compiled by Seeking Alpha, investors are required to pay around 100% premium over competitors. For reference, McDonald’s one-year price-to-earnings ratio is x31, compared to around x14 for the industry median. Respectively, EV/EBITDA is x20 versus x9.
But I argue that the premium is warranted and the risk reward for investors remains attractive. For example, another way to think of McDonald’s P/E is to say that “1 divided by x31” gives the annual shareholder return, which is 3.2%. And given McDonald’s competitive moat, that comeback could be considered a safe bet.
But why not invest in US Treasuries which are now yielding close to 4%. Because McDonald’s also gives exposure to growth and therefore expansion of returns. (Recall that McDonald’s has managed to grow its gross profit at a CAGR of around 8% over the past 3 years).
Going forward, against the backdrop of a booming market for food delivery, I believe McDonald’s could grow its business at a CAGR of 3% to 5% through 2025. The argument is simple: with restaurants located in prime real estate locations as well as important negotiations. against delivery companies, McDonald’s is poised to claim a leadership position in this emerging market opportunity.
The quality surpasses
Despite rich valuations, quality companies (such as McDonald’s) generally do very well in a recessionary environment and at a time when risk aversion dominates investor sentiment, given the quality arguments presented above. .
Therefore, while the market (benchmark S&P 500) has “collapsed” by around 20% since the start of the year, McDonald’s has managed to outperform by around 15 percentage points, losing only 5% of equity value.
Given a very difficult macroeconomic environment, I am confident in recommending holding quality stocks with a strong brand image and stable non-cyclical cash flows. McDonald’s adapts perfectly to the screen.
In my opinion, McDonald’s is likely to outperform money market securities such as Treasuries and the general stock market. Money market securities underperform inflation and the stock market looks very vulnerable to a recessionary environment and a contraction in EPS.
McDonald’s should be able to deliver a stable return – given the quality arguments mentioned in this article – while protecting investors relatively well from a continued market sell-off. I think MCD stock is fairly valued, but given strong quality arguments, it is definitely worth a hold.