Shares of McDonald’s (NYSE:MCD) are currently undergoing what appears to be an unstoppable rally, with the stock hitting new all-time high levels almost every day. The rally has been largely propelled in recent weeks by investors’ enthusiasm for the company’s impressive financials and demonstrated resilience in Q1 in the face of challenges.
With MCD’s outstanding business model set to keep producing robust revenues and profits during a highly uncertain market environment, it’s quite likely that investor interest in McDonald’s stock will remain potent. However, it’s worth noting that the ongoing rally has led to a relatively expensive valuation of the stock, which may restrict its future upside potential. Accordingly, I am neutral on the stock.
Q1 Results: What Did the Market Like So Much?
McDonald’s Q1 results were undoubtedly positively received by the market, with the company posting pleasing top and bottom-line developments. Let’s examine!
Robust Revenue Growth
McDonald’s was once again able to drive robust revenue growth, driven by a higher number of restaurants and larger same-store sales. Specifically, at the end of Q1, McDonald’s had a total of 40,535 locations, 191 more than the prior-year period. Further, while total revenues grew by just 4.1%, this was largely due to a 14% decline in “Other Revenues,” which comprise nothing more than fees paid by franchisees to recover a portion of costs incurred by McDonald’s for various technology platforms, among other related fees and licensing arrangements.
Looking at the actual performance of the restaurants themselves, the McDonald’s brand continues to remain highly relevant, with revenues from franchised restaurants (which make up over 95% of all McDonald’s locations) growing by an impressive 10% year-over-year. This is a growth rate above inflation, suggesting increased foot traffic and a higher average customer ticket as well as pricing power.
The enduring appeal of McDonald’s food, which remains affordable even during uncertain economic times, is a significant factor in the company’s continued ability to generate strong sales. Therefore, given that most restaurants have increased their prices by a considerably higher margin compared to McDonald’s, it is quite likely that consumers will continue to find the brand’s value proposition highly attractive. Hence, it’s quite reasonable to assume that sales growth will remain robust in the coming quarters.
Exceptional Margins Drive Growing Profits
One of McDonald’s most attractive characteristics is that it features outstanding margins, which, combined with revenue growth, are able to drive strong growth in profits. In fact, McDonald’s EBITDA margin in Q1 came in at 53%, which is by far the best among its industry peers.
For context, in their most recent results, Restaurant Brands International (NYSE:QSR), Yum! Brands (NYSE:YUM), Wingstop (NASDAQ:WING), and Chipotle Mexican Grill (NYSE:CMG) posted EBITDA margins of 31.5%, 31.2%, 30.8%, and 19.1%, respectively. These are some of the most prominent companies in the QSR space, and yet, their margins can not even approach those of McDonald’s. This is because of McDonald’s highly-scalable business model, including more than 95% of the company’s restaurants being franchised, as previously mentioned.
Specifically, the bulk of the company’s revenues are derived from the real estate it owns and the royalties paid by its franchisees, which amount to a 5% fee on their top-line sales. This enables McDonald’s to reap the rewards of increased same-store sales without being vulnerable to rising restaurant operating expenses that may be triggered by inflation or other factors.
Overall, McDonald’s reported a highly-profitable quarter, with earnings per share skyrocketing by 66% to $2.45, thanks to a combination of various factors. These include the 4% increase in revenues, its operating margin expanding from 40.8% to 42.9%, the share count declining due to $3.90 billion in buybacks taking place over the past 12 months, and the fact that last year’s earnings had been negatively impacted by a $500 million non-operating expense related to the settlement of a tax audit in France.
Is McDonald’s Stock Reasonably Valued?
In terms of its valuation, McDonald’s management team doesn’t provide straightforward guidance. Therefore, I’m utilizing the consensus EPS estimates instead, which, based on the company’s Q1 performance and ongoing momentum, point to $11.09 for Fiscal 2023.
This estimate suggests a forward P/E close to 26.6x, which is a quite richer multiple compared to McDonald’s past decade-long range of about 15x-20x. The protracted valuation expansion was previously attributable to near-zero interest rates. Still, as investors have flocked to the stock’s secure investment case in the current highly-uncertain environment, this premium has lasted. Given McDonald’s exceptional financial performance, it’s understandable why the market has responded in this way.
The issue here, however, is that with rates on the rise, and MCD’s forward P/E near its highest level in recent history, shares are likely overvalued, offering essentially no margin of safety against a potential valuation contraction.
The stock’s dividend yield, which is currently hovering around 2.0%, also highlights the lack of a substantial margin of safety. Although the company has been steadily increasing its dividend payouts, the yield remains on the lower side of its historical range because of the recent P/E expansion. This doesn’t only indicate a weaker margin of safety but also suggests that current investors may face less promising total-return prospects in the future.
Is MCD Stock a Buy, According to Analysts?
Regarding Wall Street’s view on McDonald’s, the stock has retained a Strong Buy consensus rating based on 24 Buys and four Holds assigned in the past three months. At $317.79, the average McDonald’s stock price target implies 7.7% upside potential.
The Takeaway
McDonald’s most recent results demonstrated the ability of the company’s business model and operating structure to drive growing revenues and profits even during volatile market environments. Although this trend is likely to continue, those considering investing should exercise caution due to the likelihood of the stock’s elevated valuation restricting its potential for returns in the future.
