McDonald's growth plans could bite into profits

As the fast-food giant looks to expand internationally, its supply chain will become more difficult to manage.

By Trefis Jan 24, 2012 1:29PM
Image: Hamburger (© BananaStock/Jupiterimages) McDonald's (MCD) had a stellar 2011, with its stock gaining more than 30%. We think the company's current price, however, is more reflective of its long-term, intrinsic value.

In fact, the sound fundamentals of the company might have fueled unreal optimism and overheated the stock. Skeptics who thought the company would struggle during a recession were proved wrong as McDonald's and several other restaurant stocks, including Yum! Brands (YUM), Starbucks (SBUX) and Chipotle Mexican Grill (CMG), all significantly outperformed the broader indices.

However, there are certain factors that need to be accounted for that could potentially stymie growth in the medium term.
 
McDonald's plans to spend a hefty $2.9 billion this year on capital expenditure -- topping its 2011 expenditure of $2.6 billion -- to open 1,325 new outlets and revamp the existing ones. In China, the company opened 200 new restaurants in 2011 and will increase its investment by 50% in the country this year.


Globally, more than 80% of McDonald's restaurants are franchised but in China, only 6 of its 1,400 outlets are franchised -- the rest are company-operated. It is difficult to franchise restaurants in developing countries like China due to lack of big franchisee players who can match the stature of McDonald's, as well as an unreliable legal system that often favors local companies. Thus, the majority of the new outlets in China in the coming years will be company-operated. Since company-operated restaurants require much greater initial investment than franchised restaurants, McDonald's high capital expenditure is not limited to just 2012.


With company-operated restaurants, McDonald's will be exposed to rising real estate and labor prices. Franchised restaurants are relatively insulated from such fluctuations. The company will also have to deal with supply chain and quality issues. Generally, developing countries have a higher rate of inflation than advanced economies, which can put a downward pressure on the EBITDA margins.


McDonald's Company Operated Restaurants EBITDA Margin

McDonald's is also trying to improve its image by refurbishing and introducing more comfortable seating in its existing restaurants in the U.S. In addition, the company will roll out its much anticipated McTV this year. All of these expenses are not one time investments as maintaining them will require greater cash flow in the coming years.

 

Recently, McDonald's was the target of a San Francisco City law that required fast food companies to meet certain nutritional standards before they could use promotions with free toys. The U.S. Congress is also contemplating passing a law that would limit the classes of antibiotics used in animal agriculture. In fact, a recent study revealed that a whopping 75% of Americans want legislation passed to restrict the use of antibiotics at animal farms.


With increased healthcare under the Federal government, it wouldn't be surprising to see new laws aimed at fast food companies that are viewed as contributing to obesity and related diseases. At the same time, companies meeting certain nutritional standards might get tax benefits.


The last few years have also seen consumers turning to healthier products. All these factors might force McDonald's to change its basic structure. And structural changes could be potentially damaging as they might include introducing new products that may not be as popular or profitable.


Moreover, as McDonald's expands its food selection domestically and looks to expand internationally, its supply chain will become more difficult to manage.  It could be more prone to shocks -- like inflation or shortages --  that would be hard to offset among value-oriented customers domestically and price-sensitive developing markets internationally.


We have a $95 price estimate for McDonald's, which is about 5% lower than the current market price.


See our complete analysis for MCD stock here.


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