McDonald’s Corporation

FNCE 203 – Analysis of Equity investment

Prepared for: Professor Wang Wei Mun

Prepared by:

• DAI Yuchen G3519076M

• NI Rui Sha G3528096R

• WEI Lai G3519070N

• WANG Tenglong G3528545N

• YU Xue G3528638T
Company profile

Company Overview

McDonald's is the world's largest chain of hamburger fast food restaurants,

serving nearly 47 million customers daily. Each restaurant is operated by a
franchisee, an affiliate, or the corporation itself. The revenues of the
corporation come from the rent, royalties and fees paid by the franchisees, as
well as sales in company-operated restaurants. McDonald's revenues grew
27% over the three years ending in 2007 to $22.8 billion, and 9% growth in
operating income to $3.9 billion. In addition to McDonald’s signature
restaurant chain, it held a minority interest in Pret A Manger until 2008, and
owned the Chipotle Mexican Grill until 2006 and the restaurant chain Boston
Market until 2007.

25,000.00

20,000.00

15,000.00
Sales(millions)
10,000.00

5,000.00

0.00
2004 2005 2006 2007 2008

Business Model

McDonald's Corporation earns revenue as an investor in properties, a

franchiser, and an operator of restaurants. Approximately 15% of McDonald's
restaurants are owned and operated by the Corporation directly. The rest are
operated through a variety of franchise agreements and joint ventures.
McDonald's business model is slightly different from that of most other fast-
food chains. In addition to ordinary franchise fees and marketing fees, which
are calculated as a percentage of sales, McDonald's may also collect rent,
which may also be calculated on the basis of sales. As a condition of many
franchise agreements, which vary by contracts, the Corporation may own or
lease the properties on which McDonald's franchises are located.
SWOT Analysis

McDonald’s main strength lies in its globalization, with 31,000 restaurants

serving 120 countries, which makes McDonald’s the biggest name in the
industry. It is increasingly looking for opportunities by continued adaptation to
societies needs such as USDA and supersize meal upgrade. Through such
innovation opportunities, it may possibly able to overcome its weakness of its
advertisements and products that target younger members of the community.
The main threat is the current world economic standing. Although the
company’s revenue streams are diversified, depending on the length of the
recession, it will inevitably be negatively impacted.

Industry Analysis

Industry Overview

Since late 2006, the fast food industry's growth has been slowed by rising
food and energy prices. The high prices of commodities, combined with the
housing slump and a weakening job market are taking a toll on restaurant
spending in the U.S. Fast food restaurants have navigated this difficult
landscape with varying levels of success.

International players such as McDonald’s and Yum! Brands had the most
success as explosive growth in emerging markets has offset rising costs and
the slowdown in US market. Other companies like Sonic and Domino's have
turned to new marketing campaigns and product innovation to boost growth
and profitability.

Industry Standing

The Fast Food Hamburger Restaurant industry is dominated by McDonald's

who possesses approximately 46.7% of the market share. The Fast Food
Hamburger Restaurant industry is a $67 billion segment. Burger King is
second behind McDonalds with a 13.9% share of the segment. The Fast Food
Hamburger Restaurant industry is extremely competitive because each
restaurant offers similar menus and prices.
 Market Share
26.70% McDonald's

46.70% Burger King

Wendy's
12.70% Others
13.90%

Under current economic situation, the strong international growth is driving

sales. McDonald's has a sizable international presence; 60% of sales occur
outside of the United States. In addition to developed markets like the U.K.,
Canada, South Korea and Australia, McDonald's operates in fast
growing emerging markets like China, India, Russia and Eastern Europe. By
tapping into a growing global middle class, the company's international
operations have consistently posted strong same-store sales growth. China is
a particularly promising opportunity. In 2007, McDonald's launched the
breakfast menu in China, extended store hours to 24 hours in major cities,
and implemented drive-thru to capitalize in this huge market.

Challenges

Consumer preferences that gravitate towards more nutritional food decrease

the appeal of eating at McDonald’s. As these consumer trends continue to
shift towards the mainstream, public perception of McDonald's becomes
increasingly negative. Since McDonald's is the most recognized brand name
in the fast food industry, these negative publicity events have widespread
impact on its brand equity. Furthermore, because there are many alternatives
to fast food, the corporation's sales depend on its ability to maintain its brand
name and attract new customers. The introduction of salads and public
nutrition campaigns are examples of McDonald's efforts to adapt its business
model to changing trends in the market.
McDonald's earnings are sensitive to prices of commodities such
as beef, corn, cheese and poultry. Since 2005, food prices have increased
substantially, but competition has prevented McDonald's from passing costs
along to customers. Thus, increasing input prices have come at the expense
of margins.

Recent Growth and Performance

Sales Revenue

McDonald’s revenue grew at a compounded annual growth rate of 6% from

2004 to 2008. The growth is quite slow and steady due to the current
economy downturn and the food commodity price increase.

Net Income

Net income grew at a compounded annual growth rate of 24.7% from

$2,278.5 million in 2004 to $3,544.2 million in 2006, but experienced a 32.4%
decrease in 2007 to $2,395.1 million. This drop is largely due to the pre-tax
operating charges of $1.7 billion ($1.32 per share) related to impairment and
other charges primarily as a result of the company’s sale of its business in 18
Latin American and Caribbean markets to a developmental licensee.

Normalized Adjusted Net Income

Adjustments made to net income

comprise of interest income,
investment income and non
recurring items. After adjustment
and normalization using net
margin, the normalized adjusted
net income shows a steady growth
trend.
 3,500

3,000

2,500

2,000

1,500

1,000

500

0
2004 2005 2006 2007 2008

NormalizedAdjustedNet Income
(millions)

Reinvestment Rate

The reinvestment rate of this company shows a negative result over the past
years. It can be explained by the declining of company’s working capitals,
which consist of current assets and current liabilities. Based on firm’s financial
reports, we found this company actually had larger current liabilities than its
current assets in year 2004 and 2007. Hence, we use an average
reinvestment rate over the past five years to replace these two years’ rates
respectively. However, we believe this negative reinvestment rate is a
temporary phenomenon reflecting volatile working capital.

Return on Equity

The company’s return on equity has been quite stable over years. Overall
ROE during last four years is 27.31%. ROE in 2008 is 28.65%, shows a
slowly and steady increasing trend.

Marginal ROE

The company has been employing a company-operated strategy for growth,

which emphasizes more on developing and refining operation standards. With
this strategy, the company closed down about 75% of its old investment,
comparing to 60% of new restaurant openings from 2006 onwards in major
markets. The ROE of old investments might differ from new ones. Therefore,
utilizing marginal ROE may be a better measure of the company’s profitability.
Its average marginal ROE is about 19.99%.

Parameters

Extraordinary growth period

Because of the current economic downturn and the price of food commodity
such as beef and corn increased since late 2005, we observed the company’s
revenue growth is quite steady in the past few years.

However, we expect that along with the economy recovery, the growth of
restaurant industry will enjoy a rebound. Also, the company is expanse in
emerging global markets such as India, Russia and Eastern Europe. With a
particularly promising opportunity in China, we expect the company will have
an extraordinary growth period of the next five year followed by five years
transition phase prior to achieving stable growth.

During extraordinary growth period, the cost of equity is 7.51%. The beta used
is beta of operating assets calculated based on historical beta of 0.65 which is
subjected to Bloomberg formula adjustment. The risk free rate of 2.29% is
obtained from 5 years US bond rate. The equity premium is the weighted
average premium calculated based on the percentage of revenue from
different geographical segment.

With an overall marginal ROE of 19.99% and reinvestment rate of 36.38%, we

get the growth rate of 7.27%, which is very close to analysts’ expectation of
7.9%.

Transition period

The growth prospects for McDonald’s will diminish as it expands and reach a
stable growth rate when there’s market saturation in emerging markets. Over
the 5 years transition period, the growth rate, equity reinvestment rate and
cost of equity will change linearly before entering the stable growth phrase.

Stable growth period

As the economy fully recovered and the global emerging market matured, the
beta will exhibit mean reverting behaviour towards 1. In addition we expect
the risk free rate will increase to 4.39% as we believe that the current risk free
rate is artificially low due to the global recession. At the long run, equity
premium should be the same as that in US, the matured market, which is 5%.
And this results in cost of equity of 9.39%.

We expect long term growth rate of 5% due to the development of emerging

markets. Considering the saturation of the market, we forecast a marginal
ROE of 20%. We arrive at the reinvestment rate of 25%.

Valuation

Company’s 2008 fiscal year end (31 Dem, 2008)

Based on the inputs above, the present value of cash flows that occurred
during extraordinary growth, transition stage and stable growth are being
summed to attain the value of operating assets. This is then combined with
the value of non-operating assets on the same date to obtain the value of
equity of $70,187 million, or expected share price of $62.93. Comparing our
valuation with the company’s actual share price of $57.07, we found the stock
is slightly undervalued and investors should buy.

Sensitive Analysis

We performed a sensitivity analysis of how the stock price varies with

marginal ROE and Beta of operating assets. Within an 80% to 120% range of
changes of marginal ROE, the stock price changes from $56.24 to $78.29.
When changing Beta of operating assets, we have the stock price changing
from $28.95 to $62.93. Moreover, we then took both these two factors into
consideration and the fair value of stock varied substantially from $45.23 to
$112.09. Compared to the current stock price of $57.07, we believe the stock
is now undervalued and we recommend a buy call to investors.
Appendix

Reference

2008 annual report, McDonald’s

Market share, 2009 Technomic Top 500 Chain Restaurant Report

Commodity prices, available from Bloomberg

Financial ratios, from the REUTERS,
http://www.reuters.com/finance/stocks/ratios?symbol=MCD

http://money.cnn.com/markets/bondcenter/

US economy recovery later this year, Article from: The Advertiser,

http://www.news.com.au/adelaidenow/story/0,22606,25437962-913,00.html

Financial Crisis May Offer Retail Opportunities, September 23rd, 2008

http://www.ifoapplestore.com/db/2008/09/23/financial-crisis-may-offer-retail-
opportunities/

Negative reinvestment rates, “Investment valuation: tools and techniques” by

Aswath Damodaran

US fast food market outlook 2010,

http://www.researchandmarkets.com/reports/706287/