Why We're Lovin' McDonald's

McDonald's MCD may seem like an unconventional choice for our top restaurant pick. Stagnant traffic trends in 2019 have called into question the lasting efficacy of the company's various “velocity drivers,” including Experience of the Future store formats, digital ordering, and delivery. Competition remains fierce, with several rivals seeing strong comparable sales results from plant-based burgers and premium chicken sandwiches, and promotional activity is likely to escalate in 2020. On top of this, the company recently had a high-profile management change, with McDonald's U.S. head Chris Kempczinski assuming the CEO reins from Steve Easterbrook in November 2019.

While these factors are investment considerations, we still see several reasons McDonald's should be on investors' radar screen. Our confidence stems from new technology investments (particularly at the drive-thru), menu innovation plans, a recession-resilient brand, strong cash return qualities, and an underrated management team. Results could be choppy through the management transition in the first half of the year, but ultimately, we believe there are several positive catalysts at the forefront.

Identifying a top pick in the restaurant industry heading into 2020 was not an easy task. The industry is undergoing one of its most disruptive periods in several decades, with operators facing evolving consumer dining preferences, rising labor costs, disruption from third-party delivery aggregators and other emergent sources of competition, food away from home pricing still outpacing food at home pricing, and pockets of macroeconomic weakness. Not surprisingly, restaurant industry comparable sales growth (as measured by third-party data provider Black Box Intelligence) remained generally in the low single digits in 2019, with comparable traffic trends continuing to decline even as many operators touted “incremental” delivery transactions.

Despite these operating challenges and questions about their impact on future fundamentals, the industry continues to trade near peak multiples, making investment opportunities more difficult to identify. According to Capital IQ, the restaurant industry is trading at an average forward price/earnings multiple of 26 times and an average forward enterprise/EBITDA multiple of 16 times, compared with 10-year industry averages around 23 times and 13 times, respectively. We believe some of the multiple expansion we witnessed in 2019 is warranted, as large-cap quick-service restaurant companies continue to outpace the broader industry due compelling value propositions, technology investments, and attractive capital allocation profiles stemming from the move to a more asset-light, franchised structure in recent years. However, at current market prices, we generally see the restaurant category as fairly to slightly overvalued.

With the industry facing significant challenges while also trading near peak multiples, screening for new investment ideas is even more challenging. However, looking at the industry trading patterns of the past decade, three characteristics stand out to us in evaluating new restaurant investment ideas when industry valuation multiples are misaligned with industry transaction growth trends:

(1) The company has made the necessary technology investments to adapt to changing industry trends, but these have yet to fully materialize in its fundamentals.

(2) The company has scale to maintain a compelling value proposition in case a more pronounced economic downturn arises.

(3) The company offers a high-quality income story.

In our opinion, McDonald's best fits these qualities among companies in our restaurant coverage, but it also offers a number of other unique catalysts.

10 Reasons to Consider McDonald's in 2020
1: Chris Kempczinski Is an Unknown yet Underappreciated Leader
The sudden departure of Easterbrook in November 2019 raises natural questions about McDonald's leadership under the new CEO, who is not well known by the Street. However, we believe 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: McDonald's Is Still Reaping the Benefits of EOTF 1.0...
With negative comparable transaction growth thus far in 2019, it's not surprising that franchisees and the broader market have called into question the efficacy of Experience of the Future investments. However, as with Panera's 2.0 initiative, 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: ...While It Transforms the Drive-Thru Experience With Acquisitions and Embarks on EOTF 2.0
The 2019 acquisition of Dynamic Yield (a personalization and decision logic technology company) and Apprente (a voice-based conversational artificial intelligence platform) 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: New Technologies Can Unlock New Restaurant Formats and Greater Market Density
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 aggregators. Our model now projects accelerating unit growth in the latter part of our explicit 10-year discounted cash flow forecast.

5: Delivery Still Represents a Sizable Opportunity
We forecast that McDelivery as a percentage of systemwide sales will more than double over the next 10 years, from 4% in 2019 to almost 9% 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: McDonald's Is Poised for a Bounce-Back Menu Innovation Year
McDonald's largely missed out on the two most significant U.S. 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: CITIC-Carlyle Partnership Has McDonald's Positioned for Growth 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: McDonald's Tends to Be More Recession-Resistant Relative to the Industry
We're not forecasting a recession in the United States 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: McDonald's Offers Greater Valuation Upside Relative to the Industry
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: New Capital Allocation Plans Should Be a Positive Catalyst
As it successfully wraps up its 2017-19 cash return goals of $22 billion-$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.