By Brad Thomas, Wide Moat Research,Trades Of The Day, 2024-08-02
I don't know if you noticed, but McDonald's reported poor Q2 2024 results on Monday.
I'm talking about really poor results across the board:
- Revenue was $6.49 billion instead of the expected $6.63 billion.
- Adjusted earnings per share were $2.97 instead of $3.07.
- Same-store sales retracted 0.7% versus the 1.04% predicted growth.
- Global same-store sales growth was even worse at -1% versus 0.84%.
Meanwhile, international-owned same-store growth was -1.1% compared to analysts' expectations of 1.85%. And international franchised same-store sales fell -1.3% compared to 0.41%.
So bad news on top of bad news on top of bad news on top of bad news.
McDonald's, it turns out, is under pressure in both China and the U.S. due to more careful consumer spending. This is understandable, considering how Big Macs are rarely a necessity, and we all know McDonald's hasn't been shy about raising its prices in the last few years.
CEO Chris Kempczinski acknowledged this on the Q2 earnings call, saying that those higher charges “contributed to our underperformance.”
In France, meanwhile, he noted there's “a competitor… who's being aggressive on pricing.” And over in the Middle East, McDonald's has lost favor over its perceived stance on Israel.
Yet despite all those woes, investors sent the stock up more than 4%.
Believe it or not, I can't help but agree with them.
All McDonald's Roads Lead Back to Real Estate
Did you know McDonald's is one of the world's largest real estate owners?
For the record, that's almost undoubtedly not why investors were so optimistic on Monday. They were much more likely focused on McDonald's optimistic outlook in its follow-up earnings call.
Essentially, Kempczinski said the company has been a value leader for 70 years, and it aims to reclaim that status again. “This won't happen overnight,” he cautioned, “but it will happen” thanks to McDonald's “unique competitive advantages.”
For my part, I would argue its real estate is a big part of that exclusive edge.
McDonald's owns 41,822 restaurants across 100 countries, with around 95% of those franchised out. This means that in order to cash in on the McDonald's name, franchisees have to pay an initial franchise fee, an ongoing royalty fee of 4% of each restaurant's gross sales, a 4% marketing fee…
And property rental fees, which add up very nicely for corporate.
Now, I do have to add here that McDonald's doesn't always own the land its fast-food restaurants are built on. Oftentimes, it leases those grounds under very long-term contracts, then subleases the properties – buildings and all – to its franchisees.
But as John F. Love explained in his book, McDonald's: Behind the Arches, “The beauty of McDonald's taking a ‘sandwich' position on real estate… was that it produced predictable profits.”
So much so that he sees it as more of a real estate business than a hamburger joint.
Previous McDonald's owner Ray Kroc “marked up McDonald's lease costs, initially by 20% and then by 40%,” he writes. Franchisees don't have a choice in that, the aforementioned expenses, or paying taxes and insurance on their “rentals.”
It's a take-it-or-leave-it proposition. And as we already know, tens of thousands of franchisees have been more than willing to sign on the dotted line.
The REIT Route Is Pretty Much Closed
All told, McDonald's real estate portfolio is massive. There's no other way to describe it when the company's owned land and buildings are worth more than $40 billion.
If it was a real estate investment trust (REIT), that sum wouldn't amount to net-lease competitorsVICI Properties (VICI) – with its $50 billion enterprise value – or Realty Income (O) at $78 billion.
But those two are enormous players in their sector. Plenty of other REITs would aspire to McDonald's holdings… which amounted to over $9.8 billion in rent checks last year.
So why doesn't it go the REIT route? After all, Olive Garden owner Darden Restaurants (DRI) spun off its real estate intoFour Corners Property Trust (FCPT) in 2015. Sears did the same, resulting inSeritage Growth Properties (SRG). And Caesars Entertainment (CZR) followed suit in 2017, forming VICI Properties.
Plus, they did it tax-free!
So why doesn't McDonald's do the same?
It's a good question, but there's an equally good answer since Congress has since closed that window. Today, C-corporations can still spin off their real estate into REITs if they want, but without the tax-free incentives.
McDonald's and any other real estate-heavy company must pay Uncle Sam a hefty slice of the profits if they want to monetize their real estate this way.
Who knows? That might change again someday. But in the meantime, it's not as if McDonald's is suffering from its property situation.
As we already established, far from it.
Dividends Galore
So you can see, McDonald's is essentially a real estate business disguised as a fast-food chain.
The company collects rent checks and royalties from its franchisees which makes for a very steady and predictable income machine.
I'll also point out that the company is a tried-and-true dividend payer. By that, I mean it's a dividend aristocrat – a publicly traded entity that's rewarded its shareholders with a rising payout for at least 25 years in a row.
That means it increased its dividend in both the Great Recession and the Covid-19 shutdowns.
Better yet, if it follows that pattern for the next two years, it'll become a dividend king – a company that's met that challenge for 50 years in a row.
Mark my words: That's no small feat. There are only 54 companies that can claim that kind of dividend commitment.
REIT or not, McDonald's has a lot going for it. And its shareholders are clearly very willing to stick with it through thick or temporary thin.
Perhaps they also recognize how analysts are forecasting growth of 9% in 2025 and 7% in 2026. Maybe they've factored in how shares are trading at 21.9x their price-to-earnings ratio… which is notably lower than its normal valuation of 23.5x.
Put together, my team and I think McDonald's could return 20% or more over the next 12 months.
Regards,
Brad Thomas
Editor, Intelligent Income Daily
Source: Wide Moat Research
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