Dear Mr. Berko: What are McDonald's largest competitors? They've got to be what's damaging McDonald's revenues, which, according to Morningstar, have been declining every year since 2013. How can McDonald's compete with all the new franchises selling hamburgers, fries and shakes? And how can stock analysts continue to recommend McDonald's when sales have declined for five straight years? I own 150 shares of McDonald's, which I bought at $66 in 2010. Should I sell this stock?
— LS, Erie, Pa.
Dear LS: No!
Some of the top burger chains competing with McDonald's are BurgerFi, Burger King, Culver's, Steak 'n Shake, White Castle, Shake Shack, A&W, Whataburger, Hardee's (and Carl's Jr.), Wendy's, Five Guys, Krystal, Checkers (and Rally's), In-N-Out Burger, Sonic, Big Boy, Cheeburger Cheeburger, Wimpy, Red Barn and Smashburger. The top 500 burger chains generated $76.2 billion in revenues last year, and about 35 percent of those revenues derived from McDonald's. I've hamburgered at each of the above franchises and others, and I've found that there are only two places in the world that make a better burger than McDonald's. One is in East Harlem, and the other is a cafe in Kathmandu. Neither is franchised. Among the prominent reasons consumers choose McDonald's (MCD-$185) are clever marketing, superior taste, consistent product quality, fair prices and clean service areas. Lousy service is MCD's only conspicuous negative.
MCD has more than 37,000 locations, and until five years ago, some 7,000 of those units were corporately owned. Therefore, the proceeds from the sales of burgers, shakes and fries from those 7,000 units were included in MCD's total corporate revenues. In 2013, MCD decided to refranchise most of its company-owned units, keeping about 1,500 company stores for training purposes. As MCD refranchised some 5,500 units, proceeds from the sales of burgers and drinks were replaced by lower franchise fees, leading to a decline in revenues. Even though revenues have declined for five years, net profit margins have improved significantly, and I believe that trend will continue. Though the newer model generates lower revenues, franchise fees and royalties will improve MCD's profitability and cash flow and positively goose its share value. Since 2013, when management decided to change its business model -- converting company-owned units to franchised units -- net profit margins have improved from 19.9 percent to an expected 28.5 percent this year, and they could be 29.5 percent in 2019. And operating margins, which for years traipsed around the 35 percent level, zoomed to 48 percent this year and could be 49.5 percent in 2019. Moreover, MCD's shares have doubled in price. That's impressive.
MCD also generates impressive revenues via rent it charges franchisees who lease the real estate and equipment from the mother corporation. The real estate market has been hot for the past seven years. MCD owns nearly 50 percent of the land and about 70 percent of the buildings at its 37,000-plus locations, and some analysts figure this accounts for nearly half the market value of MCD stock. A business model in which MCD is the landlord ensures steady income even if burger sales were to be impacted for short periods of time.
Yes, the competition is catch-as-catch-can. The fancy off-the-wall burger joints that keep coming to the market are basically niche players hoping to generate a dependable following. But the mystique of a new type of burger preparation, a better bun, avant-garde fries and exotic flavors eventually wears off. And many of those IPOs with bizarre burgers and sapid shakes eventually disappear into the ether, where the Whangdoodle mourneth for her firstborn.
MCD is an excellent income growth stock. It has increased earnings annually for over 30 years, expects to earn $7.70 a share this year and may earn $8.35 in 2019. The $4.64 dividend yields 2.5 percent. The dividend has been increased in each of the past 30 years, and next year it may be increased to $5.02. Hold on to your MCD. It has held up quite well in a volatile market. During the past 10 years, this stock has posted an impressive 16.3 percent average annual total return.
Please address your financial questions to Malcolm Berko, P.O. Box 8303, Largo, FL 33775, or email him at email@example.com.