Introduction To Service Industry Restaurants Marketing Essay

The food service industry continues to grow in volume and revenue every year and typically divides itself into two categories: full-service restaurants and fast-food restaurants. Each individual restaurant is in competition with other food service operations within the same geographical area. The fast food restaurant industry is highly competitive. McDonald’s competes with other restaurants through the quality, variety and value perception of food products offered. McDonald’s Corporation’s main competition comes from other fast-food restaurants; most notably, YUM! Brands Inc, Wendy’s International, Dominos and Burger King.

Figure1: The total revenues of the major players in the fast food industry (www.ycharts.com)

The figure represents the market share of McDonalds in the fast food industry. McDonald’s Corporation (MCD) has company operated and franchise restaurants all over the world. They are the leading global food service retailer by means of over 30,000 restaurants in more than 117 countries, serving about 50 million people every day. Franchising plays a major role in McDonald’s system with 26,216 were operated by franchisees (including 19,020 operated by conventional franchisees, 3,160 operated by developmental licensees and 4,036 operated by foreign affiliated markets (affiliates)-primarily in Japan) and 6,262 were operated by the company. Their total revenue in 2009 was $ 23 billion. McDonald’s success in the fast food industry stems from their main success factors which are branded affordability, menu variety and beverage choice, convenience and daypart expansion, ongoing restaurant reinvestment and operations excellence. These success factors are used to promote McDonald’s brand image, provide customers with quality products and differentiate themselves from other

competitors like YUM Brands (YUM owns brands like KFC, Pizza Hut, Taco Bell and Long John Silver)

After extensive research, analysis and valuation, it is found that McDonald’s corporation is currently an undervalued company and rated as a Market Outperform and thus I recommend this stock as a “Buy.”

Executive Summary

The food service industry is one of high competition; however, McDonald’s has been able to obtain the position as the leader in market capitalization with a market capital of $74.6B in 2009. While McDonalds has deployed high amounts of capital, the company manages its asset base with high inventory turnover while also maintaining cost efficiency.

Industry Demand Drivers:

The market of the food service industry attributes much of its growth to global sales and revenue. Despite tough environment, McDonald’s delivered an exceptional year of growth, posted strong sales and increased market share around the world. In 2009, global comparable sales increased 3.8 percent, fueled by solid gains in the United States (+2.6 percent), Europe (+5.2 percent), Asia/Pacific, Middle East and Africa (+3.4 percent), Latin America (+5.3 percent) and Canada (+5.8 percent). Earnings per share for the year increased 9 percent to $4.11 (13 percent in constant currencies), while consolidated operating income increased 6 percent (10 percent in constant currencies). We also returned $5.1 billion to shareholders through share repurchases and dividends paid, bringing our three-year cash return total to $16.6 billion-notably at the high end of our stated target of $15 to $17 billion for the years 2007 through 2009.

Globally, McDonald’s caters and adapts to different cultures and societies, while still providing them with the same McDonald’s experience. With a significant portion of McDonalds sales derived from international stores, foreign denominated sales should generate additional earnings leverage given the weakening of the US dollar against other currencies.

McDonald’s is well positioned:

McDonald’s is able to maintain a loyal customer base, and compete with the existing competitors by introducing variation to their menu, such as the Dollar Value Menu. Also, in order to adhere to a more concerned health concise society, McDonald’s has implemented holistic approach which consists of High-Quality Choices for customers, Consumer-Friendly Nutrition Information and communicate responsibly. The Happy Meal, which has been a long standing child’s favorite, now has options such as fruit instead of French Fries and all white meat chicken nuggets. As for one McDonald’s company goals is to adhere to outstanding customer service, strengthens the maintenance of long standing customers, as well as develop new relationships with customers of a new generation.

Franchising business model:

Within Fast Food restaurants franchise models are common. Franchise models can grow faster using others’ capital. Franchises have to be pay rent

and royalties based on a percent of sales along with minimum rent payments, and initial fees. On the other hand, company-owned models have greater control over pricing, operations and can close underperforming restaurants more quickly. In 2009 the total no of franchised restaurants was 26,216 compared to 25,465 in 2008 and the number of company operated restaurants decreased by 3.6%. The total revenue from franchises in 2009 was $7,286.2 Million an increase in 4% compared to 2008.

McDonald Franchises

Revenue from Franchises

Key challenges and Adaptability

Intensity of competition: Competitors of the industry also try to compete with similar products; therefore, leading to price wars. McDonald’s created a Dollar Value Menu, in response to competitors such as Wendy’s 99 cent menu. Overall, the industry has tried various product differentiations in order to accumulate greater market share, but most consumers are drawn to the classics. McDonald’s is doing more and more to compete with health focused restaurants like Subway. Nutritionist and other leading experts have been hired to join the McDonald’s team in order to ensure that the correct items are added to the menu, while still keeping and improving the classics that they are famous for. For example, the chicken nuggets that we all grew up on are now 100% white meat. McDonald’s is flexible in their menu to conform to the changing tastes of society.

Bargaining Power of Suppliers: In recent years the industry has had a small problem with beef, because of the outbreak of the mad cow disease. This problem raised the cost of beef in Europe tremendously but the cost actually went up around the world because of the beef shortage in Europe. The suppliers that sell to McDonald’s have a strong voice also because of the fact that the switching cost for McDonald’s as a whole would be so tremendous, so any problems or disputes would be worked out with there suppliers.

Comparative Ratio Analysis

Ratio analysis helps us analyze the financial trends of previous years and extrapolate those trends into future years for McDonald’s and its core

competitors within the industry. It is divided into three areas: fundamentals, growth and profitability, and capital structure of the company. Liquidity ratios are used to determine how liquid the firm is, and how it will meet its obligations. This also helps us determine how risky the firm is by determining if the company is employing an adequate amount of liability or risk to generate profit. Profitability ratios give us the perspective profitability of the firm is operating. The ratios will help in accurately valuing the company at its current condition, compare its performance against competitors, and project the future results of the company.

Fundamentals of McDonalds (MCD) vs. YUM Brands (YUM)

Table 1

Financial Condition

Company

Industry Average

S&P 500

Debt/Equity Ratio

0.74

1.82

1.13

Current Ratio

1.4

1.3

1.4

Quick Ratio

1.3

1.2

1.2

Interest Coverage

30.6

18.8

28.0

Leverage Ratio

2.1

3.8

3.8

Book Value/Share

13.12

11.95

22.35

The industry average is calculated as an average of competitor brands like YUM, Burger King and Wendy’s.

Current ratio: Since 1999 McDonald’s has experienced a steady increase in their current ratio. The present current ratio of 1.4 is higher compared to industry average of 1.3. This increase shows that McDonald’s has more ability to pay off their short term debts from the sale of their currents assets. Overall, McDonald’s is in fairly good shape because their current ratio is growing.

Receivables Turnover: McDonald’s has consistently been well below its competitors YUM with accounts receivables turnover. This means that they aren’t collecting their accounts receivables as promptly as their competitors. This prevents McDonald’s from reinvesting and expanding their restaurants which is a major source of revenue. This also allows for a greater chance of default on their accounts receivables.

Asset Utilization: This ratio indicates how profitable a company is relative to its total assets. The return on assets (ROA) ratio illustrates how well management is employing the company’s total assets to make a profit. The higher the return, the more efficient management is in utilizing its asset base. McDonald’s Asset Turnover has consistently been lower than its competitor YUM since 1999.

Debt to Equity Ratio: The debt-equity ratio is another leverage ratio that compares a company’s total liabilities to its total shareholders’ equity. McDonald’s has maintained a fairly low Debt to Equity Ratio of 0.74 which means that the company has an efficient amount of equity that can cover the cost of its liabilities compared to Yum of 3.14 or the industry average of debt to equity ratio of 1.82.

Book value per share: This is an indication of how much shareholders are paying for the net assets of a company. McDonald’s book value of 13.12 is higher than the industry average (11.95) or YUM (3.05)

Net Income: The net income for McDonald’s suffered a dip of 23% in 2007 but recovered in the year 2008, 2009. The total net income in 2009 was $ 4,555 Million compared to YUM who had a net income of $1071Million

Shareholders Equity: Shareholders’ equity represents the amount by which a company is financed through common and preferred shares. The average Shareholder’s Equity for MCD is $13,287M compared to YUM who has a $709M.

Dividend: MCD has consistently grown in dividends over the years. This is one of the most attractive features of MCD. Comparing the dividends of MCD and YUM, MCD has 25% increase on YTY compared to YUM who has only 14%.

Growth and Profitability

Table 2

Investment Returns %

Company

Industry Average

S&P 500

Return On Equity

34.8

48.2

21.4

Return On Assets

16.2

13.1

7.5

Return On Capital

17.6

15.4

10.0

Return On Equity (5-Year Avg.)

22.7

29.0

16.4

Return On Assets (5-Year Avg.)

11.4

10.1

7.6

Return On Capital (5-Year Avg.)

13.0

12.5

10.3

The industry average is calculated as an average of competitor brands like YUM, Burger King, and Wendy’s.

Revenue Growth: The global recession has affected the revenue of both the companies. By year 2009 the consumer demand and currency exchanges have helped recover to pre-recessionary levels.

EPS and Growth: The portion of a company’s profit allocated to each outstanding share of common stock. Earnings per share serve as an indicator of a company’s profitability. The EPS for MCD is 4.11 which have increased

from 9% from the previous year while the EPS for YUM is 2.26. The growth of EPS has been fluctuating due to the global economic crises.

Profit Margin: A higher profit margin indicates a more profitable company that has better control over its costs compared to its competitors. MCD has a profit margin of 20% compared to Yum is 10%.

Return on Equity (ROE): Return on equity measures a corporation’s profitability by revealing how much profit a company generates with the money shareholders have invested. The ROE for MCD is 34.8 which is less than the industry average of 48.2. From the above figure we can infer for 2009 the ROE for YUM is 180%, but this has not been consistent over the years. For a long term investor this is not good.

Capital Structure Charts

Table 3

Price Ratios

Company

Industry Average

S&P 500

Current P/E Ratio

16.4

20.9

22.4

P/E Ratio 5-Year High

NA

6.8

15.8

P/E Ratio 5-Year Low

NA

3.2

2.4

Price/Sales Ratio

3.21

2.33

2.03

Price/Book Value

5.30

7.11

3.21

Price/Cash Flow Ratio

12.70

11.90

13.80

The industry average is calculated as an average of competitor brands like YUM, Burger King, and Wendy’s.

Market Capital: Market capitalization represents the public consensus on the value of a company’s equity. McDonald’s in 2009 had a market capital of $67.3B compared to YUM brand that had a market capital of $16.35B. It also represents the market estimate of a company’s value, based on perceived future prospects, economic and monetary conditions.

Price to Earnings Ratio: A stock with a high P/E ratio means that investors are expecting higher earnings growth in the future compared to the overall market, as investors pay more for today’s earnings in anticipation of future earnings growth. From the table 2 McDonald’s PE is 16.4, which is below the industry average of 20.4. However there are limitations since the ratio depends on the earnings per share. McDonald’s earnings per share of 4.24 are above the industry average of 1.43.

Price to Book Value: This ratio used to compare a stock’s market value to its book value. A lower P/B ratio could mean that the stock is undervalued. From the above figure McDonald has a stable P/B ratio compared to the Yum. From table 3 the P/B ratio for McDonald is 5.31 which is below the industry average of 7.11.

Price to Sales ratio: The P/S ratio measures the price of a company’s stock against its annual sales. From table 3 we can understand that the P/S ratio for McDonald’s is 3.21 compared to the industry average of 2.33. This means that the investor would be paying $3.21 for every dollar of McDonald’s sales.

Price to Cash Flow Ratio: This ratio compares the stock’s market price to the amount of cash flow the company generates on a per-share basis. McDonald’s has a Price/Cash Flow ratio of 12.70 which is higher than the industry average of 11.90.

Conclusion

In our overall analysis of McDonald’s Corporation using a variation of methods and models, we have conclusively found that McDonald’s is currently undervalued in the market and is a ‘Buy’. The Method of Comparables was used, which included such ratios as: Price/Earnings, Price/Book, Price/Sales, and Price Earnings growth ratio valuations. The ratio valuations were calculated by finding the industry average and using a varying of other factors to project an expected share price. The industry average is calculated as an average of competitor brands like YUM, Burger King, and Wendy’s.

Price to Book Ratio

$

Industry Average of Price to Book value

7.11

Current Book Value of McDonald

13.12

Estimated price of share

$93.28

Current Market Price

69.37

Trailing Price to Earnings Ratio

Industry Average of Trailing Price to Earnings Ratio

17.9

Current McDonald’s earnings per share

$4.11

Estimated Market price

$73.59

Current Market Price

69.37

Dividends Yield Ratio Analysis

Industry Dividend Average (%)

2.73

McDonald Dividend per share

2.2

Expected share price found by dividing McDonald’s

(Dividends per share)/ (Industry average Dividends yield ratio)

$80.50

Current Market price

$69.37

Forward Price to Earnings Ratio

Industry Average of Forward Price to Earnings Ratio

14.73

Current McDonald’s earnings per share

$4.11

Estimated price of share

$60.54

Current Market Price

69.37

All Data obtained from Yahoo finance on 13/016/2010

From the above calculation the estimated price of McDonald is between $60.54 – $93.28. However McDonald’s corporation has faced previous law suits on being held accountable for obesity, similarly following the litigation process of cigarettes and tobacco companies. The courts ruled against this issue in McDonald’s favor, making this a remote future risk factor. In addition, MCD in it’s effort to be a more socially responsible corporate citizen, by supporting a healthier society, has developed “light” and healthy menu items in order to give customers additional eating options and in doing so, broadening the array of its customer base while offering it’s existing customer base with healthier menu options.

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