YTD McDonald s vs. Peers. YTD S&P500 vs. McDonald s

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1 Student Investment Management (SIM) SIM Analyst: Joseph P Chandraraj SIM Portfolio Manager: Royce West Corporation (NYSE: MCD) Data as of August 17, 2009 Recommendation Price 12-Mo. Target Price Upside** Sector Industry HOLD $54.50 $ %** Consumer Discretionary Restaurants ** 13% upside includes 3.63% ($2.0) annual dividend yield. * Next earnings release: October 19, 2009 Investment Thesis: The one-year target price for MCD is $59.61 based on its competitive position within the fast-food/quick service restaurant industry, current macro-economic factors, and its strategy to grow in both domestic and international markets. The valuation is based on a Discounted Cash Flow (DCF) and Absolute Valuation Models. Revenues (company sales & franchise fees) in 2009 and 2010 are projected to increase by 1.3% and 3.8% and EPS in 2009 and 2010 is projected to increase to $3.99 (up 6%) and $4.07 (up 2%); the consensus is projected at $3.87 (up 3%) and $4.26 (up 10%). The HOLD recommendation comes due to the fact that McDonalds is a strong defensive play against further risks to global economic rebound, an expected stock price appreciation of 9.4%, and a strong $2.0 (3.63%) annual dividend. Also, McDonalds future earnings growth will be better than expected and therefore a high probability that the stock price will move towards the 1 year target of $60. YTD vs. Peers -1.20% % 16.10% 41.40% 38.40% YTD S&P500 vs. 20.0% 10.0% 0.0% -10.0% -20.0% S&P, 8.4% MCD, -11.9% Stock Performance: McDonalds share price recovery of 8% in 2008 when the S&P500 lost close to 40% indicates the defensive nature of stock. Even though, McDonalds is currently at YTD loss of -12%, in the long run has the highest return in the quick service restaurant industry with a 5 year cumulative return of 62%. I believe the rapid expansion in emerging markets like China and India will lead to higher growth in the immediate future due to ability to cater to the local taste and the huge population with higher spending power. Catalyst for the share price: The early performance indicators of the entry into the premium coffee business is positive and it poses the main upside potential along with the positive growth rate results in the emerging markets. New products like the $4 Angus burger (introduced July 2009) may shift customers cutting expenses from the full service to in the quick service industry. Expansion in the emerging markets, with 190 new outlets in India and 500 in China over the next year could boost revenues. A potential weak dollar can boost revenues as over 65% of revenues are from outside the United States. The profitability of depends on efficient operations, effective marketing, and its ability to provide fast service. Risk Assessment: faces risk at multiple levels of operation and execution. At a high level, the key risks are: regulation and litigations, product development and execution, costs (labor cost in a highly labor intensive industry and volatile commodity prices), safety (ability to manage the potential impact from food-borne illnesses), global markets (political instability, social and ethnic unrest), the economy and with close to 65% of revenue from outside the U.S., fluctuations in currency exchange rate pose significant risk. Brand (strong) Under Valued (no) Management (strong) Financial Health (strong) Risk (medium) Growth (medium) Financial Data E 2010E Revenues ($bn) $23.5 $23.8 $24.7 Operating Margin (%) 27.5% 29.3% 28.7% Net Income ($Million) $4,313 $4,573 $4,660 EPS ($) $3.76 $3.99 $4.07 Dividend/Share ($) $2.0 $2.0 $2.0 Cash/Share ($) $1.79 $1.72 $1.69 Share Data 52 week range $45.79 to $67.00 Performance (%) YTD 5 Year 1/08-8/09 MCD -11.4% 62.0% -5.0% YUM! Brands 11.2% 55.6% Page 1-9.5% S&P % -16.1% -30.0%

2 Table of Contents Company Overview...4 Demand Drivers...4 McDonalds- A good defensive stock...5 Key Success Factors...5 Industry Analysis...6 Top Industry Trends...6 Porters 5 Force Analysis...7 Industry Valuation...7 Competitive Landscape...8 Macroeconomic Analysis Revenue, Operating Cost, Net Income and EPS Projections Revenue Projections Operating Cost Projections Revenue and EPS historical performance relative to Restaurant Industry and Sector Net Income and EPS Projections DCF Valuation DCF Sensitivity Analysis Absolute Valuation Financial Analysis Profitability Ratios Analysis Effective Ratios Analysis Liquidity Ratios Analysis Risks Conclusion Appendix Appendix 1: Revenue Projections by Revenue Source and by Geography Appendix 2: Capital Expenditure and Depreciation/Amortization Projections Appendix 3: Cost/Expense Projections by Revenue Source and by Geography Appendix 4: Net Income Statement Historical Trend and Projections Appendix 5: DCF Valuation Page 2

3 List of Figures Figure 1: Revenue by Region..4 Figure 2: System wide Restaurants by Ownership trend 4 Figure 3: Cumulative 5 year Restaurant Growth 5 Figure 4: 2009 U.S. Restaurant Industry Sales by Segment...6 Figure 5: U.S. Restaurant Industry Sales 6 Figure 6: Porter s Five Forces.7 Figure 7: Top 30 Quick Service Restaurants - by % Sales Change...8 Figure 8: U.S. GDP Breakdown...10 Figure 9: Personal Consumption Breakdown...10 Figure 10: Non Durable Goods Breakdown.10 Figure 11: Food consumption Breakdown...10 Figure 12: Regression Consumer Spending & McDonalds..11 Figure 13: Regression Disposable Income & McDonalds 11 Figure 14: Regression Unemployment & McDonalds..11 Figure 15: Net Income Projections Figure 16: EPS Projections...14 List of Tables Table 1: U.S. Restaurant Industry Key Statistics 6 Table 2: Restaurant Industry Valuation..7 Table 3: Vs Peer Competition Stock Performance - YTD, 1 Year and 5 Year.8 Table 4: Corporation Vs Key Competition Key Financial Statistics.9 Table 5: Corporation Revenue Projections..12 Table 6: Corporation Operating Cost Projections 13 Table 7: Corporation Revenue and EPS performance relative to Industry and Sector 14 Table 8: DCF Valuation Results...15 Table 9: DCF Sensitivity Analysis...15 Table 10: Absolute Valuation Matrix...16 Table 11: Profitability Ratio Analysis...17 Table 12: Effectiveness Ratio Analysis 17 Table 13: Liquidity Ratio Analysis Page 3

4 Company Overview 1 Corporation ( was founded in 1948 and is currently based in Oak Brook, Illinois. franchises and operates restaurants in the food service industry (both counter service and drive through services). All restaurants are operated either by the company or franchisees, including conventional franchisees under franchise arrangements, and foreign affiliate markets and development licensees under license agreements. As of March 31, 2009, out of the 32,060 restaurants in 118 countries, 25,578 were operated by franchisees (18,487 operated by conventional franchisees, 2,957 operated by developmental licensees and 4,134 operated by foreign affiliated markets) and 6,482 were operated by the company. revenue consists of sales by company operated restaurants and fees (rent, royalties and percentage of sales) from restaurants operated by franchisees and licensees. Under conventional franchise arrangement, the franchisee provides a portion of the capital required for equipment, signs, seating, and reinvesting in the business over time. The company owns the land and building or secures long term leases. Under developmental license arrangement, the licensee provides capital for the entire business, including real estate. has no capital invested. has equity investment in a number of foreign affiliates. Figure 1: Revenue by Region ($23.5Bn in 2008) Figure 2: System wide Restaurants by Ownership trend APMEA 18% Europe 42% United States 34% Other 6% benefits from global diversification, with close to 65% revenue from outside the U.S., however it also faces risk due to exchange rate volatility 30,000 25,000 20,000 15,000 10,000 5, Company-operated restaurants Franchised restaurants In 2007, set a 3 year target to refranchise 1000 to 1500 existing company owned restaurants between 2008 and 2010 Source: 10K company report Source: 10K company report Demand Drivers Typical customers are young men, 18 to 35 years of age, as they tend to cook infrequently and eat larger meals. The average check at a true fast food restaurant is $3 to $4 according to National Restaurant Association. The average check at a fast casual restaurant is closer to $8. customer relevance in the U.S. is attributed by their menu and prices, choices and variety, and customer service. Globally, caters and adapts to different cultures and societies, while still providing them with the same 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. 1 Page 4

5 Figure 3: Cumulative 5 year Restaurant Growth 12.00% 10.00% 8.00% 6.00% 4.00% 2.00% 0.00% United States Europe Source: 10K company report APMEA in recent years is focusing its attention in growing its business outside the U.S. especially emerging markets of China and India is a mature company. As its key United States markets reach saturation levels, has shifted its focus to the international markets as a source of growth. With a massive population of increasingly affluent customers, China and India have become key markets. The cumulative 5 year restaurant growth rates (net increase in the number of restaurants) in Asian Pacific, Middle East and Africa (APMEA) are more than 4 times than the restaurant growth rates in the United States. adapts to local preference by changing menus, ingredients and operating procedures. McDonalds- A good defensive stock A regression analysis between the excess return and S&P 500 (market) excess return for the last 30 years results in an R-Square of a low correlation indicating non-cyclical behavior. Even though many stocks had a tough time in 2008, was actually up about 8% last year, while the S&P 500 was down close to 40%. corporation being a fast food restaurant is therefore a cheaper alternative for consumers who may cut back spending on higher-end restaurants and may turn to cheaper alternatives during economic downturns. Key Success Factors The key success factors for operating in the quick-service restaurant industry are: Cost efficiency: Ability to maintain price points are important and therefore, with rising labor costs (especially in a high labor intensive industry) and managing volatile commodity prices are important. Product development, Marketing and promotions: Ability to introduce new products that keeps increasing customer footprint is important - marketing and promotions help towards this effort. Currency exchange management: With close to 65% of its revenue from outside the U.S., is subject to risk arising from fluctuating currency rates - hence a necessity to control this factor. Brand Management: Ability to react to new regulations, litigation and any new nutritional factors will impact brand. Value menu and happy meals for Kids: Ability to hold price points and run effective promotions in this segment is a key to driving sales and increase customer footprint. International expansion towards profitability: Ability to develop menu s that cater to the local taste and compete with low cost local competitors will determine profitability in emerging markets like India and China. Page 5

6 Industry Analysis Industry: Restaurants Sub-Industry: Quick Service Restaurants The restaurant industry includes companies that own, operate, and/or franchise dining establishments. The restaurant industry is made up of the quick service restaurant segment and the full service restaurant segment. is a quick service restaurant; however, the quick service restaurant industry and the full service restaurant are substitutes and thereby compete with each other. The quick-service restaurant segment accounts for more than a third of the total dining industry. Figure 4: 2009 U.S. Restaurant Industry Sales by Segment ($565.9 Billion of current dollars) Quick Service Restaurant 33% Full Service Restaurant 67% The restaurant business is relatively defensive during Source: economic downturns because dining out is one of the last areas of expenditure consumers cut back on. During the economic slowdown from , consumer spending on food away from home only dropped for one year and quickly hit a new all-time high in Top Industry Trends Steady Sales Growth: Increase in consumer spending on food away from home has driven steady sales growth in the quick service industry. In the last decade, fast food sales grew at an average annual rate of about 5% 3, while sales have been strong, the expansion of new restaurants has been limited. Chains are focusing on improving or closing struggling locations versus opening new restaurants. Quick-service restaurants may not suffer as much as the full-service restaurant, because consumers cutting down on eating outside may most likely trade down to cheaper options rather than fully cutting down on eating out. Figure 5: U.S. Restaurant Industry Sales (Billions of current dollars) Table 1: U.S. Restaurant Industry Key Statistics (Billions of current dollars) Restaurant industry sales as a percentage of U.S. GDP Overall economic impact of the restaurant industry 4% $1.5 trillion * Source: National Restaurant Association Restaurant industry - Total employment Percentage of Restaurants with less than 50 employees Average industry sale per day Source: National Restaurant Association 13 million (9% of U.S. workforce) 91% $1.5 billion Page 6

7 Top Industry Trends (continued) Positive Demographic Trends: Per capita spending on fast food is projected to rise 6 percent between 2000 and 2020, according to the USDA, primarily due to rising incomes and changing household structure. Projected increases in personal income and smaller households outweigh the effect of the aging population, which favor spending in full service restaurants. Cooking at home is less economical for households, making fast food an attractive value. In addition, the number of hours the primary household manager works influences fast food spending, and time-starved consumers will continue to look for convenient, economical meal solutions. Food quality/healthy eating: In a recent survey by the National Restaurant Association, 76% of adults said that they were trying to eat healthier now at a restaurant than they did 2 years ago. International Expansion/Growth: As key US markets reach saturation levels for large chains, companies look to international markets as a source of growth. With a massive population of increasingly affluent customers, China has become a key market. Companies change menus, ingredients, and operating procedures to adapt to foreign preferences. Porters 5 Force Analysis Figure 6: Porters 5 force Industry Analysis Barrier to Entry: Low Supplier Power: Medium Rivalry: High Buyer Power: High Threat of Substitutes: High Overall Take: Unattractive, with high competition The restaurant industry s is highly competitive with intense rivalry. The Buyer power is high as the consumer has many choices with no switching costs. The supplier power can vary, being low for restaurant chain where procurement is consolidated and high for family owned restaurants. The threat of substitution is high, with options ranging from different types of restaurants to eating at home The Barrier to Entry is low, as starting a restaurant requires relatively low capital requirements, however, establishing a brand loyalty can take time. Industry Valuation Table 2: Restaurant Industry Valuation Absolute Basis High Low Median Current P/Trailing E P/Forward E P/B P/S P/CF Relative to SP500 High Low Median Current P/Trailing E P/Forward E P/B P/S P/CF Source: Thompson Baseline The restaurant industry s median ratios indicate the restaurant industry is on the expensive side. However, it does not mean that it s a bad investment; in this case the restaurant industry s earnings are growing at a faster rate than the market. Additional research indicates that the restaurant industry benefits from consumer behavior that eating out is the one of the last areas where the consumer reduces spending in order to increase their saving. Page 7

8 Competitive Landscape The fast food and quick service restaurant industry includes about 200,000 restaurants with combined annual revenue of about $120 billion. The industry is highly fragmented with the top 50 companies holding about 25% of the industry sales 4. The demographics and personal income drive demand and the profitability of individual companies depends on efficient operations, effective marketing, and ability to provide fast service. Large companies have advantages in purchasing, financing and marketing. Small companies can compete by offering unique products or serving a local market. The industry is a highly labor intensive, the average annual revenue per worker is just under $40,000. Fast food restaurants also compete with companies that offer meals or prepared foods, including full service restaurants, supermarkets, delis, convenience stores, snack shops and cafeterias Primary competitors in the fast food/quick service industry include: Wendy s Arby s Group Inc. (WEN), Burger King Holdings Inc. (BKC), Yum! Brands Inc. (YUM), CKE Restaurants Inc. (CKR), Jack in the Box (JACK), Starbucks Corporation (SBUX), Other Restaurant and Fast Food Restaurants. Table 3: Vs Peer Competition Stock Performance - YTD, 1 Year and 5 Year Company (Ticker) Starbucks (SBUX) Bob Evans (BOBE) Yum! Brands (YUM) CKE Restaurants (CKR ) Jack in the Box (JACK) (MCD) Burger King (BKC) YTD Stock Return 99.6% 39.1% 11.0% 1.5% -7.4% -12.5% -23.1% Company (Ticker) Starbucks (SBUX) Yum! Brands (YUM) Bob Evans (BOBE) (MCD) Jack in the Box (JACK) CKE Restaurants (CKR ) Burger King (BKC) 1 Year Stock Return 22.5% -1.6% -10.3% -10.5% -11.6% -30.5% -32.3% Company (Ticker) (MCD) Yum! Brands (YUM) Jack in the Box (JACK) Bob Evans (BOBE) Burger King (BKC) CKE Restaurants (CKR ) Starbucks (SBUX) 5 Year Stock Return 61.8% 55.6% 13.1% 2.4% -7.8% -47.3% -47.3% Source: Yahoo! Finance It is evident from the above returns that even though returns are poor YTD, in the long term has done really well, and also has a strong dividend 3.63% ($2) annual yield. 4 Page 8

9 The table below summarizes how Corporation compares to companies in the Restaurant Industry Table 4: Corporation Vs Key Competition Key Financial Statistics Company Previous Fiscal Year Revenue ($ millions) Current Fiscal Year Projected Revenue ($ millions) Previous Fiscal Year EPS Current Fiscal Year Projected EPS Projected Current Fiscal Year P/E McDonalds Corporation (1) Yum! Brands (2) CKE Restaurants (2) Papa John s International (2) Jack in the Box (2) Bob Evans Past 5 year EPS growth (%) Projected 3 Year EPS growth (%) $23,522 $23,826 $3.76 $ $11,279 $10,972 $1.96 $ $1,483 $1,465 $0.69 $ NA 11.3 $1,132 $1,097 $1.30 $ $2,540 $2,482 $1.99 $ $1,751 $1,780 ($0.17) $ Farms (2) (1) projections based on Segment/Income Statement projection analysis (Appendix 4) (2) Competitor data from Baseline/Reuters research data Source: Reuters Research Data, Thompson Baseline and SIM Analyst Projections Figure 7: Top 30 Quick Service Restaurants - by % Sales Change (Fiscal Year 2008) 35.00% 30.00% 25.00% 20.00% 15.00% 10.00% 5.00% McDonald's Rank: % Corporation Source: Quick Service Restaurant Magazine: Page 9

10 Macroeconomic Analysis The total U.S. GDP is about $14.3 trillion. 70% ($10 trillion) of it is personal consumption. The food industry makes up a sizable portion of the GDP at $1.4 trillion, about 9.6% of the GDP. The restaurant industry s share is currently at $0.57 trillion, about 4% of the U.S. GDP. The breakdown, from the U.S. GDP, to personal consumption, to non-durable goods, to food expenditure, to restaurants expenditure is illustrated below: Figure 8: U.S. GDP Breakdown (in trillions $ and % of GDP) Figure 9: Personal Consumption Breakdown (in trillions $ and % of Personal Consumption) Personal Consumption Other Durable Goods Non Durable Goods Services $0.96, 10% $4.29, 30% $10.01, 70% $6.25, 62% $2.80, 28% Non Durable Goods: 19.6% of GDP Source: US Bureau of Economic Analysis Figure 10: Non Durable Goods Breakdown (in trillions $ and % of Non Durable Goods) Source: US Bureau of Economic Analysis Figure 11: Food consumption Breakdown (in trillions $ and % of Food Consumption) Food Clothing & Shoes Restaurant - Food Non-Restaurant - Food Gasoline, other energy Other, non durable $0.27, 10% $0.37, 13% $0.79, 28% $1.38, 49% Food: 9.7% of GDP $0.81, 59% $0.57, 41% Restaurants: 4% of GDP Source: US Bureau of Economic Analysis Source: US Bureau of Economic Analysis Page 10

11 The key macroeconomic factors that affect the restaurant industry are: unemployment rate, discretionary income, personal saving rate, and consumer spending and confidence. The restaurant industry has been impacted negatively by the rising unemployment rate, decrease in discretionary income, consumer spending & confidence and increase in personal saving rate. Even though competes in the restaurant industry, it is important to note the follow two points: operates in the quick-service/fast food restaurant segment and therefore is less affected by the above macro economical factors as consumers cut down their spending from eating at full-service restaurants and look for cheaper options in quick-service restaurants like. Research has shown that restaurant industry as a whole is relatively defensive during economic downturns because dining out is one of the last areas of expenditures consumers cut back on. 5 Therefore, it will be interesting to see the impact of the key macro economical factors on as its one of the biggest quick-service restaurants rather than the restaurant industry as a whole. Figure 12: Regression Consumer Spending & McDonalds Figure 13: Regression Disposable Income & McDonalds Consumer Spending McDonalds Disposable Income MCD R = R = Source: Thompson Baseline Source: Thompson Baseline Figure 14: Regression Unemployment & McDonalds Unemployment Rate MCD R = Source: Thompson Baseline Corporation is clearly a good defensive stock. It is also interesting to note from the regressions that when consumer spending and disposable income increase or are relatively steady, the stock price of McDonalds goes up relatively faster. However, when consumer spending and disposable income fall then the stock price of McDonalds remains relatively stable. Similar conclusion can be made regarding unemployment rate. This analysis further substantiates the point that dining out is one of the last areas of expenditures that consumers cut back on and consumers switch from full service to quick service to reduce costs. 5 Page 11

12 Revenue, Operating Cost, Net Income and EPS Projections Revenue Projections The overall revenue growth, across all segments for 2009 is projected to grow by 1.11%. The key factors and assumptions considered for revenue projections by geography are: United States: Refranchising strategy of converting company owned to franchisees, reimaging and new restaurants Premium coffee sales New products like the Angus burger (introduced 7/2/20s09). Lower consumer spending and higher unemployment rates (9.5% overall and ¼ teenagers). Poorer global economy and impact of local market conditions. Loss of NBA contract (second quarter 2009) Europe: Refranchising strategy of converting company owned to franchisees and reimaging 200 new McCafes primarily in Germany and France. Increase total locations offering extended and 24-hour service. Poorer global economy and impact of local market conditions APMEA: Expansion, more new restaurants in India (250) and China (500). Locally relevant strategy and breakfast business. Growth rate will slower than expected in China relative to previous years due to recent lower spending trends. Table 5: Corporation Revenue Projections McDonald's Corporation Total Revenues ($ millions) United States (% increase) Europe (% increase) APMEA (% increase) Other (% increase) Total Revenues Consensus , % 11, % 5, % 1, % Projection ,714 8, % 2.9% 11,051 10, % 3.8% 4,961 4, % 5.4% 1,437 1, % 3.8% , % 10, % 4, % 1, % , % 9, % 4, % 1,290 (45.2%) Actuals ,906 7, % 7.3% 8,926 7, % 8.0% 3,599 3, % 8.5% 2,356 2,740 (14%) 20.6% , % 7, % 2, % 2, % ,525 6,737 2,721 1,906 28,217 26,162 24,720 23,826 23,522 22,787 20,895 19,117 17,889 NA 24,126 23,630 22,570 Source: 10K reports and SIM Analyst Page 12

13 Operating Cost Projections The overall operating expense for company operated restaurant is projected at 82.5%, for franchised restaurants at 17.7% and SG&A at 10%. The key factors and assumptions are considered are: With about 75% of grocery bill comprised of 10 different commodities, a basket of goods approach is the most comprehensive way to look at the Company s commodity costs. For the full year 2009, the total basket of goods is expected to rise about 5% to 5.5% in the U.S. Restaurant industry is highly labor intensive and the minimum wage to increase to $7.30 July 1, 2009 The last 3 years for a company operated restaurant: Food expense: 40%, Payroll/Employee Benefit: 31% and Occupancy & Other costs: 29%. Assuming the food cost increases by 5.5%, labor cost by 1% (as most state minimum wages are close to or higher than federal minimum wage), the overall cost increase is 2.6%, which is 80.07% of sales. We took the larger of (80.07% or 81.5%-Last years) In 2009, Selling, General & Administrative expenses is expected to decline by 1%, due to certain items in 2008 such as the biennial Worldwide Owner/Operator Convention and the Beijing Summer Olympics. Table 6: Corporation Operating Cost Projections Projection Actuals McDonald's Corporation Total Operating Costs ($ millions) Company Operated 16,156 14,98 14,160 13,769 13,653 13,742 12,905 11,919 11,052 Franchisee Operated 1,532 1,422 1,344 1,277 1,230 1,140 1,058 1,021 1,002 SG&A 2,600 2,413 2,283 1,963 2,355 2,367 2,296 2,118 1,939 Others, net (55) (51) (167) (161) (159) 1, Total Operating Cost 20,234 18,767 17,619 16,848 17,079 18,908 16,460 15,133 14,419 Source: 10K reports and SIM Analyst Revenue and EPS historical performance relative to Restaurant Industry and Sector Earnings Per Share and Revenue Growth trend and performance relative to the restaurant industry and its sector is summarized below. The Revenue Growth long term trend and current trend are below the levels of the restaurant industry and the sector. However, the Earnings Per Share growth trend are above the levels of the industry and sector, except for the most recent quarter. Page 13

14 Table 7: Corporation Revenue and EPS performance relative to Industry and Sector Growth Rate % EPS growth Recent Quarter EPS growth Past 12 Month EPS growth past 5 years Revenue growth Recent Quarter Revenue growth Past 12 Months Revenue growth Past 5 years Corporation Restaurant Industry Vs Industry Sector (5.0) 9.2 (0.4) 0.8 (1.5) (4.4) (7.0) (0.9) (1.3) (3.4) 0.7 (4.0) Vs Sector Source: Thompson Baseline Net Income and EPS Projections The net income for fiscal year 2009 is forecasted to increase by 6% to $4,573 million and the EPS is forecasted to increase by 6.1% to $3.99 against a consensus of $3.87 based on the revenue and operating cost projections illustrated above. A detailed projections of net income is illustrated in Appendix 4 Figure 15: Net Income Projections Figure 16: EPS Projections 6,000 5,000 4,000 3,000 2,000 1, Source: 10K reports and SIM Analyst EPS history and forecast ($) Consensus 2012E* consensus not available Source: 10K reports, Thompson Baseline & SIM Analyst Page 14

15 DCF Valuation DCF methodology estimated a 1 year target price of $60.27 for McDonald. The DCF model assumes an operating margin of 29% based on a 5 year historical data and future operating costs, a terminal FCF growth rate of 4%, a discount rate of 10% and tax rate of 30%. A detailed summary of all assumptions are summarized in above section and the revenue and cost projection for 2009 to 2012 by revenue sources (company operated sales and franchise revenue) and by geography, and capital expenditure is summarized Appendix 1, 2 and 3. The projected income statement and cash flow statements are summarized in Appendix 4 and 5 respectively. Table 8: DCF Valuation Results Terminal Value: $105,016 million P/E: $15 EV/EBITDA: 9 Free Cash Yeild: 5.8% Shares Outstanding: 1,146 Current Share Price: $55.08 NPV of Free Cash Flow: $28,586 million NPV of Terminal Value: $40,488 million Projected Equity Value: $69,074 million Implied Equity Value per Share: $60.27 Upside (downside) to DCF: 9.4% Source: DCF Valuation, Appendix 4 DCF Sensitivity Analysis The DCF sensitivity table shown below shows the equity share price given different cash flow and WACC assumptions. In the model, an increase in 0.5% in the terminal growth rate would increase the equity value per share to $63.9, whereas an increase by 0.5% in the discount rate would reduce the equity value per share to $55.5. Table 9: DCF Sensitivity Analysis Growth Rate Discount Rate Source: SIM Analyst Page 15

16 Absolute Valuation In order to better evaluate, a valuation using various ratios and multiples is analyzed. The valuation includes analysis of: Forward Price to Earnings, Price to Sales, Price to Book, Price to EBITDA and Price to Cash Flow ratios. In the analysis the target multiple is projected to be closer to the median ratios as it is assumed that the multiples will revert to the median given the current economic scenario and growth opportunities of McDonalds. Also, the target earnings and sales per share are determined from Income Statement projections (please see figure 12 and 13 for details), and the book, EBITDA and cash flow per share are determined by dividing the current ratio by the current stock price and then taking their inverse. The valuation results are summarized below. Table 10: Absolute Valuation Matrix Forward Price Earnings Ratio Price Sales Ratio Price to Book Ratio Price to EBITDA Ratio Price to Cash Flow Ratio High Low Median Current Target Multiple Target E, S, B, etc/share Target Price Weight Weighted Average Target Price $ % $ $ % $ $ % $ $ % $ $ % $8.74 Source: Data from Thompson Baseline and Forecast by SIM Analyst Weighted Average Valuation $58.94 The weights are assigned based on importance of the ratio to the valuation going forward, hence the forward price earnings ratio is given the most weight as it is forward looking. The methodology reveals a projected stock price of $58.94 for McDonalds. This gives an upside of 8.1% given the current stock price of $ Based on the above two valuation models, the final 1-year target price is estimated to be $59.61 (average of the DCF and Absolute Valuation), giving the stock at upside of 13.01% (9.4%capital gain+3.63% dividend yield). Page 16

17 Financial Analysis Ratio Analysis is used to dissect and analyze the financial performance of ; the three areas analyzed are profitability, effectiveness and liquidity. This includes analyzing the ratio trends of and the company s performance relative to the restaurant industry and the sector. Profitability Ratios Analysis Table 11: Profitability Ratio Analysis Profitability Ratios % Gross Margin Past 12 months Gross Margin Past 5 years Operating Margin Past 12 months Operating Margin Past 5 years Net Margin Past 12 months Net Margin Past 5 years Corporation Restaurant Industry Vs Industry Sector Vs Sector Source: Data from Thompson Baseline has maintained healthy profitability ratios. Comparison of the past 5 years and past 12 months numbers indicate that the trend is improving and performance is better when compared with the restaurant industry and the sector. Effective Ratios Analysis Table 12: Effectiveness Ratio Analysis Profitability Ratios % Return on Assets Past 12 months Return on Assets Past 5 years Return on Equity Past 12 months Return on Equity Past 5 years Corporation Restaurant Industry Vs Industry Sector Source: Data from Thompson Baseline Vs Sector Page 17

18 With respect to the effectiveness ratios, McDonalds is showing positive improvements with both the year over year trends and relative to the restaurant industry and the sector as illustrated above. Liquidity Ratios Analysis Table 13: Effectiveness Ratio Analysis Profitability Ratios % Corporation Restaurant Industry Vs Industry Sector Quick Ratio Vs Sector Current Ratio Total Debt to Equity Source: Data from Thompson Baseline Again, with respect to the effectiveness ratios, McDonalds is showing positive improvements with both the year over year trends and relative to the restaurant industry and the sector. Risks faces risk at multiple levels of operation and execution. At a high level, the key risks are: Regulation and Litigations, Product Development and Execution, Costs (labor and commodity) and Currency Exchange rate, Safety, Global Markets and Economy. Regulation and Litigation: The cost, compliance and other risks associated with the often conflicting regulations, especially in the United States can adversely affect and can increase its exposure to litigation or governmental investigations or proceedings. The impact of nutritional, health and other scientific inquiries and conclusions, which constantly evolve and often have contradictory implications, but nonetheless drive popular opinion, litigation and regulation in ways that could be material to Product Development and Execution: Ability to roll-out new products and product line extensions based on global and local market conditions is a risk that needs to managed and executed by Costs (labor and commodity) and Currency Exchange Rates: The restaurant industry is highly labor intensive, therefore rising labor cost, such as increase in minimum wage will have a negative impact. ability to manage volatile commodity prices is also an important factor for risk management. With close to 65% of revenue from outside the United States, is exposed to significant risks arising from fluctuations in foreign currency exchange rates. Safety: ability to manage the potential impact from food-borne illnesses or product safety issues is an important risk management issue. Page 18

19 Risks (continued) Global Markets: The challenges and uncertainties associated with operating in developing markets, such as China, Russia and India, which may entail a relatively higher risk of political instability, economic volatility, crime, corruption and social and ethnic unrest pose significant risk as close to 65% of revenue is from outside the U.S. Economy: The impact of the current economic conditions on unemployment levels and consumer confidence, particularly if conditions worsen, and the effect of initiatives to stimulate economic recovery and to stabilize or further regulate financial markets will have an impact on the cost and availability of funding for the Company and its franchisees. Inflation and foreign exchange rates also pose significant risks. Conclusion The final 1-year target price for Corporation is $59.61, with the stock trading at $54.50 on August 17, This gives the stock an upside of 13.01%, which includes an annual dividend yield of 3.63% ($2.0). Based on the above detailed company, industry, economic, financial and valuation analysis, I recommend to HOLD the stock. Few key reasons are summarized below: Relatively good upside returns of 13.01%. Also, the DCF sensitivity analysis indicates higher probability the stock price should range from $55.9 to $63.9 Good annual dividend yield of 3.63% ($2.0 per stock) Good defensive stock, based on the economic analysis, if the economy deteriorates further then the stock value should hold relatively stable, however, if the economy improves, the stock value will go up. On target to beat analyst expectations this year and a projected 13%, 3-year increase in EPS, highest in quick-service restaurant industry. Higher comparable sales for each month this fiscal year (2009) Strong brand name and strong management Strong financial position relative to the restaurant Industry and the sector, along with a consistent improvement trend in profitability, effectiveness and liquidity ratios Refranchising strategy (from company operated to franchisee) will improve profit margins A mature company with good growth prospects in emerging markets as its already well established in international markets and currently in expansion mode Strong early signs emerging from the premium coffee business Ability to roll-out new products ($4 Angus Burger - latest introduction in July, 2009) will continue to increase customer footprint The main risk that may affect earnings is the fluctuations in exchange rate, with close to 65% of its revenue from outside the United States. However, with the high deficits facing the United States, and with most popular opinions suggesting a weaker dollar moving forward, it should augment the projected earnings of Corporation. Page 19

20 Appendix Appendix 1: Revenue Projections by Revenue Source and by Geography McDonald's Corporation Projection Actuals Segments ($ millions) REVENUE Company Operated Sales United States 5,213 4,918 4,729 4,636 4,636 4,682 4,410 4,098 3,828 Europe 8,842 8,187 7,723 7,498 7,424 6,817 5,885 5,465 5,174 APMEA 4,702 4,275 3,958 3,770 3,660 3,134 2,674 2,453 2,390 Other ,978 2,433 2,002 1,663 Total Company Operated Sales 19,703 18,272 17,268 16,745 16,561 16,611 15,402 14,018 13,055 Franchised Revenues United States 4,062 3,796 3,615 3,476 3,442 3,224 3,054 2,857 2,697 Europe 3,093 2,864 2,702 2,549 2,499 2,109 1,753 1,607 1,563 APMEA Other Total Franchised Revenue 8,514 7,891 7,452 7,080 6,961 6,176 5,493 5,099 4,834 Total Revenues United States 9,275 8,714 8,344 8,112 8,078 7,906 7,464 6,955 6,525 Europe 11,935 11,051 10,425 10,047 9,923 8,926 7,638 7,072 6,737 APMEA 5,457 4,961 4,593 4,358 4,231 3,599 3,053 2,815 2,721 Other 1,550 1,437 1,357 1,308 1,290 2,356 2,740 2,275 1,906 Total Revenues 28,217 26,162 24,720 23,826 23,522 22,787 20,895 19,117 17,889 Consensus NA 24,126 23,630 22,570 Appendix 2: Capital Expenditure and Depreciation/Amortization Projections Projection Actuals McDonald's Corporation ($ millions) CAPX 2,300 2,200 2,100 2,100 2,100 1,900 1,600 1,400 1,300 % of Sale 8.2% 8.4% 8.5% 8.8% 8.9% 8.3% 7.7% 7.3% 7.3% Depreciation/Amortization 1,411 1,308 1,236 1,191 1,208 1,214 1,250 1,250 1,201 % of Sale 5.0% 5.0% 5.0% 5.0% 5.1% 5.3% 6.0% 6.5% 6.7% Page 20

21 Appendix 3: Cost/Expense Projections by Revenue Source and by Geography McDonald's Corporation Projection Actuals Segments ($ millions) OPERATING COSTS AND EXPENSES Company Operated Restaurant Cost United States 4,250 4,010 3,856 3,780 3,780 3,806 3,567 3,330 3,097 Europe 7,246 6,709 6,329 6,145 6,084 5,612 4,925 4,648 4,367 APMEA 3,856 3,505 3,246 3,129 3,076 2,663 2,333 2,186 2,126 Other ,661 2,080 1,755 1,462 Total Company Operated Expenses 16,156 14,983 14,160 13,769 13,653 13,742 12,905 11,919 11,052 Franchised Restaurant Cost United States Europe APMEA Other Total Franchised Expenses 1,532 1,422 1,344 1,277 1,230 1,140 1,058 1,021 1,002 SG & A Expenses United States Europe APMEA Other Total SG & A Expenses 2,600 2,413 2,283 1,963 2,355 2,367 2,296 2,118 1,939 Impairment and other charges United States Europe (11) APMEA (9) 139 Other , (23) 36 Total Impairment and other charges , (28) 281 Other Operating (Income) / Expenses, net Gain on sales of business (15) (14) (132) (128) (126) (89) (38) (45) (45) Equity in earnings of unconsolidated affilates (133) (123) (117) (112) (111) (116) (77) (53) (60) Asset disposition and other expenses Total Other Operating (Income)/Expenses, net (62) (57) (173) (167) (165) (11) Total Operating Cost and Expenses 20,234 18,767 17,619 16,848 17,079 18,908 16,460 15,133 14,419 Page 21

22 Appendix 4: Net Income Statement Historical Trend and Projections McDonald's Corporation Income Statement in millions except per share data REVENUES 2012 Projection Actuals Sales by Company Operated Restaurants 19,703 18,272 17,268 16,745 16,561 16,611 15,402 14,018 13,055 Revenues from franchised restaurants 8,514 7,891 7,452 7,080 6,961 6,176 5,493 5,099 4,834 Total Revenue 28,217 26,162 24,720 23,826 23,522 22,787 20,895 19,117 17,889 OPERATING COSTS/EXPENSES Company operated restaurant expense 16,156 14,983 14,160 13,769 13,653 13,742 12,905 11,919 11,052 Franchised restaurants expenses 1,532 1,422 1,344 1,277 1,230 1,140 1,058 1,021 1,002 Selling, general & administrative expenses 2,600 2,413 2,283 1,963 2,355 2,367 2,296 2,118 1,939 Impairment & other charges, net , (28) 281 Other operating income (expenses), net (62) (57) (173) (167) (165) (11) Total operating costs and expenses 20,234 18,767 17,619 16,848 17,079 18,908 16,460 15,133 14,419 Operating Income 7,983 7,396 7,101 6,978 6,443 3,879 4,435 3,984 3,470 Interest (Expense) (523) (523) (523) (523) (523) (410) (402) (356) (358) Nonoperating income (expense), net Gain (loss) on sale of investment Income from continuing Operations before tax 7,538 6,951 6,656 6,533 6,158 3,572 4,156 3,660 3,133 Income Tax 2,261 2,085 1,997 1,960 1,845 1,237 1,288 1, Income from continuing Operations 5,277 4,866 4,660 4,573 4,313 2,335 2,868 2,578 2,278 Income from discontinued Operatioins, net of taxes Net Income 5,277 4,866 4,660 4,573 4,313 2,395 3,546 2,602 2,279 Earnings per share Basic Diluted Consensus NA Weighted average shares outstanding Basic 1,127 1,188 1,234 1,260 1,260 Diluted 1,146 1,146 1,146 1,146 1,146 1,212 1,252 1,274 1,274 Dividend per common share Page 22

23 Appendix 5: DCF Valuation Historical End of Year Projected Year Ending Revenue 17,889 19,117 20,895 22,787 23,522 23,826 24,720 26,162 28,217 29,345 30,519 31,740 33,010 34,330 35,703 % growth rate NA 6.9% 9.3% 9.1% 3.2% 1.3% 3.8% 5.8% 7.9% 4.0% 4.0% 4.0% 4.0% 4.0% 4.0% Operating Income 3,470 3,984 4,435 3,879 6,443 6,978 7,101 7,396 7,983 8,510 8,851 9,205 9,573 9,956 10,354 Operating Margin 19.4% 20.8% 21.2% 17.0% 27.4% 29.3% 28.7% 28.3% 28.3% 29.0% 29.0% 29.0% 29.0% 29.0% 29.0% Interest and Other- net (336) (299) 400 (247) (285) (445) (445) (445) (445) (293) (305) (317) (330) (343) (357) Interest % of Sales -1.9% -1.6% 1.9% -1.1% -1.2% -1.9% -1.8% -1.7% -1.6% -1.0% -1.0% -1.0% -1.0% -1.0% -1.0% Taxes 855 1,083 1,288 1,237 1,845 1,960 1,997 2,085 2,261 2,465 2,564 2,666 2,773 2,884 2,999 Tax Rate 27% 30% 31% 35% 30% 30% 30% 30% 30% 30% 30% 30% 30% 30% 30% Net Income 2,279 2,602 3,546 2,395 4,313 4,573 4,660 4,866 5,277 5,752 5,982 6,221 6,470 6,729 6,998 % Growth NA 14% 36% -32% 80% 6% 2% 4% 8% 9% 4.0% 4.0% 4.0% 4.0% 4.0% Add Depreciation 1,201 1,250 1,250 1,214 1,208 1,191 1,236 1,308 1,411 1,467 1,526 1,587 1,650 1,717 1,785 % of Sales 6.7% 6.5% 6.0% 5.3% 5.1% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% 5.0% Plus/(minus) Changes WC (89) 412 (163) (36) 246 (5) (16) (26) (37) (38) (40) (41) (43) (45) (47) % of Sales -0.5% 2.2% -0.8% -0.2% 1.0% 0.0% -0.1% -0.1% -0.1% -0.1% -0.1% -0.1% -0.1% -0.1% -0.1% Subtract Cap Ex 1,300 1,400 1,600 1,900 2,100 2,100 2,100 2,200 2,300 2,201 2,289 2,381 2,476 2,575 2,678 Capex % of sales 7.3% 7.3% 7.7% 8.3% 8.9% 8.8% 8.5% 8.4% 8.2% 7.5% 7.5% 7.5% 7.5% 7.5% 7.5% Free Cash Flow 2,091 2,865 3,033 1,673 3,667 3,659 3,779 3,948 4,350 4,980 5,179 5,386 5,602 5,826 6,059 YOY growth 37.0% 5.9% % 119.2% -0.2% 3.3% 4.5% 10.2% 14.5% 4.0% 4.0% 4.0% 4.0% 4.0% Terminal Discount Rate 10.0% Terminal FCF Rate 4.0% Terminal Value $105,016 million P/E 15.0 Shares Outstanding $1,146 million Total Debt $10,446 million Total Cash $1,980 million EV/EBITDA 9 Free Cash Yield 5.8% Cash/Share $1.73 Current Share Price $55.08 NPV of Free Cash Flow $28,586 million NPV of Terminal Value $40,488 million Projected Equity Value $69,074 million Implied Equity Value/Share $60.27 Upside (downside) to DCF 9.4% Page 23