McDonald’s Q3 Preview: Don’t Worry About E. Coli, It’s An Automation Play
Contributor since 2023 / 3053 Followers
Summary:
- McDonald’s Corporation is leveraging automation to drive foot traffic and reduce labor costs, positioning itself well despite wage pressures and health concerns.
- The ‘Fight for $15’ movement poses a threat, but McDonald’s automation efforts can mitigate potential labor cost increases.
- Despite an E. Coli outbreak, McDonald’s earnings estimates remain favorable, with automation expected to boost EPS growth.
- McDonald’s real estate and royalty business model provides stable cash flow, making the current valuation reasonable and offering potential upside.
- Heading into earnings, shares are a strong buy.
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Co-Authored By Noah Cox and Brock Heilig.
Investment Thesis
While McDonald’s Corporation (NYSE:MCD) shares are selling off today on the news of an E. Coli outbreak at stores across the US, shares overall have staged a strong recovery since the middle of the summer. US consumers have proven to be more resilient than expected.
Powering this, McDonald’s has launched a new series of value deals on their menu that is driving foot traffic at its stores. So far, it seems to be working.
However, getting consumers into the stores to buy these value deals is only part of the story. In order for McDonald’s to actually increase margins via these value items, the fast food chain needs to prioritize optimization and automation. That’s precisely what they’re doing.
The fast food chain has invested heavily in automation in multiple areas of their Golden Arch locations to help speed up operations and minimize labor cost.
While former President Donald Trump did serve fries in the drive-thru window at a McDonald’s location in Pennsylvania this past week, there is no guarantee that this will be the future of fast food work. I am bullish on the fast food chain.
McDonald’s should benefit even further from the automation it is implementing. I believe that shares are a strong buy.
Background On McDonald’s Automation
McDonald’s and other fast food companies have been pressured by the “Fight for $15” movement. This movement, in essence, is fighting for the federal minimum wage to be raised to $15 per hour. Currently, the federal minimum wage in the United States is just $7.25 per hour, and it has not been raised since 2009.
The movement started in 2012, and it has now turned into a global movement. Although many states have raised their minimum wage to a number greater than $7.25, the federal minimum wage remains at $7.25.
Obviously, if this “Fight for $15” were to ever be successful and the federal government raised the minimum wage to $15 per hour, it would pose a major threat to companies like McDonald’s. It relies on minimum wage pay to help support its menu of affordable fast food.
A jump in minimum wage from $7.25 to $15 would be a 106% increase, which would more than double McDonald’s labor costs.
The fast food company is already planning for this possibility. McDonald’s has already started automating many of its stores, even in California, where the minimum wage for fast food is $20 per hour.
One of the main things McDonald’s is doing to automate its restaurants is implementing self-serve kiosks. The biggest benefit that these kiosks offer is that they allow the restaurants to take more orders at one time. By some estimates, if automation techniques like kiosks could eliminate 8 employees at a fast food location (like McDonald’s), this could help each franchise save up to $326,312 per year. If just ½ this number (so 4 employee roles) were eliminated due to automation, like kiosks (or more of the full service as we have seen from the McDonald’s pilot), this would still be $163,156 in annual savings per store. This is a big deal.
“…[an automated kiosk] improves the overall flow of customers within the restaurant and allows McDonald’s to serve a larger number of patrons simultaneously,” the article by Wavetec wrote.
Here’s how this makes McDonald’s corporate more money: each McDonald’s store is required to pay roughly 5% of gross sales per year in a royalty to McDonald’s corporate (this is a big part of the corporate entity’s revenue). With more automation, each store can serve more food at a lower cost (thereby further increasing foot traffic). It’s a win-win for franchisees and for corporate.
In fact, these new menu items (which I believe are partially financially feasible because of automation) are directly listed as a foot traffic driver for the fast food giant.
McDonald’s biggest competitor, Wendy’s, has also been using AI in its drive-thru windows to allow consumers to order their food without talking to an actual human. This is something that McDonald’s experimented with for a brief period of time, but it has since pulled back from AI ordering in drive-thrus (I think they will come back to this later).
McDonald’s has said it’s looking to “evaluate long-term, scalable solutions” for AI ordering in drive-thrus, and it hopes to find a solution by the end of 2024. I’m optimistic about what these automations will bring as well.
Earnings Preview
Even with concerns about the E. Coli outbreak, McDonald’s earnings estimates look favorable over the coming quarters as these new foot traffic. Among 28 analysts, EPS estimates are pegged to come in at $3.20/share and revenue at $6.81 billion for the company. They’re set to report on October 29th before the market opens.
Growth from here is set to accelerate (and I believe this is due in part to automation). EPS is supposed to clock in at $3.44/share by Q4 2026.
In the Q2 Earnings Call, Executive Vice President Ian Borden spoke about how automation has positively impacted the business in every way.
“…our customer satisfaction scores in the US are at kind of an all-time high for this point in the year,” Borden said.
We’re seeing that pretty consistently around the world. We’re getting faster, we’re delivering a better experience. And when you put all that together, that’s what kind of defines value for the consumer. And we certainly are adamant and relentless that we’re going to get that right in each and every market to be in a winning position -Q2 Call.
While most of these bullish EPS forecasts came before the E. Coli outbreak this past week, I continue to be long run bullish.
On the earnings call, I will be looking for commentary on how automation will be able to help the business even further. I’ll dive into this in the risks section, but I think automation can help solve the E. Coli outbreak/prevent the next one as well.
Valuation
From a traditional valuation standpoint, let’s be clear: McDonald’s stock’s forward GAAP P/E ratio is 45.77% higher than the sector median number of 18.56 (coming in at 27.06), giving the fast food chain a quant rating of a D+.
Despite this, I think valuing the company on traditional P/E metrics misses the main idea.
As Ray Kroc, a former CEO of McDonald’s from 1961-1984, said, McDonald’s is in the real estate business.
“I’m not in the hamburger business. My business is real estate,” Kroc once told a group of Harvard students. McDonald’s essentially is in this business today as well by charging rent to their franchisees and by collecting a royalty rate of 5%. This is much more stable cash flow.
The whole goal of the McDonald’s business is to make their franchisees more successful so that the real estate that the franchisees put their stores on is worth more. McDonald’s then charges rent, it charges money for food and supplies to be delivered to the store, and they loan the franchisees’ money as well.
Given all these things, their cash flow is still far more predictable than a normal food establishment. I think McDonald’s trading at 27.06 times earnings, especially when it’s becoming increasingly automated, is actually very reasonable (if not undervalued).
From here, I strongly believe earnings-per-share growth will accelerate as McDonald’s adopts more automation.
I think we can see McDonald’s trade at closer to 35 times earnings. If shares were to converge on this forward P/E, this would represent 29.34% upside.
E. Coli & Foot Traffic Are Risks, But Automation Can Help Here Too
The main risks for McDonald’s center around the overall health concern of US consumers.
What I mean by this is both the actual physical health of consumers, but also their financial health.
Before this E. Coli outbreak, McDonald’s saw slowing foot traffic at many locations over the last 18 months as the prices of McDonald’s menu items have outpaced inflation. These new value deals have helped bring customers back in store. But these new E. Coli outbreaks may serve as a temporary setback.
At the same time, other fast food chains have started implementing a value strategy to help support their brands. McDonald’s competitor Subway recently just rolled out a $6.99 offer on any of its foot long subs.
To help compete against other chains (like Subway) and fight off E. Coli fears, McDonald’s can further leverage automation to not only further control labor costs, but also improve food quality. New industrial automation systems can actually scan meat for diseases (which would help the brand significantly improve food quality at stores and lower disease risks). Companies like Veritide offer tools to help detect fecal matter on raw meat, lowering the odds that contaminated meat is served at McDonald’s restaurants.
Bottom Line
McDonald’s (facing both an E. Coli outbreak and wage pressures from employees) knows it has to adapt to continue to serve iconic food at affordable prices here in the US (and around the globe).
The company has been (and likely will increasingly be) a pioneer in the fast food space with new automation systems. The fast food chain’s rollout of new automation tools really allow the company to serve more customers in a shorter amount of time. This leads to more revenue (and more royalties) for McDonald’s corporate.
I believe McDonald’s has set itself up in a strong position to where even if the federal minimum wage is raised to $15 per hour, costs increase won’t nearly be as bad for the company. This is because the proliferation of automated tools will help lower overall store level labor costs.
With this, I think McDonald’s has a unique opportunity in front of them to accelerate EPS growth. I believe we will start to see the results of this as they go to report earnings this quarter. Despite the E. Coli outbreak, I think shares are a strong buy.
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.
Noah Cox (main account author) is the managing partner of Noah’s Arc Capital Management. His views in this article are not necessarily reflective of the firms. Nothing contained in this note is intended as investment advice. It is solely for informational purposes. Invest at your own risk.
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