The True Value Ceators of the DJIA Part V
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In this fifth and last article in a series of five, a closer look will be taken at McDonald’s (NYSE: MCD) residual earnings generation ability. Thus far in the series, it has been discovered that a positive correlation seems to exist between an investor’s long term returns and their ability to actively locate firms that can consistently grow their residual earnings on common equity.
The following value creation framework was utilized to further examine IBM’s (NYSE: IBM), Intel’s (NASDAQ: INTC), Wal-Mart’s (NYSE: WMT), and McDonald’s performance over the past five years. As depicted, the generation of earnings above and beyond a firm’s cost of capital requirements has many individual drivers. It was concluded in the first four articles that the systematic control of all of these drivers was the force behind excess earnings growth (a very difficult task indeed).
Readers should keep in mind that a simple increase in sales or earnings is not a true value-creating activity. First, these figures can be manipulated by aggressive accounting measures. Likewise, they can receive a boost through non-value creating activities like acquisition sprees. A quick look at Tyco International offers a suitable example – the company’s recent announcement of a breakup shows that the many individual entities do not work perfectly or create value in unison.
Over the five year test period, MCD’s residual earnings grew at a compound annual rate of 27.3%, and an investment in the corporation to date since early January 2007 would have yielded an average return of around 21.7% per year. With the exception of Intel’s relatively weak per share price returns, investment returns from the other three DJIA firms seem to have a strong correlation with residual earnings generation (all figures on 5 year CAGR):
- Wal-Mart: Residual growth 14.2%, Return 6.7%
- IBM: Residual growth 18.3%, Return 15.4%
- McDonald’s: Residual growth 27.3%, Return 21.7%
- Intel: Residual growth 49%, Return 7.5%
Similar to the previous post’s discovery of IBM, it is positive to note that McDonald’s also has been able to continuously grow residual earnings through the primary improvement of its core business fundamentals.
Primary Residual Earnings Drivers
In examining the change in MCD’s residual earnings compared to its change in ROCE and its equity balance, it can be determined that the vast majority of the change in residual earnings over the past five years was explained by the change in the corporation’s return on net assets. In fact, the company’s common equity balance actually decreased over the test period, so an even higher increase in ROCE was necessary to make up for the declining net asset base and still report a net increase in residual earnings.
Remember that Residual Earnings = (ROCE – Cost of Capital) * Average Equity
MCD’s return on common equity of 34.6% and 33.2% in 2010 and 2009, respectively, represented a large improvement compared to the firm’s five year ROCE average of 26.3% and ten year ROCE average of 20.7%
There are several drivers behind the firm’s higher return on common equity. First, MCD has been able to drastically improve its core business over the past several years by capitalizing on its local economies of scale strategy. This is even more impressive concerning the very unfavorable economic environment experienced over the past several years – perhaps Big Macs are not the first thing to be cut from discretionary spending in time of downturn.
MCD’s return on its core net operating assets – RNOA, defined as post-tax operating income divided by net operating assets – increased at an average annual growth rate of 12.2% throughout the study period. The increase in RNOA was by far the largest influence on the firm’s improvement of ROCE, explaining an average of 80% of the change in ROCE over the five years studied. The corporation also received a meaningful boost from leverage use:
ROCE = RNOA + (Financial Leverage * Spread)
For 2010 – 34.6% = 22.7% + (62.35% * 19.13%)
For 2006 – 18.2% = 14.3% + (39.78% * 9.70%)
As depicted, between the two example years the corporation’s growth in return on common equity was driven by three primary factors: an increase of RNOA (return on core assets) of 58.7% and a subsequent increase in spread of 97.2%, as well as an increase in the use of financial leverage of 56.7%.
The increasing RNOA led to a drastically increased spread due to the company’s long term debt cost remaining relatively stable over the five year period. The increased spread received a further multiplier boost from the firm’s overall use of leverage. There is little need to go further into the use of debt (MCD’s debt balance increased by about 8% per year over the five years), so on to a closer examination of RNOA growth.
As to what happens with most firms over time – those that have the efficiency and competitive advantage to even produce residual earnings – McDonalds’ excess operating earnings appear to be returning slowly to a mean level. The corporation’s five year residual operating income CAGR of 33.9% is significantly less than its ten year average growth rate of 41.2%.
Because the corporation has benefited from cost cutting measures (to be discussed), the decline in return is most likely due to natural competitive forces. The food service industry is, after all, undoubtedly the most fragmented in the entire world of business. Despite MCD’s many competitive advantages, the sheer volume of substitutes prevents it from always being a consumer’s number one choice.
Although residual earnings are increasing at a decreasing rate, they are still increasing nonetheless, and the corporation is therefore still creating significant value. In examining the two primary drivers for return on net operating assets – asset turnover and gross/operating margins – it was concluded that the latter is responsible for explaining nearly 90% of the change in MCD’s RNOA.
The company has benefited from an unbeatable local economies of scale growth strategy. Each individual market essentially represents its own important cog in the greater MCD machine, and each market is characterized by a unique advertising campaign and personalized menu items. Similarly, each cog has its own unique supply chain dynamics, further facilitating the control of individual input costs.
Over the past ten years, MCD has opened more than 4,000 restaurants worldwide, yet has efficiently increased the rate at which it is decreasing its individual input costs as a percentage of sales.
In addition to these cost cutting measures, the corporation continues to generate more on a comparable asset base. Same store sales in the US and Europe have increased every year for the past seven years, and restaurants in the Asia region experienced a meaningful comparable store sales increase of 6% in 2010. This, once again, is attributable to the company’s local marketing approach and the addition of new products and services – i.e. brewed coffee, 24/7 operating hours, and free WiFi.
Despite MCD’s cost saving measures, as mentioned, the growth in its excess return on net operating assets is nonetheless decreasing. In research presented in a 2011 publication entitled “Ratio Analysis and Equity Valuation” (Nissim and Penman), it was shown that from 1964 to 1999, core RNOA tends to fade towards central values over time due to the forces of competition. (The study was conducted on all AMEX and NYSE firms over the time period). This holds true in most cases for even the most powerful corporations.
In fact, the top 10% of the core RNOA generators studied (median 29% RNOA) actually experienced average declines towards 18% within five years. MCD’s ability to continue growing residual operating income 70 years after its founding exemplifies the corporation’s unbeatable competitive advantage.
Using the aforementioned local markets strategy, the corporation has created a local economies of scale foundation on which it can experience significant cost savings through smaller-scale supply chain dynamics and shared and customized advertising campaigns. Similarly, the offering of personalized products (hot wings in China, for instance), the company has gained an extremely loyal following of captive customers. These two fundamentals – economies of scale and captive customers – are two inputs in the creation of an insurmountable competitive advantage.
To conclude the series, investors should keep a keen eye out for those firms that can continually increase their excess earnings on common equity – not necessarily just sales, earnings, or net asset growth. Based on the study of Wal-Mart, McDonald’s, Intel, and IBM, it appears that higher-than-average long term investment returns can be unlocked by those investors who can successfully isolate these special firms from the entire universe of stocks.
gibbstom13 has no positions in the stocks mentioned above. The Motley Fool owns shares of International Business Machines, Intel, and McDonald's. Motley Fool newsletter services recommend Intel and McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.