Hidden assets drive McDonald’s profit

The best companies have a lot of things in common and often one trait they share is hidden assets.

Hidden assets come in many forms but they are usually things that are under appreciated or overlooked, even though they hide in plain sight. Some are intangible like goodwill, or a global brand, or strong customer loyalty.

Others are more concrete. Research and development spending is a big one. R&D costs are written off immediately but create new products over time. Eli Lilly, one of my top picks in 2023 is a good example.

Lilly spends a high 25% of sales on R&D which comes to about US$7 billion annually of spending. Its shares rose 71% to end the year at US$ 618 directly because of a long term research investment in diabetes management. Over time that led to a drug called Mounjaro aimed at Type 2 diabetics and later a version of the same drug aimed at the weight loss market.

Mounjaro stimulates insulin production which slows digestion and makes people feel fuller, longer. They eat less and lose weight which reduces stress on their heart and other organs. The drug has been a home run.

Microsoft (NDQ: MSFT), another of my top performers in 2023, rose 63% to close the year at US $367.75. Microsoft spent a record US $27 billion on R&D, about 12% of revenues. The money enhanced its cloud and AI capabilities and allowed it to explore such things as the metaverse and augmented reality.

Real estate is another hidden asset. The value of the purchase is carried on company books at cost but the value appreciates over time. The holdings can also generate rent.

This hidden asset is where McDonald’s Corp. (NYSE:MCD) the world’s largest fast food chain, gets most of its money. While it serves burgers and fries to 65 million people every day that is not nearly as profitable as its real estate portfolio.

Roughly 95% of the 44,000 McDonald’s outlets are owned by franchisees who are responsible for the maintenance and upkeep of the properties. McDonald’s owns the land and buildings the outlets sit on. Franchisees pay an average 10% of sales as rent, plus another 4% of sales for franchise royalties.

McDonald’s 2022 annual report shows that 61% of revenue came from rent and royalties. Industry analysts calculate McDonald’s gets about 80% of its profits from this part of its business.

Here’s an update:

McDonald’s (NYSE: MCD) Closed Friday at $290.87 (All figures in US dollars)

Background: McDonald’s is the largest and best-known fast-food franchise in the world. Almost half of the 44,000 outlets are in Asia or other emerging markets, although the US remains its largest single market.

Performance: The shares rose 10% in 2023 and are up 1.4% year-to-date at their current price.

Recent developments: Another one of McDonald’s hidden assets is its commitment to innovation. Its loyalty program is one of the largest in the world, with more than 150 million active users. It plans to expand that to 250 million users by 2027. It is also undertaking an aggressive store expansion program with an emphasis in Asia and wants to increase the overall number of its restaurants to 50,000 by 2027.

In November, to help meet those goals, McDonald’s announced a partnership with Google Cloud to look for ways to accelerate innovation in automation at its drive throughs and online ordering. This will reduce complexity for employees and lead to hotter, fresher food delivered more quickly.

McDonald’s reported better-than-expected results for its third quarter ended Sept. 30, with revenue and profit beating expectations.

System-wide revenue rose 14% to $6.69 billion with same-store sales globally rising 8.8%. Net income was $2.32 billion or $3.17 per share, up 22% from a year earlier.

In early December, McDonald’s announced a trial of specialty coffee stores under the CosMc’s banner. The outlets will sell highly customizable caffeinated beverages with some food. They will mostly offer cold drinks including flavoured iced teas and slushies.

The test will involves 10 stand alone stores in Illinois and Texas. They are opening as stand alones because adding new drinks to its regular menu would complicate kitchen operations and slow down service.

The niche is high margin. The bulk of Starbuck’s sales come from cold, sweet drinks. McDonald’s CEO Chris Kempczinski warned investors not to get too excited as McDonald’s tries new things all the time. It is worth noting that its experiment with plant-based burgers was not a success. They were discontinued in the US in August 2022 after a little more than a year though are still sold in some international markets.

Dividend: With the December payment, McDonald’s increase its dividend for the 47^th consecutive year. The 9.9% increase to $1.67 quarterly ($6.68 a year) yields 2.31% at current prices.

Outlook: Hidden assets are the closest thing to something for nothing. McDonald’s has many of them including investments in technology, a commitment to innovation, and a business model that uses its real estate as a way to generate stable and predictable revenues.