Credit Summary: McDonald's Corporation (A-, stable) Successful restructuring and improved fundamentals support a leveraged capital structure

Transcription

1 ? Credit Summary: McDonald's Corporation (A-, stable) Successful restructuring and improved fundamentals support a leveraged capital structure Morningstar Credit Ratings, LLC 17 September 2018 Contents 2 Credit Rating Rationale 3 Credit History 4 5 Pillar Analysis 6 Company Overview 8 Projections 8 Capital Structure and Liquidity Analysis 10 Peer Comparison 12 Appendix Wesley E. Moultrie, CPA, CGMA Vice President Wesley.moultrie@morningstar.com Executive Summary McDonald's has successfully turned around its operations, which the strength of its systemwide sales, comparable-store sales, operating margins, cash flows, and credit pillar scores reflects. McDonald's has introduced new and enhanced menu items, generated mid-single-digit global comparative sales for the past 12 quarters, successfully accelerated the pace of refranchising, and generated cost savings through global restructuring. The company reached its 2018 goal of refranchising 4,000 restaurants at the end of 2017, one year ahead of schedule. This will result in an expansion in royalties, licensee fees, and free cash flow, and a decline in operating expenses to offset a net decline in nominal revenue. Refranchising will also increase the predictability of the company's operating earnings, margins, and cash flow. Debt levels have increased over the past few years to fund McDonald's leverage recapitalization, but we believe leverage has plateaued and the company's improving fundamentals will support a moderation in its credit risk. Key Takeaways Upon executing its turnaround plan McDonald's is now focused on delivering long-term growth through its Velocity Growth Plan, which we believe combined with menu innovation will provide a strong foundation for continued growth. McDonald's has identified three growth accelerators: Experience of the Future, or EOTF, which focuses on restaurant modernization and technology; Digital Engagement, which expands choices for how customers order, pay, and are served through additional functionality on its global mobile app, self-order kiosks, and technology that enable table service and curbside pickup; and Delivery. In addition to enhanced customer satisfaction, full restaurant modernization combined with EOTF investment provides a mid-single-digit sales uplift in the first full-year and coupled with menu innovation, is expected support McDonald's top-line growth through the near to intermediate term. McDonald's current three-year target return of $22 billion $24 billion of cash to shareholders in the form of dividends and share repurchases is manageable given the company's cash flow generation, refranchising proceeds, and current initiatives to increase revenue and earnings and to reduce capital expenditures. Although debt levels are likely to increase, leverage is expected to remain steady. Companies Mentioned Name/Ticker Rating Outlook Coupon Maturity Price Yield Spread McDonald's Corporation A- Stable 3.8% 04/01/ % +102 Starbucks Corporation A- Stable 3.5% 03/01/ % +108 Yum Brands Inc. BB Stable 4.75% 06/01/ % +235 Source: Interactive Data, as of Sept. 11, 2018

2 Page 2 of 17 Credit Rating Rationale McDonald's corporation owns and manages one of the most iconic brand franchises in the world. We believe the strength of its global branding, cohesive franchisee system, highly efficient supply chain, and economies of scale continue to support McDonald's significant competitive advantage. In consideration of these attributes, Morningstar's Equity Research Group assigns the company a wide-moat rating. MCR's low Business Risk assessment stems in part from McDonald's moat and the stability of its operating earnings and cash flows. Yet, its moat trend is negative as stagnant guest traffic trends in the informal dining-out marketplace, evolving consumer taste preferences, emergent sources of competition across multiple channels, aggressive industry promotional activity, and uneven global macroeconomic and geopolitical trends will pressure McDonald's brand intangible asset in the years to come. The company's moderate Solvency Score is anchored by returns on invested capital in the high teens, which are comfortably in excess of MCR's estimated weighted average cost of capital of 8.3%. However, McDonald's Cash Flow Cushion is weak, constrained by significant intermediate-term maturities, elevated interest and lease payments over our five-year forecast period. McDonald's leverage also continues to look high for the rating category, a consequence of taking on debt to finance the company's aggressive share repurchase program. We view McDonald s turnaround as successful. Global comparative sales remained on trend at 4% for the second quarter ended June 30, marking 12 consecutive quarters of positive comparable sales growth. Morningstar believes that through multiple operational initiatives, McDonald's is building a stronger platform for future growth by employing a three-prong strategy: The company has increased its use of technology, including the ability for customers to transact through kiosks and mobile devices as well as the introduction of table service and delivery in some markets, which appears to benefit consumers while helping to reduce service costs; McDonald's revamped its value menu options by establishing a $1, $2, $3 menu platform, which is driving incremental sales and guest counts; and McDonald's created a platform for premium menu choices, which vary across geographies, to generate excitement and allow the consumer to trade up, but more important, it increases the company's competitiveness, particularly with fast-casual restaurants and specialty burger chains. We believe the recent U.S. menu enhancements that include McDonald's national rollout of its Signature Craft line sandwiches, new Buttermilk Crispy Tenders, and the relaunch of McCafé, represent greater product quality and are performing well. We also believe that the relaunch of the McCafé line will resume competitive pressure on Starbucks Corporation (A-, stable). Of note is the company's rededication to improving burger quality, which is reflected not only in its Signature Crafted Recipe, which is a platform for multiple sandwich products, but also in the company's movement of utilizing fresh, not frozen, beef patties in its Quarter Pounder burger, which we believe is the mainstay of the company's burger menu. Credit Strengths McDonald's cash flow generation is substantial with the company generating cash flow from operations less capital expenditures in excess of $4.0 billion annually throughout the forecast period. At the restaurant level the company average unit volume is high at approximately $2.4 million, which exceeds most quick-serve restaurant chains.

3 Page 3 of 17 McDonald's investments in EOTF, which focuses on restaurant modernization and technology and digital engagement, is transforming the restaurant experience and we believe is strengthening its platform for growth. As McDonald's accelerates the pace of converting restaurants to EOTF, it is placing renewed emphasis on improving its service model and strengthening relationships with its customers, in part through digital channels and a loyalty program. The company's licensee fees, royalties, and rental income provide over 40% of the company's revenue, which provides greater predictability to McDonald's operating earnings and cash flow stability. Credit Weaknesses Refranchising company-owned restaurants could reduce McDonald's ability to influence its system, which may make the company increasingly dependent upon the willingness and the ability of its franchisees to execute operational changes and menu changes. This may lower the company's ability to manage product and service quality and may delay implementation of future major initiatives and strategic plans. Given McDonald's aggressive cash return to shareholders, failure to continue to maintain a high level of operating performance, could lead to a stagnation of operating earnings, cash flow, and weaken its credit profile. Although McDonald's has recently become more responsive to changing consumer preferences and how they choose to interface with the company's restaurants, historically McDonald's has been slow to adapt to change and has lost market share. The success of McDonald's recent initiatives has reverse several negative trends and the company has improved guest counts and grown faster than the industry. Failure to periodically renovate its restaurants, enhance menu offering, engage the consumer and become more agile could erode current gains and reduce McDonald's brand equity, and have a negative impact on operating results and weaken its credit profile. Credit Rating History On Jan. 31, 2018, McDonald's A- credit rating was affirmed based on successful execution of its operating strategy; increased competitiveness evidenced by system-wide and same restaurant sales growth, and improved unit operating margins. On Feb. 1, 2017, McDonald's A- credit rating was affirmed, reflecting the strengthening of its operating fundamentals, the early success of its turnaround program, and the stability of its pillars, which is supported by the company's intangible asset, cohesive franchisee system, economies of scale, and a focus on unit-level productivity improvement. On May 11, 2015, McDonald's credit rating was downgraded three notches to A- as a result of weakening operating fundamentals concurrent with the company's commitment to a leverage recapitalization that resulted in debt levels increasing 61.5% to $21.4 billion by year-end Dec On Feb. 8, 2010, McDonald's was initiated with an AA- rating.

4 Page 4 of 17 Exhibit 1 McDonald's Credit Rating History Source: Morningstar Credit Ratings, LLC Pillar Analysis Exhibit 2 McDonald's Credit Pillar Summary Current Rating: A- Strongest Weakest Rating Pillars Business Risk Cash Flow Cushion Solvency Score Distance to Default Source: Morningstar Credit Ratings, LLC Please refer to the appendix for a full description of the rating pillars. Business Risk (3-Low): McDonald's benefits from strong competitive advantage, medium uncertainty, low dependency on capital markets and mild cyclicality. However, McDonald's receives an aggressive management score because of its leverage recapitalization and heightened share repurchases. Size (Very large): McDonald's is the world's largest restaurant company, with 37,241 restaurants worldwide operating in 120 countries. In 2017, its systemwide sales were $90.9 billion, composed of $78.2 billion franchised, developmental licensee and affiliated sales and $12.7 billion of company-operated restaurants sales. McDonald's franchised revenue is likely to increase as the company's target is to franchise 95% of its restaurants up from its current 92% today.

5 Page 5 of 17 Economic Moat (Wide): McDonald's wide moat as assigned by Morningstar Equity Research Group is derived from the company's intangible assets inherent in its brand portfolio, and its cohesive franchise network, influence over suppliers, and substantial economies scale. Uncertainty (Medium): McDonald has a medium uncertainty score as it continues to successfully navigate macro-economic factors and the volatility in commodity and labor costs. Industry competition is intense, and the company not only faces heightened competition from quick serve restaurant chains, but also from fast casual rivals. With over 58% of its operating income derived from outside of the U.S., McDonald's is also exposed to economic fluctuations abroad, including currency movements, minimum wage hikes, and negative publicity tied to foodborne illness. The company size, diversification, and high degree of franchise restaurants lessen the negative impact of some of these factors and increase the predictability of the company's revenue, operating income and cash flow. Product/Customer Concentration (Diversified): McDonald's is geographically diversified with approximately 64% of its revenue and 58% of its operating income generated outside of the United States. Management (Fairly Aggressive): McDonald's leverage recapitalization supported a capital allocation policy featuring heightened share repurchases and dividends. These resulted in more than a temporary step-up in leverage that has weakened the company's Business Risk score and Solvency Score. Dependence on Capital Markets (Dependent): While debt maturities are manageable due to McDonald's strong cash flow generation the company has over 50% of its debt maturing within MCR s five-year forecast period negatively impacting this score. Similar to other consumer defensive companies, McDonald's carries high short and intermediate term debt maturities. With its aggressive Cash Return to Shareholders Program and a continuous need to increase debt levels to support shareholder remunerations, McDonald's credit risk could increase if its operating fundamentals weaken. In general, higher debt levels increases a firm's dependency on capital markets. Cyclicality (Mild Cyclicality): We view cyclicality as low. Although food expenditures away from home are discretionary expenditures and susceptible to recessionary pressures, quick service restaurants have historically exhibited less sensitivity to macroeconomic conditions, due to their low price point. Cash Flow Cushion (7-Weak): McDonald's score is weak due to the high level of maturities within the forecast period, increasing interest cost and high lease payments relative to our cash flow expectations. Solvency Score (3-Strong): McDonald's has a solid Solvency Score, which is supported by high ROICs (20% at Dec. 31, year-end) resulting from greater operating earnings, a lower capital base due to refranchising and good liquidity, which more than offset the company's higher leverage and slightly lower interest coverage due to increased debt levels. Distance to Default (3-Strong): The strength in McDonalds share price provides a significant equity cushion and a strong default score. The company has a market capitalization of $125 billion and $31 billion of debt. However, McDonald's also has substantial operating lease commitments that are not captured in this measure of equity support, which if capitalized, MCR estimates would increase the company's debt obligation by $13 billion.

6 Page 6 of 17 McDonald's Corporation Overview McDonald's owns, operates and franchises namesake restaurants in more than 120 countries. The company competes globally in a highly fragmented market. According to Euromonitor International, $1.2 trillion in annual sales was generated in the informal eating out category in 2016 and McDonald's garnered a 7% market share that year based upon its systemwide sales. Except for some variation among different geographies to accommodate local taste and preferences, McDonald s restaurants each offer a similar menu. The company structured its segments with similar characteristics and opportunities for growth geographically as follows: U.S.: McDonald's largest segment International Lead Markets: established markets including Australia, Canada, France, Germany, and the U.K. High-Growth Markets: markets in China, Italy, Korea, the Netherlands, Poland, Russia, Spain, Switzerland, and related markets Foundational Markets and Corporate: the remaining markets in the McDonald's system Exhibit 3 Segment Data Source: Morningstar Credit Ratings, LLC as of July 23, 2018, *Adjusted TD includes total debt plus 8 times rents The U.S. restaurant industry is characterized by intense competition based upon price and quality. On the supply side, it is subject to periodic overcapacity and on the demand side, susceptible to variations in the business cycle. However, benefiting the industry is the continued increase in spending for food consumed away from home, which continues to outpace spending for food consumed at home. During the past few years heightened competition from specialty burger chains and fast-casual restaurants has taken market share from the company. Several of its competitors were able to provide greater menu variety, higher product quality, and greater digital engagement. In order to combat a declining customer sales count and comparable-store sales, in 2015 McDonald's hired a new CEO, Steve Easterbrook, who embarked upon a restructuring effort. The company instituted several measures aimed at reinvigorating operating performance and positioning the company to be, in its words, "recognized by

7 Page 7 of 17 customers as a modern and progressive burger company." To this end, McDonald's prioritized strategic initiatives that focused on running better restaurants, driving operational growth, returning excitement to the brand, and enhancing financial value. Management's initial steps were to restructure the company organization to generate fresh energy and innovative ideas and execute against its turnaround plan. In addition to the customer-relevant changes discussed in the previous section, McDonald's also targeted increasing the company's financial value through refranchising, cost savings, and increasing return of cash return to shareholders: Refranchising. McDonald's hit its global refranchising target of 4,000 restaurants in 2017, achieving its goal one year ahead of schedule. The company is currently 92% franchised and its long-term target is to become approximately 95% franchised. McDonald's completed the sale of its China and Hong Kong restaurant business, including more than 1,750 company-operated restaurants, to a developmental licensee for $1.6 billion in In addition, McDonald's also received $974 million in 2017 primarily from the sale of 435 restaurants in Sweden, Denmark, Norway, Finland, and an undisclosed number of restaurants in Taiwan. Under the terms of the China developmental licensee agreement, McDonald's retains a 20% ownership in the business. As stated previously we believe that rent, royalties and licensee fees provide a more stable revenue stream with a higher margin compared with company-owned stores. The franchise model and the developmental licensee model are also significantly less capital intensive as the franchisees are responsible for future investments in the business. Under McDonald's franchise arrangement, the company generally owns the land and building or secures a long-term lease for the restaurant location and the franchisee pays for equipment, furniture and fixtures, and signage. McDonalds receives rent and royalties based upon a percent of sales, subject to minimum payments, along with initial fees paid upon the opening of a new restaurant. Cost Savings. McDonald's established a target of reducing its general and administrative levels by $500 million or approximately 20% by the end of 2018 from a base of $2.6 billion at the beginning of Actions taken in 2015 and 2016, including the redesign of the organization to eliminate layers of management and increase spans of control, more centralization of noncustomer-facing business processes and execution against its refranchising targets, have so far resulted in savings of more than $200 million. Returning Cash to Shareholders. McDonald's achieved its three-year target of $30 billion cash return to shareholders by the end of 2016 and embarked on returning $22 billion $24 billion for the next threeyear period ending The company recently indicated that it was comfortable returning $24 billion, the top end of the range by year-end From Jan. 1, 2017, to the first six months of 2018, McDonald's returned $12.6 billion of cash to shareholders, achieving just over 50% of its target. Financial Projections. We are forecasting that McDonald's actions will increase guest count and generate 3% 5% comparative restaurant sales in the near to intermediate term. We are expecting a 1%

8 Page 8 of 17 increase in sales due to new restaurants. We forecast that McDonald's operating costs will decline as a result of refranchising and its restructuring initiatives, and its royalties and licensee fees will increase, boosting operating margins, earnings and EBITDA. Incorporated in the forecast is management expectation of fully realizing its $500 million of cost savings and the cash flow benefit of $400 million $500 million from the 2017 Tax Cuts and Jobs Act. We expect lease-adjusted leverage to decline to approximately 3.6 times over our five-year forecast period. We are projecting that revenue will decline 16% to $19 billion in 2018 and increase modestly by the end of 2019, reflecting the impact of substantial refranchising activity in Beyond 2019, we expect revenue to grow at an average annual rate of 5%. We further expect operating margins to expand to 40% and adjusted EBITDA margins to 49% as longer-term cost savings from franchising take effect. Exhibit 4 Financial Projections $s in Millions 2018E 2019E 2020E 2021E 2022E Revenue 19,169 19,243 20,216 21,306 22,284 Revenue Growth -16.0% 0.4% 5.1% 5.4% 4.6% Operating Income 9,052 9,510 10,009 10,756 11,428 Operating Income Growth 3.5% 5.1% 5.3% 7.5% 6.2% Adjusted EBITDA 9,795 10,260 10,675 11,439 12,127 Cash Flow From Operations 7,017 7,041 7,451 8,037 8,600 Capital Expenditures (2,400) (2,400) (1,505) (1,210) (1,166) Dividends (3,302) (3,578) (3,896) (4,147) (4,413) Free Cash Flow 1,315 1,063 2,050 2,681 3,021 Gross Debt / EBITDA Adjusted Debt/EBITDAR EBITDAR/Interest+ 1/3 Rents Source: Morningstar Credit Ratings, LLC Capital Structure and Liquidity Analysis McDonald's debt stands at $31 billion for the quarter ended June 30, and we estimate that the company's maturities will average $2.2 billion per year for , and $20 billion thereafter. We believe that maturities are manageable with liquidity well supported by the company's cash balance of $2.4 billion at quarter-end and by McDonald's trailing-12-month free cash flow after dividends of $557 million. We are projecting that annual free cash flow will exceed $1.0 billion during the next couple of years and double thereafter (see projections). We calculate lease-adjusted leverage of 3.8 times for the trailing twelve month ended June 30, and we estimate the company's lease adjusted interest coverage ratio at approximately 8 times. In addition to cash on hand, additional financial flexibility is provided by McDonald s $2.5 billion credit agreement expiring in December 2019, which also acts as a backstop to the company s commercial paper program. With its migration to a more heavily franchised system, we believe McDonald's is now in a better position to manage its leveraged capital structure supported by more consistent revenue, higher operating earnings and cash flows. As a result, we expect McDonald's overall credit profile to stabilize,

9 Page 9 of 17 and absent material increases in shareholders payouts, we are forecasting that its total adjusted debt to a multiple of EBITDAR will be maintained between the mid- to high 3.0 times. McDonald's adjusted debt includes an estimate for the capitalization of operating leases of $13 billion, which is expected to decline with its refranchising activities. Exhibit 5 Capital Structure ($s in Millions) Capital Structure ($s in millions) Maturity dates Interest rate 1 (%) 12/31/ xebitdar Fixed ,533 Floating 4.3 3,193 Total U.S. Dollar ,726 Fixed 1.6 8,447 Floating 0.0 1,323 Total Euro ,770 Total British Pounds ,009 Total Canadian Dollar - Fixed Total Japenese Yen - Fixed Fixed Floating Total other currencies ,106 Fair Value Adjustment (6) Deferred Debt Cost (120) Total Debt 30,980 Deduct Capitalized Lease Obligations 13,206 Total Adjusted Debt 44, x Total Cash and Equivalents 1,623 Net Adjusted Debt 42, x Adj. EBITDAR latest twelve month ended June 30, ,572 (1) Weighted-average effective rate. (2) Amounts are as reported Dec. 31, 2017, except for floating rate U.S. debt and the total debt amount which was adjusted to reflect the total balance $30.9 billion at June 30, Source: Morningstar Credit Ratings, LLC as of Aug 5, 2018, *Adjusted TD includes total debt plus 8 times rents Capital Allocation McDonald's believes its step-up in leverage optimizes its capital structure while continuing to target an investment-grade credit rating. McDonald's does not have a publicly stated dividend policy, though historically it has paid out just over 50% of its cash flows from operations on average. The company has a long-term goal of paying out all of its free cash flow to shareholders through both dividends and share repurchases. We estimate that funding McDonald's current three-year, $22 billion $24 billion payout target will require $2.5 billion $3 billion of additional debt over this period. The company's 2018, $2.4 billion capital expenditure budget has $1.5 billion dedicated to EOTF investment. Once this heightened level of investment is completed in 2019, we expect capital expenditures to decline and boost McDonald's free cash flow Peer Comparison We compare McDonald s to similarly rated Starbucks and its lower-rated competitors Yum Brands, which owns and operates Taco Bell, Kentucky Fried Chicken and Pizza Hut; and Restaurant Brands

10 Page 10 of 17 International, whose ownership includes Burger King, Tim Hortons, and Popeyes Louisiana Kitchen International. Starbucks, which has a limited food offering that accounts for an estimate of 25% of its revenue, competes mainly with McDonald's McCafé line of coffee beverages. As the world's largest restaurant chain McDonald's has considerable economies of scale with systemwide sales in excess of $90 billion, which is substantially greater than its primary competitors, whose systemwide sales are as follows: Yum Brands Inc. at $47 billion, Restaurant Brands International Inc. at $30 billion (pro forma for Popeyes), and Starbucks, with net revenue of $22 billion at its fiscal year 2017, which we use as a proxy for its systemwide sales. On a per-unit basis, McDonald's restaurants eclipse its competitors, generating $2.4 million in revenue, more than twice the quick-serve industry average and significantly greater than its primary competitors. Benefiting from a geographically adaptable business model and a first-mover advantage in several markets, McDonald's has garnered leading share in several international markets, with the exception of China, where Yum has expanded faster. McDonald's has greater profitability margins than its peers because of its scale and focus on unit level profitability. As a result, McDonald's EBITDAR margins lead its competitors. Unlike the other industry players, McDonald's owns over 40% of the land and 70% of the buildings for its restaurants in consolidated markets, which provides it with considerable control over occupancy cost and generate substantial rental income for the company. Over the past few years, the industry s larger players have engaged in operational and financial restructuring, through refranchising and leverage recapitalization, and aggressively returning capital to shareholders. As a result, leverage has expanded for the group, pressuring ratings resulting in several downgrades. Yum Brands rated the lowest, operates with the greatest amount of leverage and has the weakest credit pillars. Starbucks rated similar to McDonald's with comparable credit pillars has the lowest leverage, historical exhibited greater growth than McDonald's and has led the industry with digital engagement, but with a focus on beverages is much less diversified. Exhibit 6 Peer Analysis (in Millions) Trailing-Twelve Months Ended June 30, 2018 Financial Metrics MCD SBUX 1 YUM Credit Rating A- A- BB Revenue $21,587 $24,114 $5,752 EBITDA $9,907 $5,863 $1,914 Margin 46% 24% 33% EBITDAR $11,572 $7,192 $2,128 Margin 54% 30% 37% Debt $30,980 $9,799 $9,666 Adjusted Debt $44,186 $20,443 $11,378 Rent-Adjusted Leverage Debt and adjusted debt amounts reflect the company's $3.0B Aug. 8 notes issuance. Source: Morningstar Credit Ratings, LLC K

11 Page 11 of 17 Appendix

12 Page 12 of 17 Company Name Moat and Trend The following description comes directly from Morningstar's Equity Research Group: "Nonexistent switching costs, intense industry competition, and low barriers to entry make it challenging for restaurant operators to develop an economic moat. Although McDonald's has faced increased competition, self-inflicted product pipeline, pricing, and marketing issues, a tepid macro environment, and evolving consumer views about menu composition and in-restaurant experience, we believe it possesses a wide moat. Our moat rating is based on a mix of structural and intangible competitive advantages, including a widely recognized brand, a franchisee system aligned on driving unit-level productivity improvements, and meaningful economies of scale. These qualities were instrumental in helping McDonald's to build the largest restaurant chain in the world (based on systemwide sales) and resulted in leading market share in most countries in which it operates, with the notable exception of China. McDonald's generated $91 billion in sales at its company-owned and franchised restaurants during 2017, representing almost 4% of the $2.5 trillion global restaurant industry. This almost doubles our Yum Brands' systemwide sales of $47 billion in 2017 (including Yum China) and dwarfs Restaurant Brands International ($30 billion on a pro forma basis after the acquisition of Popeyes) and Subway ($12 billion). "With strong brand awareness, consistent customer experience, convenient restaurant locations, and a uniform value-priced menu balancing core menu items with locally relevant options, McDonald's is among the few restaurant chains to enjoy success globally. McDonald's average trailing 12-month sales of around $2.4 million per restaurant trumps the quick-service restaurant industry average of just over $1 million per location. Additionally, we believe exterior and interior restaurant decor upgrades, moreefficient kitchen and drive-through configurations, and an Innovation Center (a 38,000-square-foot facility where the company can simulate new restaurant prototypes across a wide range of configurations, technologies, dayparts, and guest count volume) can assist with management's velocity growth plans and drive restaurant productivity metrics higher over an extended horizon. "Menu innovation has historically played an important role in enhancing McDonald's intangible asset moat source. Management has cited executional and complexity issues with its menu over the past several years, so we're encouraged by ongoing menu rationalization efforts and a more streamlined value menu offering. We view these decisions as prudent, but also acknowledge that the composition of McDonald's menu will require a careful balance between rationalization and incorporating local preferences, something that could take additional time and resources (capital, labor, data analytics) to

13 Page 13 of 17 fine-tune. To that end, we find management's three-prong approach to rebuilding guest traffic commendable. This includes: (1) a focus on family-oriented products/experiences and the breakfast daypart to retain current customers; (2) convenience/value improvements to regain lapsed customers (including a streamlined version of the McPick value menu, $1 beverage menu, and $1-$2-$3 menu); and (3) an emphasis on coffee/snacking and operational consistency to convert casual customers (accentuated by stand-alone McCafé kiosk/pastry counters in certain locations). We're also intrigued by management's emphasis on creating a customer Experience of the Future flexible enough to accommodate the demographic, competition, taste, and franchisee permutations across its different operating regions while incorporating input from local and regional decision-makers. This is most apparent in McDonald's international lead market segment (Australia, Canada, France, Germany, United Kingdom), where innovations in each company are establishing a blueprint for more sustainable growth across the entire system. "Although migrating innovations from international lead markets to the U.S. will take additional time to implement given its size and competitive set, we're becoming more constructive about the longer-term opportunity for the company to return to sustainable comparable sales growth in the mid-single-digit range. Our confidence stems from the recipe changes utilizing higher-quality ingredients and incremental labor investments and training, driving improved speed of service and order accuracy metrics and helping boost comparable sales in the U.S. and helping to improve McDonald's brand perception among consumers even before the successful launch of all-day breakfast, reinforcing our wide moat rating. While all-day breakfast exceeded management's expectations and helped to bring back guest traffic, we continue to believe the more important takeaway is that the program went from a single test market in May to nationwide rollout in October. This implies McDonald's is overcoming its recent supply chain execution hurdles while demonstrating a greater level of coordination across the system, which we believe portends a more seamless rollout for new products, promotions, and other instore innovations in the future. "This was apparent at McDonald's March 2017 investor day, where we walked away more encouraged about how much thought went into seamlessly integrating McDonald's mobile order and pay and plans for the Experience of the Future initiative, including rolling it out to 2,500 U.S. locations by the end of the year and most of the U.S. system by 2020 (aided by franchisee co-investment incentives). It was abundantly clear that management has put considerable time and resources into developing the platform to scale and adapt to evolving consumer preferences, including new kitchen configurations that can accommodate additional capacity from mobile/delivery orders and an innovative mobile ordering/payment platform that uses geofence virtual-perimeter technology to facilitate customers mobile order when they are nearing any U.S. location. Mobile order and pay capability was rolled out at all 14,000 U.S. locations and another 6,000 locations across Canada and the U.K. as of the end of While we don't expect the Experience of the Future rollout or mobile order and pay to have the same immediate impact as the all-day breakfast--and with no significant contribution benefit until 2018 at the earliest--we believe the combination of ordering flexibility (including counter, kiosk, web, and mobile ordering), menu customization (including the ability to custom-build burgers, chicken sandwiches, and salads), customer experience (including a blend of front counter, table service, and curbside delivery),

14 Page 14 of 17 and future loyalty program/targeted marketing opportunities will collectively have a more sustained impact than a platform like all-day breakfast, giving us comfort in our five-year U.S. comparable sales targets in the mid-single-digit range. "While McDonald's full transformation will still take time, we're comforted that the company's brand intangible asset moat source is backed by a cohesive franchisee and affiliate system, which collectively operated almost 93% of the chain at year-end, expanding to 95% over a longer horizon through refranchising efforts. This structure allows the company to expand its brand reach with minimal corresponding capital needs while providing an annuity like stream of rent and royalties, even during challenging economic times. As a result, McDonald's generates excellent free cash flow and returns on invested capital in the mid- to high teens. These results are even more impressive when considering that the firm owns 45% of the land for its restaurants (around $5.5 billion in land assets), meaning that the returns are generated on a higher invested capital base than most franchised restaurant chains. We believe considerable land assets provide an additional competitive buffer that most other restaurant firms cannot match. "We also appreciate McDonald's aspirations to becoming a more nimble organization, particularly with respect to making more menu and marketing decisions at the local and regional level. Although we consider McDonald's size and scale to be a key competitive advantage--the foundation of our cost advantage moat source--questions about the agility of its supply chain have surfaced in recent years, especially in a restaurant industry experiencing changing taste preferences at a local and regional level, a more pronounced consumer shift toward healthier foods, and some fast-casual players reaching critical mass (which we believe have captured a share of McDonald's previous middle- to upper-middle income consumers). There have been instances when competitors have been able to bring new products to market more rapidly than McDonald's because of raw material procurement constraints, but we are hopeful that impressive speed-to-market for the all-day breakfast launch in the U.S. paired with localized menu decisions will help to alleviate some bottlenecks in the system and level the playing field somewhat. "With stagnant guest traffic trends in the informal eating out marketplace, evolving consumer taste preferences, emergent sources of competition across multiple channels, aggressive (and often irrational) industry promotional activity, and uneven global macroeconomic and geopolitical trends, we expect McDonald's brand intangible asset moat source will come under additional pressure in the years to come, resulting in a negative moat trend rating. Yum Brands, Restaurant Brands International (Burger King/Tim Hortons/Popeyes), Subway, Wendy's, Chick-fil-A, and a host of fast-casual restaurant rivals all vie for market share in the intensely competitive restaurant industry, making it more difficult for the McDonald's brand to stand out among consumers, both in terms of pricing power and driving restaurant traffic. "We appreciate the three primary challenges facing the U.S. business today that management had identified in recent years. One, the pricing gap between its value, core, and premium products has become too wide, with the value-oriented menu absorbing 'too much inflation' and resulting in

15 Page 15 of 17 consumer trade-down that limited the impact of its more premium products. Management has also acknowledged that the company had been slow to react to a rapidly evolving restaurant industry, marked by changing taste preferences at a local and regional level, a more pronounced consumer shift toward healthier and authentic foods, and the fast-casual category reaching critical mass (which we believe has diverted a portion of McDonald's previous middle- to upper-middle-income consumers). Lastly, management recognized that it had added too much complexity to the menu over the past 10 years. "Easterbrook and the McDonald's system have done a commendable job implementing a number of global customer engagement and operational improvements aimed at improving the company's intangible asset moat source. These include fewer but more impactful menu innovations across all dayparts and pricing tiers, a meaningful reduction in menu items, using technology for capacity/throughput/delivery initiatives, improved marketing messaging and reach, and use of consumer-driven insights to improve the planning process with franchisees and suppliers. While these initiatives have driven traffic across the globe and should result in incremental trade-up and add-on purchases, we believe the company will have limited pricing power over the foreseeable future amid industry promotional activity and new sources of competition across multiple channels, supporting our negative moat trend. "Despite questions about the strength of McDonald's brand intangible asset, we believe the strength of the company's franchise system and scale advantages is intact. McDonald's remains the largest player in the global QSR industry (accounting for 12% of U.S. QSR sales and about 4% of global restaurant sales), and franchisee-level returns have remained relatively healthy even under heightened competition."

16 Page 16 of 17 Descriptors for Pillar Analysis Rating Pillars Score Range Business Risk Cash Flow Cushion Solvency Score Distance to Default Strongest 1-2 Minimal Very Strong Very Strong Very Strong 3-4 Low Strong Strong Strong 5-6 Moderate Moderate Moderate Moderate 7-8 High Weak Weak Weak Weakest 9-10 Very High Very Weak Very Weak Very Weak Business Risk Pillar Components Country Risk (10% of Business Risk Score) Weakest Strongest Very High Risk High Risk Moderate Risk Low Risk Company Risk (90% of Business Risk Score) Size Economic Moat or Sustainable Competitive Advantage Uncertainty Weakest Very Small None None Extreme Small Very High Moderate Narrow Moderate High Large Medium Strongest Very Large Wide Substantial Low Product/Customer Concentration Management Dependence on Capital Markets Cyclicality Weakest Highly Concentrated Aggressive Extremely Dependent Highly Cyclical Concentrated Fairly Aggressive Highly Dependent Cyclical Neutral Neutral Dependent Average Cyclicality Diversified Fairly Conservative Low Dependence Mild Cyclicality Strongest Highly Diversified Conservative Very Low Dependence Non-Cyclical

17 Page 17 of 17 Morningstar Credit Research For More Information Todd Serpico West Washington Street Chicago, IL USA 2018 Morningstar. All Rights Reserved. Unless otherwise provided in a separate agreement, you may use this report only in the country in which its original distributor is based. The information, data, analyses, and opinions presented herein do not constitute investment advice; are provided solely for informational purposes and therefore are not an offer to buy or sell a security; and are not warranted to be correct, complete, or accurate. The opinions expressed are as of the date written and are subject to change without notice. Except as otherwise required by law, Morningstar shall not be responsible for any trading decisions, damages, or other losses resulting from, or related to, the information, data, analyses, or opinions or their use. References to Morningstar Credit Ratings refer to ratings issued by Morningstar Credit Ratings, LLC, a credit rating agency registered with the Securities and Exchange Commission as a nationally recognized statistical rating organization ( NRSRO ). Under its NRSRO registration, Morningstar Credit Ratings issues credit ratings on financial institutions (e.g., banks), corporate issuers, and asset-backed securities. While Morningstar Credit Ratings issues credit ratings on insurance companies, those ratings are not issued under its NRSRO registration. All Morningstar credit ratings and related analysis are solely statements of opinion and not statements of fact or recommendations to purchase, hold, or sell any securities or make any other investment decisions. Morningstar credit ratings and related analysis should not be considered without an understanding and review of our methodologies, disclaimers, disclosures, and other important information found at Investment research is produced and issued by subsidiaries of Morningstar, Inc. including, but not limited to, Morningstar Research Services LLC, registered with and governed by the U.S. Securities and Exchange Commission. The information contained herein is the proprietary property of Morningstar and may not be reproduced, in whole or in part, or used in any manner, without the prior written consent of Morningstar. To license the research, contact Vanessa Sussman ( ) or by to: vanessa.sussman@morningstar.com.