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McDonald’s : Is the Market’s Taste for It Waning?

McDonald's
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mcdonaldsNobody is bigger in the restaurant business than McDonald’s (NYSE: MCD): it has more than 35,000 stores in 100 countries on six continents, and says its serves 70 million people a day. Since its founding in San Diego in 1954, the company is one of the classic rags to riches growth stories in modern U.S. business history.  But if you’re an investor, you want to know about McDonald’s future, and, to be honest, it’s nothing like its 60-year history.  Instead of remaining on a sure-fire growth trajectory, the fast food chain is battling to maintain market share and revenue growth, and is a value play.

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Not that it looks like MCD is in any real trouble. Its financials are sound, it pays an attractive dividend that investors can count on – at least for the next few years – and the company’s stock buyback plan should continue to support sturdy shareholder value. So, I rate it a “Hold.”  But future returns look lackluster compared to some alternatives, and I don’t recommend investors look to MCD for a new position.

MCD closed at $94.30 today. It pays a dividend of $3.42, for a handsome yield of 3.44%, fifth-best among Dow stocks.  It’s also one of 54 U.S. stocks to have raised its dividends for the last 25 years, which qualifies it for the unofficial title of a “dividend aristocrat.”

The challenges for McDonald’s start to appear in its recent stock performance compared to the stock market benchmark, the S&P 500, where the trend has reversed in the index’s favor.  For the five year period from 2004 through 2008, MCD clobbered the S&P by more than 20 points, throwing off an average annual total return of 22.9% compared to the S&P’s loss of 2.2%.  But over the following five years, MCD underperformed by five points 12.9% to the index’s 17.9%. And the underperformance continues in 2014, four points behind the S&P’s year-to-date positive 5.2% to MCD’s negative 1.2%.

McDonald’s disappointing quarterly earnings report last month shed light on the reasons.  Earnings came in at $1.40 a share, up from the first quarter, but four cents below analysts’ expectations.  Meanwhile sales rose 1%, same-store sales two of its three regions, Europe and the US were down, 1.0% and 1.5% respectively.  Sales were up only in its APMEA business (Asia-Pacific, Middle East and Africa), where they rose 1.1%, but since MCD generates only 23 percent of its total revenues, the declines elsewhere weigh more heavily. Revenues were only higher for the quarter, driven largely by the opening of new stores.

All by itself, the second-quarter report isn’t as troubling as the fact that it marked the third quarterly report in which overall same-store sales declined.  Management blames weakness in the U.S. and European economies, but the concern is that in the U.S. consumers are starting to change their tastes in favor of healthier foods. Analysts point to Chipotle Mexican Grill (NYSE: CMG) as one of the beneficiaries of this emerging trend; its stock price has more than doubled since the beginning of 2013 and tripled since 2010 (it closed at $675.14 today, and doesn’t pay a dividend).  Meanwhile, MCD has languished for the last 19 months, stuck in a range between $92 and $102 and change, the high it hit early in May.

McDonald’s senior management is responding to the challenges.  It plans to remodel its restaurants, give more those drive-up windows, introduce menu items that cater more to local tastes abroad, and reinvigorate is marketing.  It remains to be seen whether that will be enough, as the company announced that last year it remodeled just 700 of its stores.

On the other hand, the company is in the middle of a stepped-up campaign to enrich shareholders.  It recently reiterated its intentions to give back $18 billion to $20 billion in share buybacks and dividends from this year through 2016. That’s an increase of 10% to 20% over the amount it returned to shareholders from 2011 through 2013.

I’m not worried about MCD’s dividend. What bothers me is its ability to grow earnings, given trends in market share as well as the higher costs for beef it’s been paying and the prospect that its labor costs may go higher, given demands by workers for significant wage increases.  Like most fast-food restaurant chains, MCD hasn’t been able to pass along much of its higher costs by raising prices due to sluggish growth in incomes.

The consensus on Wall Street is that McDonald’s earnings will grow at 6.16% percent a year for the next five years. If that holds true, valuations stay the same at 17.13 times trailing 12-month earnings, and the company keeps the dividend yield where it is, my projections say the stock will throw off an average annual total return of 8.3% a year.  That’s OK, and dividend investors can take heart, as MCD’s  have grown at the very healthy average of rate of 21% a year over the past 10 years, and at a sustainable payout ratio of just 44 percent.

But if you’re more interested in total returns that beat the S&P 500, there are more attractive opportunities for new positions elsewhere in the Dow, or – if you’re intent on owning an eatery stock – beyond it.  I haven’t scoured their prospects, but stocks like Starbucks  (NASDAQ: SUBX), Cheesecake Factory (NASDAQ: CAKE) and Brinker International (NYSE: EAT) all pay dividends and are expected to grow earnings twice as fast or more as Wall Street thinks McDonald’s will.


About Lawrence Meyers
 lawrence meyersLarry is regarded as one of the nation’s experts on alternative consumer finance. He consults for hedge funds and private equity via his Council Member status at Gerson Lehman Group, and as a member of Coleman Research Group’s Executive Forum. He also consults for Credit Access Businesses and Credit Services Organizations in Texas. His Op-Eds and Letters to the Editor have appeared in over two dozen major newspapers. He also brokers financing, strategic investments, and distressed asset purchases between private equity firms and businesses of all stripes. You can reach him at pdlcapital66@gmail.com.

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