McDonald's Has Eased Off, But Hardly Cheap

By Stephen D. Simpson, CFA | July 22, 2013 AAA

It seems as though gravity is finally weighing on the valuations in the consumer space, as stocks like Nike (NYSE:NKE), Coca-Cola (NYSE:KO), and McDonald's (NYSE:MCD) have underperformed over the past quarter. Worries tied to the ongoing sluggishness in China and margins may be the preferred talking points, but it's hard to overlook how expensive many of these consumer stocks got.

Turning back to McDonald's, there are now some worries about near-term performance, as management's comments on same-store sales suggest slowing growth. While I think selling McDonald's shares because of a couple months' worth of same-store sales is more of a justification than a reason, and I have every confidence that McDonald's will continue to find ways to continue growing, the shares are still well above what I'd call bargain territory.

SEE: How To Analyze Restaurant Stocks

A Small Disappointment, But Disappointment All The Same
McDonald's did miss by all that much for the second quarter, but it is likely to be enough to keep the pressure on these shares.

Revenue rose 2% for the quarter, with franchised store growth of 4% somewhat offsetting the 2% growth at company-owned stores. Overall same-store sales were up only 1%, though, matching the growth of Yum! Brands (NYSE:YUM) for the second quarter. Both companies saw 1% growth in the U.S., weakness in Europe (McDonald's down 0.1%), and weakness in China, with the latter helping push same-store sales for the Asia/Mideast/Africa segment down 0.3%. McDonald's does not report Latin American results, and Latin American operator Arcos Dorados (Nasdaq:ARCO) has been trading down since May on ongoing worries about Brazil, Argentina, Venezuela, and Latin America in general.

Margins remain under pressure as the company has limited options to raise prices and the popularity of the dollar menu in the face of rising labor and input costs creates some issues. Both franchised and company-owned stores saw similar store-level margin declines (40bp for the former, 50bp for the latter), while operating income rose 2% and operating margin declined about 20bp.

Can The Company Do Much To Boost Short-Term Growth?
One of the challenges I see for McDonald's at the moment is that they are more or less stuck in terms of near-term growth. McDonald's didn't have nearly the same scandal fallout in China as Yum! Brands' KFC (though both used tainted chicken), but McDonald's is still suffering from an overall decline in restaurant traffic in this major market.

SEE: How Are Q2 Earnings Shaping Up?

Likewse, there remain meaningful challenges in the U.S.. Consumer incomes and confidence haven't improved that much, and McDonald's strong dollar/value menu remains a point of differentiation with Yum! Brands, Burger King (NYSE:BKW), Wendy's (NYSE:WEN), and to a lesser extent chains like Panera (Nasdaq:PNRA) and Chipotle (NYSE:CMG).

But even with a strong value menu and a steady focus on new product introductions, as well as a near-constant focus on the consumer experience, how much can McDonald's move the needle over a short period of time? McDonald's already boasts per-store revenues more than 2.5x the average for the space, and there's just not much management can do to convert new customers or increase the order size for existing customers.

The Bottom Line
The valuation on McDonald's shares rarely makes sense unless you view them as basically a hybrid stock/bond type of security. Unfortunately, even with that in mind, I don't see that these shares will meet my minimum return requirements. It's not that I don't believe McDonald's will maintain its leadership in the U.S. quick service space, nor that the company won't continue to expand in markets like China, India, Indonesia, and Africa. It's just that I believe all of that (and more) is already in the shares.

Even if McDonald's can grow free cash flow at a rate of about 8%, I don't see the shares as much of a bargain. With investors seemingly rotating out of consumer stocks, though, this might be a name worth checking on every so often. At or below $90, these shares start to look a lot more interesting for long-term shareholders looking for a relatively stable dividend-paying play on global consumer spending.

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