McDonald's Off The Dollar Menu

By Stephen D. Simpson, CFA | October 28, 2011 AAA

Combine a worldwide brand with solid execution, good growth, market share expansion, and a healthy dividend and it probably should be no great surprise that the stock is not cheap. Few companies are executing as well as McDonald's (NYSE: MCD) (let alone few restaurant companies), and the stock reflects this. While the company certainly has levers to pull for further growth and is a high-quality name, new investors may want to wait in the hope of a bargain before building a position here.

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Juicy Third Quarter Growth
McDonald's did well for itself in the third quarter. Revenue rose 14% as reported, and 8% on a constant currency basis, as the company saw 5% worldwide comparable sales growth. Comparable store growth was good in the U.S. (helped by a strong September) and surprisingly strong in Europe. Results in Asia were a little disappointing, but still positive.

McDonald's also has done a good job of absorbing higher costs. Although restaurant operating costs climbed 16%, management has kept solid control on SG&A expenses and was able to match revenue growth this quarter (operating income was up 14% as reported and 8% in constant currency).

Costs Are Not as Bad as You Think
McDonald's is certainly seeing higher food costs, but these aren't hurting the company all that badly. For starters, McDonald's has scale - they don't have to deal with the likes of Sysco (NYSE: SYY) or other vendors on a "take it or leave it" basis; companies will take lower margins (in the short run, at least) to keep McDonald's business. (To know more about scale, read: What Are Economies Of Scale? )

Secondly, McDonald's cost inflation is not so bad on a relative basis. Protein producers like Tyson Foods (NYSE: TSN), coffee sellers like Sara Lee (NYSE: SLE), and produce vendors like Dole Food (NYSE: DOLE) have all been raising their prices and shoppers are seeing this on the store shelves. All in all, McDonald's real costs and pass-through costs have not been climbing as much as these at-home costs, so the company remains a pretty good value for the money.

The Strong Getting Stronger
This has been a brutal stretch for restaurants. Well-known names like Friendly's, Sbarro, Perkins and Chevy's (or their corporate parents) have declared bankruptcy in the past year. At the same time, many other well-known chains like Sonic (Nasdaq: SONC) and Jack In The Box (Nasdaq: JACK) are struggling to boost foot traffic. Simply put, there is no room for marginal performance right now - you have to offer something that customers really want and at a really attractive price or they simply will not come through the doors. On the other hand, for companies that do offer that, names that include McDonald's, Panera Bread Company (Nasdaq: PNRA), and Dunkin Brands Group (Nasdaq: DNKN), this is actually not such a bad time. (To know more about restaurant stocks, check out: How To Analyze Restaurant Stocks? )

More Growth Opportunity Than People May Think
Shortly after releasing earnings, McDonalds announced that it is bringing back the McRib again on a limited basis. The saga of the McRib is a story all its own, but it highlights an underappreciated opportunity for the company. As world travelers already know, the McDonalds menu is not universal; the menu in Delhi is different from the menu in Tokyo, and from the menu in London. It frankly surprises me a bit that the company does not try to introduce some of the regional favorites - even if on just a short-term promotional basis.

Just like the occasional foreign media property becomes popular in America (think of The Office or Pikachu), it doesn't seem out of line to think that the company could find another winner this way - or at least a media promotion that could drive some curiosity traffic.

The Bottom Line
McDonald's isn't cheap. Then again, why should a company with a return on capital strongly in the teens, good organic growth, and further expansion potential (both in geography and menu items) be cheap? What's more, the company offers a dividend yield that is compelling relative to U.S. government bonds and is arguably a better credit risk today.

It's difficult to make the value argument for a new investor to buy McDonald's today, and it arguably makes more sense to wait for a better entry price. That said, it's a compelling company and if investors think that the lack of risk (and the excellence of execution) make up for the price of the stock, it is hard to argue strongly against that position.

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At the time of writing, Simpson Stephen did not own shares in any of the companies mentioned in this article.

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