(Note: The author of this fundamental analysis is a financial writer and portfolio manager. He and his clients own shares of GOOGL and SBUX.)
McDonald's Corp. (MCD) stock is dramatically outperforming tech giants like Facebook Inc. (FB), Alphabet Inc. (GOOGL ), and Microsoft Corp. (MSFT ), with the fast food chain's shares up nearly 46 percent over the past year as of noon Tuesday. These stocks all have one thing in common: the market is paying almost the same earnings multiple for each of them. However, there is one big problem. McDonald's is the only company where revenue is expected to decline for the foreseeable future. That aside, the market is still willing to pay the same multiple for shares of the hamburger chain as these technology companies.
Did McDonald's just become the next significant entrant in the cloud or artificial intelligence (AI)? To this point - No. But McDonald's is undoubtedly good at cutting and expenses and buying back shares to help boost earnings. The catalyst for the advance in McDonald's stock must be the comparable same-store sales that the company recently reported. They jumped by 6 percent along with a 10 percent increase in revenue from its franchises. But the bottom line is this: even with the significant gains in the franchise business, overall revenue still managed to decline by 10 percent on a year over year basis, to $5.754 billion. The only thing driving earnings growth at McDonald's is the relentless quest to slash operating costs.
It is impressive how investors are willing to pay an earnings multiple equal to or higher than some of the most prominent technology companies, which in fact do have significant growth both on the top and bottom line. McDonald's is more expensive than the big techs in more ways than a simple price to earnings measurement. The food chain also trades at a higher multiple than both Microsoft and Alphabet on a revenue basis. Microsoft and Alphabet are expected to grow revenue at nearly 8 and 17 percent, respectively, in the calendar year 2018. By contrast, McDonald's is expected to see total revenue shrink about 11 percent in 2018. Yep, you read that right: shrink. Investors are paying a premium valuation for shares of a hamburger chain.
Just Too Expensive
The message these numbers should be sending to investors is that either the technology names are just too cheap, or McDonald's is too expensive. More evidence of that is how expensive McDonald's is within its own universe of consumer discretionary names. Case in point, Starbucks. The company is trading at only 20 times one-year forward earnings estimates, and is expected to see revenue growth of 10 percent in 2018 to $24.75 billion. But it's cheaper than McDonald's, trading at 2.87 times future sales.
None of this seems to makes sense. And it shouldn't because in this case, the market appears to be looking for something in McDonald's that simply does not exist. At McDonald's, the growth of earnings is coming primarily from slashing expenses. When there are no expenses left to cut, the company will have to depend soley on increasing sales, which is hard in the saturated U.S. fast food market. Eventually, investors may be surprised to learn they are paying a tech-like valuation for a company with modest growth, at best.
That is the point in time when McDonald's management may have to consider diversifying from fast food service to the cloud, AI, or even mobile - just like every other tech company.
Michael Kramer is the Founder of Mott Capital Management LLC, a registered investment adviser, and the manager of the company's actively managed, long-only Thematic Growth Portfolio. Kramer typically buys and holds stocks for a duration of three to five years. Click here for Kramer's bio and his portfolio's holdings. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Upon request, the advisor will provide a list of all recommendations made during the past twelve months. Past performance is not indicative of future performance.