Can McDonald's Maintain Its Dominant Competitive Position?

| About: McDonald's Corporation (MCD)

In our August report on McDonald's Corporation (NYSE:MCD), we analyzed and evaluated its strong performance from 2002-2012 as well as the slowdown in its recent performance. We concluded that McDonald's was the unquestioned, undisputed King of the Mountain with regards to fast-food restaurants in general and burger joints in particular. At the same time, we also expressed our interest in the recent performance of Burger King Worldwide (BKW) and we believe we said it best when we said to McDonald's "Don't look back; Burger King may be gaining on you". We issued that warning to McDonald's because we had been following Burger King since June when Justice Holdings took a 29% stake in the company and helped it come back in the public markets. We also issued that warning because we were more impressed with the performance momentum from Burger King in Q2 2012 than MCD and we believed that Justice Holdings and 3G were going to refrain from sucking out any more capital from Burger to satisfy "financial engineering" schemes and were going to set up Burger King as the pesky burger chain that provides headwinds to growth for McDonald's.

McDonald's was not the only blue-chip company to see negative headwinds to financial performance from recent global macroeconomic headwinds, most notably in the form of negative translation effect from the strong U.S. dollar versus other global currencies. McDonald's saw a small decrease in its Q3 2012 revenues versus Q3 2011 levels as increased revenues from its franchisees offset a slight decline in revenue from its company owned stores. Negative currency translation costs were $317M in the quarter and represented over 4.4% of its revenues. European revenue declined by 3% at its company-owned restaurants and 6% at its franchise-operated restaurants. After excluding the impact of the weak European currencies in relation to the US Dollar, constant currency revenues increased by 7% for the company owned restaurants and 4% for the franchise-operated restaurants. The United States saw 0% growth at its company-owned restaurants and 3% at its franchise-operated restaurants. MCD's Asia, Pacific, Middle East and Africa segment saw its company- owned sales increase by 5% reported (6% constant currency) and its franchise-operated sales increase by 9% reported (11% constant currency).

The biggest concern was that so far in Q4 2012, MCD's comparable store sales dipped into negative territory for the month of October, versus a 1.9% gain in the Q3 2012 period. We remembered that MCD started off Q3 2012 with negative comps throughout its footprint and it closed the quarter with 1.9% growth in its comps. We think that trick will be harder to pull-off in Q4 2012 as MCD has started the quarter with -2% comps across the board. We were surprised that Wendy's (NYSE:WEN) had the highest Q3 2012 comp rates of the three major burger chains. Wendy's had 2.8% comps, McDonald's had 1.9% comps and Burger King had 1.4%.

Source: Company Q3 Press Releases

The negative headwinds that McDonald's saw from the currency translation effect (particularly in the Eurozone) helped exacerbate a tepid and pedestrian operating performance. On a constant currency basis that excludes the impact of currency translations into US dollars, the company only grew its EPS by 4% in Q3 2012 versus Q3 2011 levels. Negative currency translation headwinds reduced revenues by nearly 4.5% and achieved the same negative effect on operating income. Even before the economic slowdown and negative currency headwinds, we were disappointed that the company only grew its operating income by 3%. We had become accustomed to seeing higher operating income growth and we guess its former CEO Jim Skinner picked a good time to retire, that way he can leave before the growth momentum truly dissipates. Even with the efforts by Burger King Worldwide to restructure and improve its operations, McDonald's still outclasses its competition in terms of operating margins. However, we would like to note that Burger King's Q3 2012 margins were negatively impacted by $30M in charges for the disposition of assets, terminations on interest rate caps and other non-standard operating charges. BKW's operating margin would have been 27.5% had the company not taken these charges in Q3 2012.

Source: Company Q3 Press Releases

On a cash management basis, McDonald's is still the Golden Arches with regards to other burger chains. McDonald's generated nearly $2B in operating cash flows during Q3 2012 after generating $3.1B in H1 2012. After McDonald's made $724M in net capital investment expenditures during the most recent quarter, it paid down $379M in debt. The company also paid nearly $704M in common stock dividends and nearly $535M in net share repurchases and had $2.18B in remaining cash assets. We like that McDonald's not only has a positive working capital position, but that its $2.2B in cash is significantly greater than its $670M in short-term debt and accrued interest payable. Although the company has over $13B in outstanding debt, it is manageable when we consider that MCD has nearly $14B in shareholders' equity and has generated $4B in free cash flows over the last 12 months. McDonald's could easily pay down its debt in less than 3.5 years if it was to devote all of its annual free cash flows to debt retirement but it wouldn't be necessary to do so considering that interest rates are at historic lows. Even though McDonald's momentum seems to be slowing, it has a significantly higher interest coverage ratio than its peers.

Source: Company Q3 Press Releases

There is no question that McDonald's has a stronger balance sheet and cash flow generation versus other burger chains like Wendy's, which only paid $27M in YTD dividends and Burger King Worldwide, which is focusing on deleveraging its balance sheet. Wendy's recently announced it was doubling its quarterly dividend per share of $.02 to $.04 as well as a $100M repurchase program. Then again, McDonald's can afford to lever up its balance sheet since its weighted average interest cost is about 3.78% while Wendy's debt costs 6.2% in average interest expense and Burger King's is 7.5%. One interesting fact we have noticed is that McDonald's dividend yield is 3.635% is comparable to its pre-tax weighted average cost of debt of 3.78%. Because interest expense is tax deductible and dividends are not, McDonald's should keep on opportunistically repurchasing shares as it would result in greater after tax financing cash flows saved versus paying down debt.

Source: Company Q3 Press Releases

In conclusion, we remain impressed with McDonald's. We are not fool-hardy to bet against the Golden Arches, especially due to its worldwide leadership in the quick-service restaurant industry. McDonald's is also the dividend champion of the fast food and quick-service industry as well as the share buyback champion. We also like the fact that it is less than 1% above its 52-week lows. We most certainly believe that Burger King Worldwide can only dream to compete at the same level as McDonald's due to BKW's years of being subject to the financial engineering whims of the private equity sector. However, based on the global macroeconomic headwinds that the company is facing, the negative effects from currency impacting its balance and Justice Holding's recent efforts and initial progress in restructuring Burger King, we believe that McDonald's should not take its competition lightly. We don't believe that Burger King and even Wendy's will be shaking its also-ran status to McDonald's anytime soon. McDonald's is undoubtedly the best performing burger chain in the world. However, we believe that the new actions taken by Wendy's with regards to its capital investment program and the actions that Justice Holdings and 3G are taking with Burger King are setting those chains up to force McDonald's to step up its game.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: This article was written by an analyst at Saibus Research. Saibus Research has not received compensation directly or indirectly for expressing the recommendation in this article. We have no business relationship with any company whose stock is mentioned in this article. Under no circumstances must this report be considered an offer to buy, sell, subscribe for or trade securities or other instruments.

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