Why Is McDonald's Falling And Where Is It Heading?

| About: McDonald's Corporation (MCD)

Within the last month, McDonald's (NYSE:MCD) has lost $10 and has fallen from $94 to about $84 with 17 negative out of the last 20 market sessions. For another company this move would be considered minor but for McDonald's it is rather unusual. Taking into account that during the general sell off in the summer of 2011 McDonald's just fell from $88 to $82, the recent move is really worrying for McDonald's investors. Even during the Lehman Brothers panic 4 years ago, McDonald's just fell from $65 to $50 (23% decrease while the stock market fell 60%). What has changed?

Investors should not forget that it always comes down to earnings. More specifically, as past earnings are known to everyone and are readily assimilated in stock price, it is mainly the expectation of future earnings that determines stock price. McDonald's enjoyed a breathless rally during 2011 thanks to expectations for approximate EPS growth 10% for the coming years. The peak of $102 almost a year ago did not reflect earnings of 2011 (EPS 5.27), as that P/E ratio would be too high (almost 20). It reflected expectations for significant growth, i.e., EPS 5.60 for 2012 and 6.26 for 2013.

However, those expectations proved too optimistic lately. Results of 2012 hardly show any growth compared to last year's results, as the year is now likely to end with EPS 5.31 according to average consensus of analysts. Moreover, there are serious doubts about McDonald's' ability to achieve significant earnings growth next year. This is proved by the fact that consensus for next year's EPS was initially 6.26, about 18% higher than current earnings, but about 3 months ago it was revised down to 5.95 and last week it was revised down again to 5.79 (data taken from finance.yahoo.com). The budget cuts of the US, which are expected to restrict growth, and the recession of Europe, make it too hard to achieve such spectacular year to year growth. There is also the retirement of the successful CEO Jim Skinner that casts some doubt about McDonald's' future results. Since he became McDonald's CEO (2004), the company tripled EPS, which is an exceptional performance. Therefore, the recent fall in McDonald's' stock price has not been caused by lower earnings; it has been caused by lower P/E ratio adopted by the market due to limited growth expectations.

In my opinion, long term investors should not be worried. McDonald's is not a value trap. When the overall macro atmosphere improves, McDonald's will be able to achieve growth again and the market will attribute again a higher P/E ratio to the company. The profit for McDonald's investors will be two-fold because they will gain from both higher earnings and higher P/E ratio. Nevertheless, they will need to be patient because at the moment the technical picture does not look good. The stock price broke out below $86, which was a significant support that held for a whole year. This means that it is very likely to go further down, probably to $80-$82. I do not expect it to go beyond that range because many value investors will jump in at these levels.

To sum up, McDonald's investors should not be worried. A temporary pause in earnings growth has caused the recent decrease in stock price. From a technical point of view, as the stock chart is really pessimistic at the moment, if someone wants to earn an additional 2-4% from the stock, he can sell the stock now, even at a loss, and buy it back at $80-$82. Nevertheless, McDonald's has a solid growth model and, when macro conditions improve, McDonald's will be able to resume growth and earn a higher P/E multiple from the market.

Disclosure: I am long MCD. 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.