Seeking Alpha
Profile| Send Message|
( followers)  

We suggest avoiding McDonald's (NYSE:MCD) as we are dissatisfied with the current performance of the company. We were quite amazed to see how some analysts favored MCD because of the boost in November sales. However, based on our analysis, we suggest a very different stance as that boost seems temporary. We suggest avoiding MCD because of the following reasons.

Reasons:

1: The operational performance of MCD has disappointed us as it missed analyst estimates on several dimensions. Revenues for MCD has shown a decline by 20% in Q32012 compared to Q32011. Similarly, the company reported a decrease in net income by 3.45% compared to Q32011. MCD has shown a steady decrease in overall profitability margins in 2012 compared to 2011. These facts can be observed in the following graphs.


(Click to enlarge)


(Click to enlarge)

Source: Globenum Research

2: Experts use same store sales (SSS) as a key dimension to assess performance for restaurants and retail outlets. An analysis of MCD based on SSS reveals that the company has been suffering from a sheer decline in SSS over the quarters. MCD saw a decline in SSS by 2.7% in US, 1.75% in Europe and 1.6% overall as shown in the following illustrations.


(Click to enlarge)

SSS analysis (Comparison with 2011)

US

-2.7

Europe

-1.7

APMEA

-1.4

Other countries

-1.1

Total

-1.6

Source: Globenum Research

The drop in SSS can mainly be attributed to:

  • Reputation risk which MCD has faced because of recent news about obesity problems caused by company's food. MCD has also been blamed of using improper food for the chicken they use. This has badly affected company's SSS in Europe and U.S.
  • Rising labor cost due to new healthcare law firms and labor protection laws.
  • Decrease in purchasing power of target market of MCD because of recession.
  • Food cost inflation which has become a major concern as prices of inputs have increased sharply in 2012. Trends of increasing input costs are expected to continue further in 2013. This increase in prices of inputs followed by recession has made people switch to competitors like Chipotle Mexican Grill (NYSE:CMG) and Panera Bread (NASDAQ:PNRA) who are managing to provide good quality food at low prices. The table below shows percentage increase in major inputs of MCD in 2012 compared to previous year.


(Click to enlarge)

Source: Seeking Alpha

3: From a relative perspective, an analysis based on P/E does not make much sense given declining earnings of the company over the years. However an analysis based on P/S clearly indicates that the stock of the company is somehow overvalued. Based on its forwards EPS of $5.78 and historical P/E of 16.74x, we set a target price of $97 for MCD.

Although this target price suggests some capital gain in MCDs stock, we feel that capitalizing on this potential gain won't be optimal. This is because company has been reporting decline in EPS for the past few quarters. For example, if compared to Q32011, the EPS has seen a decline by 1.37% in Q32012 as shown in the following graph.


(Click to enlarge)

Source: Globenum Research

If the trend continues and the next transcript also reports declining profitability as the previous transcript reported, the analyst estimates about forward EPS will fall down. This will eventually reduce price targets and chances for capital gain will decline.

4: Our analysis implies that the sales bump of November 2012 which has invited some optimism from some analysts is seasonal, negative in real terms and already priced in. By "Negative in real terms" we mean that this boost is 5% lower than the boost of November 2011. So in real terms, this increase is negative and does not invite much optimism from our standpoint.

Our Stance

MCD is facing rise in labor and input costs, decrease in operational efficiency and increase in reputation risks. Moreover, because of the coming fiscal cliff, we fear more drop in purchasing power of customers. The increase in sales of November 2012 is already priced in and therefore, we don't expect further price increases in MCD's stock. We suggest staying away from MCD until it reports improvement in operational performance in its next earning transcript.

Source: Avoid McDonald's As November Boost Seems Priced In