The Better Burger Threat To McDonald's

| About: McDonald's Corporation (MCD)

McDonald's (NYSE:MCD) shares took a hit in early November when the company reported that its October global comparable store sales declined by 1.8%, marking the first such slide in 9 years. A good portion of the decline was surely economically driven. Some of it was also temporary, given that November's sales later showed a same-store sales increase of 2.4%. Still, and despite McDonald's recent share price revival, I would continue to sell the stock on a very important alpha driver.

In my expert view as an equity analyst, McDonald's is coming under important attack by a new and credible threat within its U.S. core market. It's a threat that I believe is not yet understood well by other analysts, media nor the market, and so should be an alpha-critical driver of the shares in the years ahead. It is structural in its essence and long-lasting in its impact, and it's one that McDonald's itself seems to have recognized internally and is attempting to mitigate. The company is facing a changing competitive landscape and industry structure within the United States due to the rise of the "better burger" and proprietors popping up everywhere to serve an increasing variety of them. McDonald's is thus challenged to defend its home turf, or go the way of many a mature company that have failed to do so, out to pasture.

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The Little Discussed Calendar Anomaly

McDonald's shares dropped 10.7% from their mid-October closing high set above $94 to their mid-November low set at approximately $84. The catalyst of the decline was obviously the company's October same-store sales, which reflected deterioration across all of the company's regional segments. One factor that affected all markets and that many media outlets and analysts have failed to note for its importance was the fact that this year's October measured up poorly against the prior-year period, while this year's November was at advantage over the prior year. That's because this year's October included one less Saturday and Sunday (busy days) and one more Tuesday and Wednesday (less busy), while this year's November included one less Tuesday and Wednesday (less busy) and one more Thursday and Friday (busier). The impacts of the monthly differences were substantial, with October's differences driving down sales this year and November's driving them higher. This could entirely explain the directional shift in the last two months of sales, but it does not explain the gradually slowing pace of growth. Maturing companies always experience gradually slowing growth, but in some cases, market share is also threatened by disruptive competition.

Operating Segment

Oct. Same-Store Sales

Nov. Same-Store Sales

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Asia Pacific, Middle East, Africa (APMEA)



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Some Not "Lovin' It"

Obviously, the downturn in European sales can be explained by the decline of economic activity in Europe, which for some markets is still deteriorating. That was seen in the company's European sales recovery in November; McDonald's noted an offsetting weight from a hampered German market. The company's pricing strategy abroad is somewhat different than its bargain burger game plan employed in North America. So with the economies of Europe deteriorating, including now economic failings in linchpin EU states Germany and France, the company's regional sales spiral there is understandable. It should also be cyclical in nature and thus a matter that should be overcome with time.

There were also other, more difficult to measure factors that may have played roles in the October decline within individual markets. For instance, October sales within the APMEA segment may have been impacted by roused anti-American sentiment in the Middle East and parts of North Africa and Asia due to the controversial film Innocence of Muslims, a theoretical effect that we discussed in late September. Perhaps a lingering impact from the protests is seen again in November's slower relative same-store sales growth within the affected APMEA segment against the faster growth in the company's European and U.S. markets.

The Value Meal Advantage

Without a doubt, every company's most significant challenge today is cyclical in nature. The laboring global economy continues to weigh against the performance of most companies across competitive markets and is indifferent to monthly anomalies. Though in this regard, the value offerings of McDonald's set it in the category with those contrarian ideas that benefit in tough times as others struggle. It's why Wal-Mart (NYSE:WMT) and Costco (NASDAQ:COST) have thrived in recent years, while department store rivals like J.C. Penney (NYSE:JCP) have been greatly challenged.

In fact, the company attributed its November revival to its Dollar Menu and promotional efforts tied to the Cheddar Bacon Onion sandwich and its seasonal and specialty beverages. The company also noted the importance of its breakfast business and the overall value provided by its offerings through the month. In tough times like these, McDonald's is supposed to pick up business from the casual dining companies that Darden Restaurants (NYSE:DRI) and Brinker International (NYSE:EAT) operate. There's another factor today, though, which I believe is going to play an increasingly important role in the performance of McDonald's and its shares.

The Better Burger Challenge

What I see happening in the United States versus the company's other markets is something relatively new and ultimately more important. A vulnerability in the fast food segment and more specifically a threat to the bargain burger flippers, including McDonald's, Burger King (BKW) and Wendy's (NYSE:WEN), has been uncovered and is being exploited.

I believe proven demand for a "better burger" signals an important secular change to the company's industry structure and competitive environment in America. This industry issue threatens McDonald's directly, and could mean a shift in market share away from all the basic burger joints serving low-cost meals. Thus, I believe the experts whom I've seen attributing recent sales fluctuations and share volatility in MCD to the efforts of long-time rivals like Burger King and Wendy's are missing the real issue.

The Big Problem Facing McDonald's

While Red Robin Gourmet Burgers Inc. (NASDAQ:RRGB) has been announcing its differentiating factor in its name since its founding in 1969, it seems entrepreneurs have finally noticed an economic value-added opportunity hiding right in front of our collective salivating mouths. Now big, tasty and juicy burgers are drawing in customers who used to go to McDonald's but who were always willing to pay more for a better burger, or at least a different burger served up in an environment other than the colorful iconic McDonald's franchises that now cover the world over.

There is certainly traction in the "better burger" segment, as evidenced by the popularity and growth of new brands including Shake Shack and Five Guys. But the story and opportunity extend far beyond those two names, with brands burning new ground across the country. I can see very clearly in my own neighborhood on Manhattan's Upper East Side that there is a new buzz about burgers.

There are chains boasting "organic burgers," which you might think true burger lovers wouldn't care about or might even avoid, but not after the documentary Food Inc. and the widely publicized "pink slime" issue. I don't know anybody who would knowingly eat pink slime, and so suddenly organic meat matters to more people than just health nuts. Others offer exotic meat burgers like lamb, bison and ostrich for those truly seeking something different. I've tried both bison and the lean ostrich meat over the course of my meat-loving life, and have found both tasty. Shops like the Shake Shack location on the Upper East Side of Manhattan are doing blockbuster business. In fact, I know one successful pizza shop operator on the Upper East Side who is now opening up burger joints in the neighborhood serving up better burgers.

In Manhattan's fishbowl test market, I see new burger places popping up everywhere. I can walk to Shake Shack's 86th Street spot without much effort. So as, where I once had to walk five blocks to find both Burger King and McDonald's locations, I now have at least five other specialty burger options within the same distance. The burger joints are basically everywhere now, and they're all taking market share from McDonald's, Burger King, Wendy's and friends.

It seems people have always been willing to pay up for a juicy better burger that costs a little more, but it's always been at diners and family style restaurants like Denny's (NASDAQ:DENN). The thing is that people rarely venture to those types of restaurants for a burger specifically. Now hungry meat-eaters have a slew of restaurants to choose from providing a variety of premium quality, organic and exotic burgers to satisfy the needs of those seeking something special.

The threat to McDonald's is relatively new, and portends to bring structural change to the burger industry niche. What was an oligopoly is suddenly dynamically competitive, where price loses some of its pull for a good many consumers. McDonald's is not asleep at the wheel though. You can see that it has recognized the threat internally and has shifted its strategic focus to face the challenge.

I'm sure the renovation of the old legacy McDonald's store layout, making it new and comfortable for more than just children, is a move toward its new competitors' efforts to reach grownups. McDonald's work behind the counter has been as aggressive, with an executive chef geared menu renovation taking shape over the last decade. Promotional sandwiches like the Cheddar Bacon Onion and the McRib are innovative efforts to meet the new meat seekers. McDonald's even spells it out in its commentary for discerning readers. In its November sales release, the company discusses "optimizing its menu, modernizing the customer experience and broadening accessibility to its brand." The company continues, saying that all this is to meet the day's "economic and competitive challenges." Optimizing its menu means providing its own "better burgers" and other specialty sandwiches and beverages, a move away from the cheapest burger competition it has waged against Burger King over the last several years. By broadening its brand, the company hopes to appeal to the less price sensitive burger buyer.

Unfortunately for MCD shareholders, the McDonald's brand may be too well established to fend off the up and comers just now making a name for themselves. If that is the case, the nation's most important food service employer may do better to just buy one of its new challengers outright. Sometimes it's better to buy a brand to reach a new niche than to extend an established brand. Obviously, this is not likely to happen unless the company realizes market share loss, and determines it is unable to stave off the competitive threat via its current menu and store enhancements. Thus, over the near term, I expect MCD's historical valuation to prove unreliable as a forecasting tool. Instead, MCD should test old low values, and trade below its mean valuation.

According to data provided at, MCD trades at a premium to its five-year average low P/E ratio and its lowest P/E ratio over that same period. MCD is just a bit off its five-year average P/E ratio currently.

MCD Valuation and Implied Price

Implied prices and price targets are based on analyst consensus EPS estimates for 2012 and 2013 of $5.31 & $5.78 as found at Yahoo Finance.



Implied Current Value

Implied Price Target

Implied Appreciation or Depreciation

Trailing 12-Months





5-Year Average





5-Yr. Ave. Low





5-Yr. Lowest





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* $87.58 is the price taken as the current price and used in all appreciation/depreciation to target price calculations.

Because of a media blitz favoring McDonald's, highlighted by a positive push for MCD by heavily followed pundit Jim Cramer, the stock might see more upside before the better burger buries it. However, I expect it will get cheaper on a valuation basis as my thesis is realized by a thus far inattentive analyst community and as legacy-loyal portfolio manager favor fades away.

Old money will stick with the stock near-term based on its discount to historical average value. As a result, outsized gains (alpha) should be available for those willing to take short position against the stock. The perennially positive portfolio manager might do fine to buy the shares of newcomer rivals as they undoubtedly begin to go public over the next several years, or consider seeking private equity investment or franchise opportunity in start-ups. I believe that current holders of MCD should at least hedge their risk.

My study of historical P/E ratios shows the stock is still short of its 5-year average, with 29% in capital appreciation upside if it were to reach that average mark in 2013. That's the appeal for the legacy interests, but the argument misses the new threat, which in my estimation should lead capital out of the stock with momentum as the threat becomes apparent in regular in operating results. While it may be much to expect the stock to quickly fall to its lowest P/E mark of the last five years of 12.2, it should easily find the five-year average low P/E of 14.6 if a bit of evidence of market share loss materializes. So, in my estimation, if this realization occurs in 2013, the stock could depreciate in value by between 3.6% and 19% over the coming year. If it takes more than a year for the evidence to turn up, well then the stock should still underperform the market over that multi-year period. Given the outlined risk, I would definitely look to other names for relative industry exposure.

Relative to earnings per share growth, the stock also appears easily overvalued, even after considering its dividend yield of 3.5%. Analysts covered by Yahoo Finance agree that the company should grow at an 8.8% average rate over the next five years. Adjusting for the yield, we can use a figure of 12.3% as the denominator in our P/E-to-growth estimate. At that mark, the five-year average low P/E of 12.2X looks most appropriate for those seeking better than average market performance. More importantly, the P/E on the 2013 EPS estimate of $5.78 measures 15.2X, giving us a PEG ratio of 1.2. That's expensive for a stock whose operating performance might come into question next year.

Conclusion and Key Risks

The "better burger" issue is an important consideration for McDonald's investors today and poses a threat to historical valuation precedence. Given that threat and the ground already recovered since the November same-store sales report, I would not add to holdings of MCD today. On the fluffy support of interests in the stock and pundits lacking understanding of the changing industry dynamics MCD must contend with, and given that it could benefit further from a fiscal cliff relief rally, I would look to any further gains over the next few weeks as opportunity to sell out of current holdings. For those capable and willing of taking short interests, I would suggest them on such strength. Finally, remember that MCD's greatest support today is derived from its Asian opportunity, which is a risk short interests must consider and contend with. However, even that opportunity comes into question when Iran is finally engaged and on any disruption to energy flow into the Asia Pacific region.

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.