Buy, Sell or Hold: McDonald's Is a Better Bargain than Ever

McDonald’s Corp. (NYSE: MCD) is thriving despite a difficult environment.

This very difficult environment is sending a lot of consumers scrambling for cheaper alternatives in dining. That is where McDonald’s distinguishes itself. With January same-store-sales up more than 7% worldwide – even in the face of the global financial meltdown – McDonald’s is proving that it can not only execute, but thrive. Indeed, sales in Asia were up 10%, while those in Europe were up 7%. Even U.S. sales were up 5%.

McDonald’s is the unparalleled leader in the arena of quick service and value dining. With roughly 31,000 restaurants in 118 countries, a balance sheet laden with $1.5 billion in cash and a size and market capitalization that dwarf the competition, it is almost impossible to compete against the Golden Arches.

It doesn’t stop there, either: In an environment such as this one, the strong get stronger and run away with the market as the weak disappear.

The Oak Brook, Ill.-based McDonald’s is the world’s leading food-service retailer, with more than 30,000 local restaurants serving 52 million people in more than 100 countries every day. More than 70% of McDonald’s restaurants are owned by independent local men and women. McDonald’s is also one of the world’s most-recognizable and most-valuable brands.

Not only is McDonald’s the largest, but its huge geographic diversification and economies of scale imbue the company with its many enduring competitive advantages. These advantages result in huge cost savings that are not as important in good times, when the industry has runaway pricing power. During lean, economic times, however, those cost savings are the difference between life and death. If you are a supplier, and you sell to the Golden Arches – much like selling merchandise to Wal-Mart Stores Inc. (NYSE: WMT) – you have very little bargaining power.

To the advantages related to economies of scale and migration to cheaper alternatives by consumers, you need to add the renewed inflation policy and the drop in commodity prices. Other than the cost of chicken, which is about 10% higher than last year, all other key food ingredients have dropped between 5% (beef) to 45% (milk). This will show up nicely in McDonald’s margins, which, coupled with sales growth, will give the company’s bottom line a nice push higher.

Who says that you cannot expand profits in a recession?

Indeed, McDonald’s is maintaining operating margins in excess of 25% and a net margin of 18%. This provides the firm a rock-solid cash flow, which, together with a very low level of debt, puts the company in the ideal situation to face these times. McDonald’s nice 3.5% annual dividend yield is very safe, meaning the company will continue its 30-year history of paying cash dividends. It will be easy to do this, since the dividend payout comprises less than 50% of the company’s yearly profits.

Also safe are the $5.5 billion in share repurchases planned by the company for 2009. These planned stock repurchases are up from last year’s $3.8 billion and represent a sure threat to any potential shorts. These strong profits produce a stunning 30% return on equity, given McDonald’s franchised model: Because nearly 80% of its restaurants are franchisee-owned restaurants, the company’s capital requirements are very low.

We mentioned shorts: The few that we’ve seen are already running to cover. In fact, of the entire restaurant sector, McDonald’s is the company with the least amount of shorts. That tells you right there that the pros do not want to risk it against Big Mac. If anything, you are almost assured that in this environment, McDonald’s will outperform most – if not all – of its competition.

McDonald’s shares, trading at only about 15 times last year’s earnings and 13 times next year's earnings – are right now at valuations that are well below historic parameters. In fact, the stock has come down nicely (for us buyers) recently as the market has sold off, allowing us to buy in at an attractive valuation, close to the bottom of last year’s range.

But this is not all. The U.S. dollar rally typically hits firms like McDonald’s, which enjoy a huge international diversification. But the rally is running out of steam, as global economic activity stabilizes and starts bouncing back later in the year, driven by globally-lax monetary and fiscal policies and the mammoth fiscal incentive packages, especially in China and the United States. As the dollar starts losing ground on other currencies, then McDonald’s international profits should rise.

New products will also contribute to higher margins. The company is introducing some products that will help bring traffic away from less-casual venues over to the Golden Arches. With these new products, McDonald’s will attack its more-pricey competitors by offering some comparable products at better prices. I would not like to have one of the competitors’ franchises if I have a McDonald’s nearby these days.

So with expanding sales and profits on the back of insurmountable competitive advantages, a solid balance sheet and a sound management that is executing thoroughly, we take advantage of this great opportunity to jump into McDonald’s.

Recommendation: Buy McDonald’s Corp., a leader in its sector with global competitive advantages, which is trading well below historical valuations, making it a sound bargain.

Disclosure: Horacio Marquez holds no interest in McDonald’s Corp.

Original post

Comments

[Rhett:]

If McDonald's is such a sure-fire investment, why doesn't the author own it?

Feb 23 09:05 AM

[aarc:]

McDo is making lots of sales and profits right now with cheap prices of commodities. Share prices reflected this condition.

What happens when commodity prices start rising with recession/depression/d... still in effect or still lingering for a few more years? They cannot raise their prices to reflect rise in commodity prices.

Feb 23 09:27 AM

[Marcap:]

That is an excellent question. Frankly I do not think that McD's is even close to being a good buy. Currently trading at roughly $55.00, its shares are already trading at almost 5 times their book value. Couple that with the fact that its P/E ratio is near the 15:1 multiplier, and it should not be hard to see that there is not much upward potential if any in the stock at its current price. Notable also should be the fact that most insiders have already dumped their shares, and did so within the last 6 months (an astounding 24% of total shares outstanding shares were sold by insiders). There are now virtually no inside shareholders (only 4/100th of 1%)....a very big red flag no doubt signaling things to come.

On Feb 23 09:05 AM Rhett wrote:

> If McDonald's is such a sure-fire investment, why doesn't the author
> own it?

Feb 23 09:50 AM

[bobbobwhite:]

Also, how can one own stock in a company that probably is the world's largest offender in the war against obesity, related health problems and resulting social healthcare costs? Not me.

Yes, customer personal responsiibility plays a large part in using its products just as in the subprime home loan mess, but if the product was not offered, it couldn't be bought. Start there.

Feb 23 10:31 AM

[jenny:]

I agree with your points. McDonald's is one of the few companies right now able to report any positive numbers. But I'd have to agree with Marcap that it isnt necessarily cheap right now so its makes the question of buy sell or hold a little more tricky.

Feb 23 03:35 PM

[Michael Del...:]

bobbobwhite,

McDonald's contributes to obesity? The people eating the food have to take responsibility for being fat. They get the credit if they lose weight, so why don't they get the blame if they gain weight?

As long as McDonald's makes money, I will own the stock. The same goes for Altria. I don't want my kids to smoke Marlboros and I don't want them to get fat, but I am not going to change society by my investment choices.

Make some money in McDonald's or Burger King and give the profits to the American Diabetes Association. They will be glad for the donation and I guarantee you that they will not care how you made the money.

Feb 24 06:04 PM

[Edward, Lor...:]

Bread and circuses! Give 'em what they want, charge 'em plenty!

The shawdow of doubt is: MCD is only partially in the food business. It is more a franchising business. It is, I understand, retreating from house-managed retail ops. The buyers of these franchises, as opposed to the buyers of McDoubles, need (1) to able to borrow money, lots of it. Credit is crucial and expensive right now. They also need (2) business ops experience to qualify. Therefore send not to know if you would buy a Big Mac, ask if you would (if they would let you) buy and operate a franchise.

Feb 26 10:52 AM