A new strain of bird flu, the H7N9 virus, threatens McDonald's (MCD) chicken sales in China and could stall its Asian sales. With McDonald's U.S. business flat of late and its European operations fighting through the region's economic woes, if its Asian business is plucked, McDonald's shares could be culled as well.
The outbreak of a new bird flu strain in China has officials shutting down poultry sales in open market settings in Shanghai and Nanjing, and has set the nation on alert. Two more H7N9 patients died on Tuesday, raising the death toll to 9. A total of 28 people are known to have been infected by the new strain of the virus so far. The virus has already been discovered in four of China's provinces, evidencing its spread. With any new strain of virus, there is some concern that it could become more easily transferable to humans and mammals, but so far with this one, there is no evidence of that. Instead, it's only being transferred to people who handle foul or eat infected birds that have not been cooked enough to kill the virus. That's good news for the world, but bad news for McDonald's chicken sales in country.
Why the Bird Flu Endangers McDonald's
I view the flu outbreak as a concerning issue for MCD shareholders, but it has thus far not impacted the stock. If the disease is destined to grow in significance, shareholders still have opportunity to land safely. MCD has proven susceptible to swings in the company's Asian operations, falling sharply after reporting May 2012 sales that were hampered by a 1.7% sales drop in its Asia/Pacific Middle East and Africa (APMEA) segment. The decline last year was attributed to slowing economic growth in China. You can see it at the start of this chart here.
The Asia/Pacific Region is critically important to the valuation of MCD given the growth characteristic it gives the stock. Otherwise, McDonald's runs a mature business in the United States that generates plenty of cash, but offers little growth opportunity, in my view.
The company has enough chicken items on its Chinese menu to appeal to local demand, and to compete with its American fast-food rival Yum! Brands (YUM) in China, which is even more vulnerable to the bird flu. One might suggest that unlike Yum! Brands' KFC chain, if the bird flu situation intensifies, McDonald's could offset lost chicken business with gains in burger sales, but that is not a given. This is especially the case when a Chinese official claims publicly that he thinks the new strain is a U.S. directed biological warfare attack. Statements like that only raise anti-American sentiment and pose another threat to American interests in China.
The Chinese government is unpredictable in terms of the actions it could take to prevent the spread of the H7N9 strain. It is likely to be less measured that the U.S. FDA. As a result, McDonald's has already reportedly taken action to limit its risk. A couple days ago, the company reportedly slashed the price of its Chicken McNugget Meal from 36 yuan ($5.80) to 20 yuan ($3.22) in China, according to the linked to article here. It is presumed that the action was meant to clear inventory just in case the Chinese government bans the sale of chicken in the near future. While McDonald's reduces its risk related to inventory, it cannot hedge what sales impact panic may spurn should the new virus continue to spread.
Given MCD's 16% total return this year, which in my view was greatly fueled by renewed investor interest in equities generally, it may be especially susceptible to injury. All one has to do is to examine the underperformance of those companies which have had bad news to report this year, like Caterpillar (CAT) and J.C. Penney (JCP). Company specific weakness will always outweigh the macro-driver for any given stock.
Study of MCD's valuation shows a stock sporting a 17.6X P/E with consensus expectations for 9.3% EPS growth over the next five years. I think it is prudent to adjust the growth rate in the PEG equation for dividend paying stocks, because of the return dividends offer to investors. If we add the 3.0% dividend yield to the 9.3% average annual growth forecast and use it in our calculation, we get a PEG ratio of 1.4X, which is vulnerable enough to bad news in my view. Given my documented long-term concerns about the better burger threat to McDonald's domestic operations, and the near-term threat of disruption to its Asian business discussed here, I would reduce risk and sell the shares before bad news can materialize. I believe a good time for that is approaching, given MCD is scheduled to report earnings on April 19th.