McDonald's Innovation Is Key For Shareholder Return

| About: McDonald's Corporation (MCD)

McDonald's (NYSE:MCD) reported its sales for the month of August earlier this month. Globally speaking, the company's sales rose a robust 1.9% on recovery in Europe. However, domestically, the company's U.S. sales rose just 0.2% last month. While McDonald's clearly has a mature business in the U.S., I see burgeoning domestic competition increasingly threatening its market share at home. The issue could weigh on the company's overall growth moving forward and impact its valuation and stock price. So, in order to preserve value, McDonald's must stay relevant in the U.S. through product innovation. In doing so, the company will do more for value creation than it does through incremental cost cutting initiatives. Thus far, the company has been successful in its efforts, and given the reliability of its cash flows and the interest of institutional investors, I believe the P/E premium it trades at to the analysts' consensus forecast for long-term EPS growth is sustainable, especially considering its 3.3% dividend yield. As a result, I see a 12% total return opportunity for MCD shareholders over the next 12 months.

It's hard not to notice the intensifying competition developing in the U.S. market, with innovative burger chains and mom and pop burger shops popping up from Bangor, Maine, to San Diego, California. I wrote about The Better Burger Threat to McDonald's in an article authored on New Year's Day this year, and it is still suggested reading for MCD interests.


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Except for occasional scares like in August, McDonald's has staved off the competitive threat through product innovation in the U.S. and abroad. The introduction of new menu items has kept things fresh and helped to continue sales growth even in the U.S. market. Burger Business recently published a report on the strategy entitled Innovation on the Menu for McDonald's, so the industry is noticing as well.

It's clear that McDonald's has recognized the threat from its nascent competition offering "better burgers" through a differentiation strategy, and is responding to that threat somewhat effectively. The company is meeting the differentiators promoting healthier options by offering its own new healthy options, like the "Egg White Delight English Muffin." Before that, there was the introduction of salads to meet the needs of the diet and exercise revolution. The company's answer to rivals offering juicy old-fashioned burgers with innovative toppings is McDonald's new Bacon Habanero Ranch Quarter Pounder. The sandwich also serves the taste buds of those seeking spice, which is an increasing number of Americans.

Of course, there have been a slew of innovative offerings at McDonald's over the years, like the many chicken sandwiches, wraps and of course the famed McRib. Let's not forget how the company faced the challenge of coffee providers introducing competitive breakfast items, including Starbucks (NASDAQ:SBUX) and Dunkin' Brands (NASDAQ:DNKN). I was very happy to find coffee in McDonald's that simulated what I would order in my summer soiree's in Greece. McDonald's full menu page illustrates its efforts in innovation for you. The company will have to continue this product innovation in order to stay relevant in the U.S.

When McDonald's offers something new and fresh that draws the interest of customers, it can price those items better than it does a Big Mac or other item. The pricing difference is not simply due to the higher cost of producing the new sandwich, but because of the customer demand for that new differentiated item. This is more than a competitive strategy then, and does more than draw customers that might stray to the new mom and pops or to Burger King (BKW) and Wendy's (NYSE:WEN). Rather, it improves profit margin, and therefore creates shareholder value. It also offsets the margin compromising initiatives that have been set forth against Burger King and Wendy's (read: dollar menu), and allows those efforts to create more shareholder value through market share grab and sales volume.

If McDonald's is to maintain some semblance of growth domestically, it is also going to have to be through market share grab. The problem is that the rise of the better burger flippers brings with it a serious challenge to that effort. So, McDonald's must stay relevant and fresh in its product offerings and not be made irrelevant by the change presented by those competitors and by the copycat challenges produced by stubborn stalwarts in Burger King and Wendy's.

So far, McDonald's has been somewhat successful in doing so, as evidenced by its same-store sales growth through these tough times. I am giving credit where credit is due, but in a follow up article, I will discuss some other things I think the company should do to guard market share and stay relevant. So, please feel free to follow along with this column so as not to miss my ongoing coverage of MCD and the free consulting service offered to burger flippers everywhere reading along.

McDonald's valuation shows the stock trades at 16.7X my EPS estimate of $5.86 for the next 12 months. Since I do not have an earnings model for McDonald's, I am relying on the analysts' consensus figures for 2013 and 2014. Because of where we are on the calendar, I'm simply averaging the two EPS estimates and getting a value for the next 12 months. This gets us the next two quarters of this year and incorporates the first two quarters of next year's estimate without any seasonal noise influencing the data.

The P/E ratio of MCD is substantially greater than the 8.56% analysts' consensus five-year EPS growth outlook for the company, giving the stock the appearance of a rich price. However, we must also incorporate the return provided by the company's dividend (Kaminis Yield Adjusted PEG or KPEG), which offers a yield of 3.3% (the dividend was just raised) for a more complete assessment. In doing so, I get a relative KPEG ratio of 1.4X for the stock, which is still a bit pricey, especially given the competitive situation I see in the industry. Still, I believe institutional and conservative investors are willing to pay up that much today for the reliable income MCD offers. Thus, I believe the value is sustainable, and can recommend the shares for purchase with a 12% return upside expectation for the next year (8.56% growth + 3.3% dividend yield).

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.