McDonald's (MCD) reported its third quarter results on Monday before the market open. Shares instantly opened lower as investors are not impressed with the modest beat on earnings and the continued lower prospects into the final quarter of the year.
At current levels, shares are fairly valued at best, while there are some potential drivers which could trigger a sell-off including food cost inflation, higher labor costs and a continued lack of growth in comparable restaurant sales.
Third Quarter Results
McDonald's generated third quarter revenues of $7.32 billion, up 2.4% on the year before. Note that McDonald's reported similar growth in constant currencies. Reported revenues were roughly in line with expectations of $7.33 billion.
Operating earnings rose by 5.6% to $2.42 billion as net earnings rose by 4.6% to $1.52 billion. Diluted earnings per share rose by 6.3% to $1.52, beating consensus estimates by a penny.
CEO Don Thompson commented on the third quarter performance, "Our unwavering commitment to providing an outstanding restaurant experience to every customer, every time guides our plans and keeps our customers at the forefront of all we do."
Looking Into The Results
Sales from company-owned restaurants rose by 1.8% to $4.92 billion. Revenues generated from franchised stores rose by 3.7% to $2.40 billion.
The improvement in earnings was mostly driven by tight expense control. Absolute selling, general & administrative expenses fell by 11% to $554.3 million. In relative terms, expenses fell by 110 basis points to just 7.6% of total revenues.
As a result, operating income advanced by 102 basis points to 33.0% of total revenues.
Note that the US represents the best performing business, showing comparable store sales growth of 0.7% and operating income growth of 5%. New core favorites and the popular Monopoly promotion drove the results.
European comparable store sales rose by 0.2% as operating income rose some 11%. Strength was seen in UK, Russia and France, partially offset by a weaker performance in Germany.
Comparable sales in Asia, the Middle East and Africa fell by 1.4%. Operating earnings fell by 12% amidst a challenging operating environment.
Looking Into The Final Quarter
McDonald's continues to expect to operate within a difficult economic environment. Global comparable sales are expected to be in line with recent trends, while restaurant margins will fall. So far in October, comparable sales are relatively flat on a global basis.
To offset the challenging economic environment, the company continues to work to optimize the menu, modernize consumer experiences and broaden accessibility.
Unfortunately, McDonald's did not provide a balance sheet with its third quarter report. The company ended its second quarter with $2.28 billion in cash, equivalents and short-term investments. Total debt stood at $13.37 billion, for a net debt position of $11.1 billion.
Revenues for the first nine months of the year came in at $21.01 billion, up by 1.9% on the year before. Net earnings rose by 3% to $4.19 billion. At this pace, annual revenues are seen around $28 billion as earnings could come in around $5.6 billion.
Trading around $94 per share, the market values McDonald's at roughly $94 billion. This values operating assets of the firm at 3.4 times annual revenues and 16-17 times annual earnings.
McDonald's recently hiked its quarterly dividend to $0.81 per share, for an annual dividend yield of 3.5%.
Some Historical Perspective
Long-term investors in McDonald's have seen great returns. Shares have risen from just $25 in 2004 to peak at $100 per share at the start of 2012. Actually shares hit upon highs of $104 in 2013, but shares have ever since retreated some 10%.
Between 2009 and 2012, McDonald's has increased its annual revenues by a cumulative 21% to $27.6 billion. Earnings rose by 20% to $5.5 billion in the meantime. Note that the company will further grow revenues and earnings in 2013, while the company retired roughly a tenth of its shares outstanding over the time period since 2009.
So all in all, McDonald's continues to struggle as consumers in the middle and low-end of the spectrum continue to be impacted by the poor economic developments. While the company is trying to offset these difficult economic circumstances by adding items to the menu, including lattes and chicken wings, comparable store sales are flat around the moment.
Yet competitors are not standing still either as Burger King (BKW) has introduced buffalo chicken strips. Other than traditional competition from Burger King and Wendy's, McDonald's sees pressures as well from the likes of Chipotle Mexican Grill (CMG) and Panera Bread (PNRA). These non-traditional "fast food" chains are reporting much higher rates of comparable restaurant sales.
So McDonald's seems to operate in a difficult economic environment nowadays, even more difficult in some aspects compared to the 2008 crisis when many consumers were "trading down." Ever since, shares have risen much further, essentially doubling since 2009. Dividend hikes have resulted in a still solid 3.5% dividend yield, as investors are happy to pay 16-17 times earnings in search for yield in this low-interest rate environment. Note that McDonald's aims to return $4.5-$5.0 billion through its shareholders in dividends and repurchases for the year, for combined payouts of around 5% per annum.
As such I believe shares are fairly valued at best at the moment. I think that lower interest rates are unlikely and could hardly boost the current valuation, while a renewed interest rate hiccup could easily cause quite a correction.
Back in July, when McDonald's reported its second quarter results, I last took a look at the firm's prospects. I noted that shares were trading near-all time highs while comparable store sales were slowing down, due to the squeezed middle and lower end of the consumer spectrum in both Europe and the US.
I noted to be cautious as comparable store sales, which were around flat on an annual basis at the time, are crucial to generate free cash flows which then can be used to return cash to shareholders. I could understand that investors were attracted to the shares given the dividend yield, and were happy to pay 18 times earnings in this low interest rate environment.
Given the complete lack of comparable store sales growth ever since, despite recent menu introductions, I am a bit more cautious at this moment. Leverage is manageable, but McDonald's is using nearly 90% of earnings to fund repurchases and dividends, leaving little potential to reduce leverage from the leftover operating cash flows.
So all in all there are few reasons to pick up some shares at this point as the company remains cautious on sales growth and margins, while already high payouts leave few possibilities to increase cash flows to investors. On top of that, there is the continued scrutiny about US restaurant workers pay, which could act as a negative going forward, if McDonald's would be pressured to increase wages.
So I can see some potential factors causing a sell-off including food cost inflation, lack of comparable store sales growth, increased labor costs and the impact of the large debt position in a renewed recession.
I remain on the sidelines on valuation motives.