McDonald's Is Bullish On 2014; Should You Be?

Nov.15.13 | About: McDonald's Corporation (MCD)

On Thursday, McDonald's (NYSE:MCD) held an investor webcast (slides available here) to offer more guidance for 2014, and there were several interesting points that helped to illuminate whether its stock is attractive at current levels after rallying 10.6% year to date, lagging the S&P 500's 25.5% return.

First, management confirmed it will spend $2.9-3 billion to open 1,500-1,600 stores while remodeling 1,000 more. In 2013, management trimmed its capital spending plans by $100 million to $3 billion due to lagging sales in China and other emerging markets. A major part of this expansion will be 350-400 new McCafe locations as McDonald's continues to see coffee as a major growth market as sales are up 70% since 2009. The company has 13% of the U.S. coffee market, so it believes it has room to gain share and boost otherwise stagnant same-store sales.

On the expense side, McDonald's is expecting mild cost pressure with commodity inflation of 1-2% in the United States and 1.5-2.5% in its European operation. Food costs have remained relatively tame since the recession, which has helped McDonald's modestly grow margins. This forecast suggests margins should remain solid in the coming quarters. However, the company does expect SG&A expenses to increase by about $200 million (roughly 8%), mostly due to higher employment expenses and its ubiquitous advertising during the Winter Olympics.

With total political gridlock in Washington, it is hard to fathom the United States increasing the national minimum wage in 2014. Instead, we are seeing several states increase minimum wages on their own. On Election Day, states like New Jersey increased their minimum wage, and if this is the start of a trend, there could be some margin pressure on McDonald's going forward. Though with states moving individually, any impact would likely be diffuse and relatively limited. Nonetheless, it is a medium term risk that does merit some investor caution.

On the revenue side, McDonald's confirmed its earlier forecast for 3-5% same store sales growth and 6-7% operating income growth. Given weak same-stores in 2013, this would be a solid reacceleration for McDonald's if they are able to meet this forecast. If they are able to meet this forecast, I expect MCD to earn just about $6 per share, which gives it a forward P/E of 16.2x. For a company that has saturated many of its major markets, this is not an overly compelling valuation and certainly is not a "screaming buy." If you believe MCD can accelerate sales growth, then you probably would want to wait for a 5% pullback to pick up shares at a decent price.

However, I think it is valid to question the accuracy of this forecast as sales have been sub-2% this year. I struggle to see the catalyst that will help McDonald's reaccelerate sales, especially in the United States. There is clearly a shift in tastes away from fast food to healthier fast casual establishments like Chipotle (NYSE:CMG) and Buffalo Wild Wings (BBWLD). The underlying fundamentals of the market will cap McDonald's potential sales gains. Further over the past five years, McDonald's has been able to outperform its fast food competitors like Burger King and Wendy's (NASDAQ:WEN). Over past few months, we have seen Wendy's reinvent itself, grow sales, and retake ceded share (more here). With fast food mostly a zero sum game in the United States, stronger competitors will make it even more difficult for McDonald's to grow sales in the 3-5% range.

I would look for 0-2% same store sales growth for EPS in the $5.75 range and long term growth of sub-5%. I struggle to see value in paying more than 15x MCD's earnings or roughly $86. I know many investors point to McDonald's growing dividend as a rationale for buying the stock here. After all, MCD raised its dividend from $0.77 to $0.81 this year, but a rising dividend alone is not a reason to buy a stock.

While dividends play a critical role in generating long run returns, they alone rarely provide the typical required rate of return (for equities generally 7-9%). A dividend grower's stock can still be above intrinsic value, and when one buys at that level, they will generate mediocre long run returns. The dividend grower argument could have been made two years ago in McDonald's when the stock was trading at $100 just as well as it is made today. Since then, the stock has been nothing but dead money while the S&P 500 rallied 40%. Investors would have been wise to recognize that despite its rising dividend, MCD was trading beyond fundamental merits and moved into another stock that was trading at a discount to fair value. Increasing dividends alone do not guarantee acceptable returns, especially when you purchase over-priced stocks.

There is no doubt that tastes in developing markets are changing while emerging markets have been bumpy, especially with issues around chicken in China. Investors have to decide whether they believe McDonald's can perform as well in the next five years as it has in the past five and grow sales in the 3-5% range. Based on their 2014 guidance, management is clearly optimistic than 2013 is just a bump in the road and not the start of a new trend. If this is your view, I would wait for a small pullback in the 5% range and buy shares. However if like me, you see significant problems facing the fast food chains as fast casual continues to gain traction, then you should not be enticed by MCD's dividend and wait for a much more substantial pullback to the mid-80's before buying shares.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in WEN over 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.