Ah the Golden Arches of McDonald's (NYSE:MCD). Perhaps the most recognizable brand on the globe. And how could it not be? It is the world's largest chain of hamburger style fast food restaurants, serving around 70 million customers daily in 120 countries. We know the MCD primarily sells hamburgers, cheeseburgers and french fries but also offers a wide variety of breakfast items, soft drinks, milkshakes, and desserts. Some see the growth continuing organically. Responding to consumer demand for healthier options the company has expanded its menu to include salads, fish, wraps, smoothies, oatmeal and fruit. New menu items appear monthly it seems, as do varying combinations of value menus and deals. MCD continues to push to be the top dog in the fast food space, and has done an amazing job at that. The stock currently trades at $95.80 with a p/e of 17 and pays a juicy 3.4% dividend yield. Today we learned that the stock was upgraded by Morgan Stanley (NYSE:MS) and in this article I want to address the upgrade and raise two concerns before investors pile into the stock on the upgrade.
We learned today Thursday January 9, 2014 that analyst John Glass at MS upgraded MCD to Overweight, but also maintained the price target of $115. In discussing the upgrade, the MS analyst stated:
"We're confident, based on history, that MCD's structural advantages (advertising budget, asset quality, superior store level cash flow, dominant market share) will eventually manifest themselves in improved sales. Meanwhile, relative to the rest of our coverage universe, MCD is cheap on an absolute and relative basis and offers a better risk/reward profile, especially after the significant run the rest of the group (and market) have experienced in 2013."
Look, I think MCD is a great company and a great stock, especially in a tax favored account for its slow but steady growth and reliable dividend. That said, I cannot justify an overweight here. The upgrade is rooted in history, but I am in the camp that it doesn't matter where you have been but where you are going (at least as a publicly traded company). I think MCD is fairly valued at 17-18 times earnings (or about $94.00-$100). The company is taking proper steps to ensure growth by expanding its menu, watching portion sizes and playing with prices. But there are two headwinds to consider before you buy this stock at what I see is fair value.
Rising Beef Costs
Beef is one of MCD's biggest headwinds. As a company that is also environmentally conscious, when the company discovered over a quarter of its carbon footprint comes from its beef purchase practices, it began a beef sustainability initiative. This plan will have MCD using environmentally sustainable beef by 2016. I don't know about you, but I have no idea what 'sustainable beef' really is and there is no accepted definition. What I do know is that beef prices have been rising heavily over the last decade. In fact, beef prices were at their highest in a decade in 2013. On top of that, beef prices are projected to rise another 4% in 2014. It is definitely going to pressure margins. Even though MCD has near limitless negotiating power, the fact is prices are up significantly. Now they want to do this sustainability plan. They are looking to purchase beef that is raised and transported in an environmentally friendly way. What this tells me is that they will reduce their carbon footprint, but there is no way I see this approach being a benefit to margins.
Rising Labor Costs
Anybody remember the 2013 strikes that fast food workers were having fighting for $15 an hour wages? I mean that is more than I first made out of college with a four year degree. There is a growing push in the United States and in other industrialized countries to raise minimum wage standards. Some states have even higher standards. While employees deserve a livable wage, the fact of the matter is that paying employees more hurts the bottom line and in turn hurts shareholders. MCD's restaurants are found in about 120 countries and territories around the world and it operates about 35,000 restaurants worldwide, employing almost 2 million people. A rise in wages paid could seriously pressure margins. And it's a real risk to buying this company's stock into 2014. The rising minimum wage is front and center on the NY Times and the cause is supported by many. Small businesses will be most impacted, and corporations will surely survive, but it will hamper growth potential. A few states have raised minimum wage from January 2014 onwards. However there is a chance federal minimum wage could be increased 40% from $7.25 per hour all the way up to $10.10 by 2015. While it is unlikely it will be passed at that rate, it could easily be $9.00 by 2015, which would still be an increase of 24%. This is a real threat to MCD growth even though it franchises most of its stores.
The MCD upgrade here comes in the face of rising beef costs and the potential for significant increases in labor costs. While MCD continues to be a pioneer in shaping its menu offerings to reach consumer's wallets, I question whether their organic growth will be enough to offset the margin pressure of beef and labor. The beef sustainability plan while environmentally sound strikes me as something that could further increase MCD beef costs. That said, MCD is fairly valued at its current price and earnings. It's still a good holding at 3.4%. I do not own the stock, but would consider getting in if a market correction brought the yield down to about 4%.
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.