Investors in McDonalds's (MCD) didn't pay much attention to some positive research coverage from analysts at Morgan Stanley on Thursday.
I don't share the broker's optimism. Current growth is low and while the dividend is appealing, the valuation is fair enough amidst high payout ratios in relation to earnings.
If anything, I belief the discussions about a hike in minimum wage could spark initial caution among investors. For these reasons I don't share Morgan Stanley's optimism, but stay on the sidelines.
Value To Be Found
According to Morgan Stanley's (MS) John Glass, McDonald's represents value on both an absolute as well as relative basis, while offering a better risk/reward profile than other competitors in the fast and casual food industry.
Glass raised the company to "Overweight" which is a bit of an unfortunate use of wording. The accompanying $115 price target, suggests shares have some 20% upside potential from current levels.
Glass is confident that the company's structural advantages, including the advertising budget, asset quality, superior cash flows and dominant market share, should translate in better sales going forward.
Glass notes that the valuation is cheap on a absolute and relative basis compared to the rest of the coverage universe. He notes that many competitors have seen strong returns in 2013. Shares of McDonald's are up some 6% over the past year. This compares to 80% returns as set by Chipotle Mexican Grill (CMG), a 90% return set by Buffalo Wild Wings (BWLD). Even Yum! Brands (YUM) returned 10% over the past year despite its problems in China.
But Not Everyone Agrees
While Morgan Stanley is upbeat about the restaurant chain, colleague Jeff Farmer at Wells Fargo (WFC) is concerned about slowing sales.
In a report issued a day earlier, Farmer promptly downgraded McDonald's to a "Market Perform" rating on the back of the sales slowdown during 2013. He notes that the company has lost market share in the US in three of the past four months. The fact that Wendy's and Burger King are stepping up is creating challenges which are expected to last in 2014.
Struggling Sales Growth
On Monday, McDonald's will most likely report its global comparable sales numbers for the month of December. Yet growth has been challenging in recent months. For November, global comparable sales inched up by just 0.5%. European comparable sales rose by 1.9%, offset by a 0.8% decline in the US and a 2.3% in decline in the APMEA region.
Total "systemwide" sales rose by 1.1% for the month, but were up 3.1% in constant currencies.
Note that November's results caused some doubt confusion. US comparables are under pressure after rising 0.2% in October. European sales actually accelerated in November, being up from a reported 0.8% growth in October.
Slower Growth Offset By Shareholder Presents
Despite these slowing sales, McDonald's has shown consistent and profitable growth for decades. In the 2009-2012 period, McDonald's has grown its annual revenues by about a fifth on a cumulative basis, while earnings grew at as similar pace.
Note that reported revenue growth has slowed down to 2% in the first nine months of the year. Of course, maintaining solid growth remains a challenge if you already serve some 70 million customers a day.
To offset the pain for shareholders, management decided to return some of its $2.3 billion in cash and equivalents to shareholders. Management hiked the dividend by 5% to $0.81 per share on a quarterly basis, providing investors with a very generous 3.4% dividend yield. The payout ratio after the hike is about 60% of total earnings.
These dividend payments of around $3.2 billion on an annual basis are complemented by a modest pace of share repurchases, bringing total cash returns to shareholders to $4.5-$5.0 billion per annum. At this pace, the company is returning 80-90% of its earnings back to its shareholders.
McDonald's has no more room left to please shareholders without returning more cash than it earns at the moment. With $13.6 billion in debt on its balance sheet, it operates with a net debt position which is north of $11 billion.
What About the Wage Debate?
With the debate about minimum wages intensifying in recent times, let's have a quick look about the possible implications.
McDonald's states that it employs roughly 440,000 workers. Of course the majority of these workers work directly in any of the almost 6,600 company-owned restaurants, but don't forget many are employed to arrange things for the roughly 28,000 franchisee restaurants as well.
It is estimated that some 1.7 million people work in total for Mcdonald's, or about 50 employees per restaurant. This includes the people being employed in the franchise restaurants. This math would imply some 330,000 of McDonald's own workers work at the restaurants, while the rest would work in offices.
Now let's for simplicity assume these people work about 20 hours a week or about 330 million hours a year. A hike of the wage from let's say $8 to $15 per hour would therefore cost about $2.3 billion. This excludes social security taxes and related benefits which depend directly on wages.
Note that this estimate is based on the company's own restaurants alone and assumes all workers at the firm's overseas operations would demand their salaries to nearly double as well.
On the other hand, roughly 80% of restaurants are owned by franchisees. Employees often work for similar wages and they too could demand hikes. This could of course result in lower earnings, higher prices and possibly lower franchise revenues for McDonald's.
Of course, if all competing firms would be pushed into rising wages it would not hurt the competitive position versus competitors, although it still could end up hurting sales. Such a wage hike, could on the other hand push McDonald's into further automation of its restaurants, requiring fewer workers to operate.
As you can see, it is impossible to determine the real impact, yet realize that implications could be huge, especially in relation to earnings of about $5.5 billion. While the debate has already intensified in recent months in the US, this is not an isolated case with more countries in developed nations opting for higher minimum wages.
On the bright side, employees who now claim don't earn enough to eat in their own restaurant could become customers again
You get the point. The stakes are high and the eventual impact on the bottom line will be hard to forecast in a precise manner, creating uncertainty which investors generally don't like.
Takeaway For Investors
Slowing growth for McDonald's in recent months is a drag on the shares, explaining why the stock underperformed last year. At roughly 17-18 times earnings, the stock is not a bargain. While the 3.4% dividend yield is very attractive, note that growth is limited while the high payout ratio probably rules out significant dividend hikes.
While this is probably still acceptable for investors looking for dividends in this low interest environment, other risks might be arising as well. The whole minimum labor wage discussion is quite big, and attention for the issue is accelerating not just in the US. While the impact of a raise could be huge, depending on the implementation, the initial reaction might be negative.
The leveraged lower and middle class might first opt for debt repayments over spending increases and the whole debate could still impact McDonald's as a leader in the restaurant industry in a major way.
I don't share Morgan Stanley's excessive optimism at this point in time, but would rather opt to stay on the sidelines with shares being rather fairly valued at this point in time.