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Summary

  • McDonald's global comparable store sales growth have halted, resulting in disappointing earnings.
  • This is as comparable sales are expected to fall in July, lowering expectations for the third quarter.
  • The increase in leverage is worrying amist lack of growth. Increased focus on obesity and healthy food remain a structural headwind.
  • As such I remain very cautious, as dividend investors seek shelter in the 3.4% dividend yield.

McDonald's (NYSE:MCD) posted a disappointing set of second-quarter results and warns that global comparable sales will fall in the first month of the third quarter.

This is as traffic is a global problem for the firm with consumers increasingly opting for more healthier food, urging McDonald's to make a more drastic move than it has already made.

I remain very cautious given the lack of growth, a multiple which is in line with the market, and the leveraging of the balance sheet. Investors could still collect their fat dividend paycheck, yet I don't see much potential for significant capital gains.

Highlights For The Second Quarter

McDonald's posted second-quarter sales of $7.18 billion which was up by 1.4% compared to the year before. Revenues came in quite a bit below consensus estimates at $7.29 billion.

Despite the modest growth on the top-line basis, the company posted a modest drop in earnings. Reported earnings came in at $1.39 billion which was down by 0.7% compared to last year.

Share repurchases saved the day, adding two pennies to earnings per share which rose to $1.40 per share. Analysts were anticipating earnings to come in three cents higher at $1.43 per share.

Looking Into The Quarter's Developments

CEO Don Thompson remains committed to its ¨Plan to Win¨ framework which calls for increased customer focus, insights, planning and actions. The company will continue to concentrate on value, marketing and operational excellence, traditionally the strong points of the business.

The very modest increase in top-line sales was the result of expansion as comparable sales were flat with higher prices offsetting lower traffic. US comparable sales were down by 1.5% amidst ongoing challenges including weak traffic trends. The US remains by far the modest important region for the company with McDonald's operating more than 14,000 of its 35,000 restaurants in this region.

European comparable sales were down by 1% as a strong performance in France and the UK was offset by continued weakness in Germany. In the APMEA region, comparable sales were up by 1.1%, driven by a solid performance in China. Of the 10,000 restaurants in the region, McDonald's operates roughly 2,000 restaurants in China.

Sales at the company's own restaurants improved by 0.5% to $4.79 billion. Yet the real growth was driven by the performance of franchised restaurants which posted sales growth of 3.2% to $2.40 billion.

Given that general costs like selling, general and administrative costs are not specified or broken up among those two major business lines, it is hard to compare the relative profitability of both the own as well as franchised restaurants.

Overall operating income was down by 0.4% to $2.19 billion driven by higher selling, general and administrative expenses as well as franchise occupancy costs. Net earnings were down a bit despite a $20.4 million ¨other¨ gain as the effective tax rate rose to 33.0% of operating income.

Valuing The Franchise

McDonald's did not provide a balance sheet yet with the release of its second-quarter results. The company ended the first quarter with $2.7 billion in cash and equivalents, while total debt of $13.9 billion results in a $11.2 billion net debt position.

On a trailing basis, the company has now posted sales of $28.3 billion on which it net earned $5.5 billion. The recent pullback to $96 per share now values equity in the business at $95 billion. This values equity at 3.4 times trailing sales and 17-18 times annual earnings.

Looking At The Past Performance, But What Will Drive The Future?

Over the past decade, McDonald's has grown its revenues by a cumulative 50% to little more than $28 billion, growing the business at roughly 4-5% per annum. The company managed to roughly double earnings over this time period, while share repurchases have pushed up earnings per share growth even more. This comes after the company has retired roughly 20-25% of its share base over this time period.

Yet in recent times earnings growth has slowed down or even stalled as problems in its North American unit as well as lower growth in Europe and the rest of the world is having a real impact. Despite various attempts to change menus and upgrade the stores, the market believes that McDonald's has to revolutionize instead of steadily make adjustments. McDonald is rapidly losing its dominant position as many more (young) consumers opt for more healthy choices. They have instead resorted to other fast-casual restaurants including Chipotle Mexican Grill (NYSE:CMG), among others.

To please investors amidst a lack of growth, McDonald's announced an aggressive plan to return $18-$20 billion to shareholders over the three-year period of 2014-2016, representing a more than 100% payout of earnings over this period. This will continue to add on to the debt position of the firm.

Final Takeaway

While Thompson continues to focus on the long-term strategy and revamp of the business, some investors are frustrated by the slow pace of improvements and the ¨easy¨ solutions to return cash to investors.

Given the disappointing flat comparable sales growth of June, while analysts were anticipating a modest increase, it is very disappointing to see the company guiding for negative global comparable sales for the month of July. Of course geo-political tensions around the world could impact McDonald's operations in Russia and Ukraine, as well as the Middle-East.

Another recent worry is the food scandal in China as a Shanghai-based supplier was mixing fresh and rotten meat supplying it not only to McDonald's but also to other names like Starbucks (NASDAQ:SBUX), KFC and Pizza Hut, owned by Yum! Brands (NYSE:YUM).

So while I admire the brand recognition and fat margins, McDonald's now trades at market multiples while it has severe headwinds including very poor traffic trends, worries about obesity and healthy food and the recent food scandal. As the company is increasing leverage to please investors, I remain very skeptical and cautious. Rather than returning cash, management should focus on a dramatic move to offer more compelling, healthier and higher-quality food.

For now the 3.4% dividend yield will continue to give support amidst very low interest rates, yet I would advise investors to remain cautious as I don't suspect much room for potential capital gains.

Source: McDonald's - Headwinds Continue As Pressure Is Building To Make A Dramatic Strategic Move