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Summary

  • Weak earnings and a meat scandal have driven McDonald's shares significantly lower recently but both may prove transitory.
  • Talk of an increase in the minimum wage ahead of November elections may limit upside but any increase will ultimately be mitigated by price increases.
  • Even on conservative estimates for growth next year, the shares can return an annualized 12% over the next 18 months.

Weak earnings and a meat scandal have created the perfect storm, driving shares of McDonald's (NYSE:MCD) lower by more than 7% from the May high. Beyond the recent events, the possibility of increased rhetoric on the minimum wage may drag on the shares as we move into November elections. Shares are extremely cheap relative to peers and the upside over the next 18 months could offer an attractive return for those willing to ride out the storm.

McDonald's reported its second quarter results last week with marginal growth to $1.40 per share and $7.18 billion in sales. Sales in the United States fell 1.5% though the company was able to manage expenses for a 1% gain in operating income. Sales were down in Europe but up 1.1% in the APMEA region (Asia/Pacific, Middle East and Africa).

Management reaffirmed its commitment to shareholder cash return with a target of up to $20 billion in dividends and share repurchases over the three years through 2016. This compares to $1.6 billion in cash return to shareholders over the most recent quarter.

Meat scandal hasn't helped but ultimately won't hurt either

McDonald's has been rocked lately by another major food safety scandal. Chinese regulators have closed a local meat supplier after the media showed workers mixing rotten meat with fresh supply. The supplier, Shanghai Husi Food, is a division of OSI Group and supplies meat to Yum Brands (NYSE:YUM) as well as McDonald's.

McDonald's has elected to keep its relationship with Illinois-based OSI Group though Yum Brands has terminated its business with the food processor. While the scandal has hit sentiment in the shares of both companies, I like that the golden arches has elected to continue with the supplier. Looking for a new supplier could further exacerbate product supply issues and increase operational costs. The problems were found at one plant and may not be an indication of a company-wide problem. I do not see customers leaving McDonald's for the incident and these things often blow over quickly enough.

Shares fell 2.1% when the news broke last Wednesday, exacerbating the slide after the weak earnings report.

Minimum wage could limit gains in the near-term

While I am positive on the shares following the recent drop in the price, developments on the battle for a higher minimum wage could weigh on sentiment for the next couple of months. I do not see a higher minimum wage as a negative for the company, which should be able to offset most of the increased wages with an increase in prices, but the overhang of uncertainty could keep investors out of the shares. With elections coming up in November, rhetoric is likely to get more heated on the issue.

More than 100 protestors, including some employees, were arrested outside the company's headquarters in May as demonstrations escalate in favor of a higher wage. The fervor over an increase in the minimum wage and what it might mean for McDonald's earnings has been overblown. Nearly 90% of the company's U.S. locations are owned by franchisees which determine their own pay rates, and only 31% of the company's $28.1 billion revenue in 2013 originated from U.S. operations.

McDonald's booked $4.8 billion in payroll & employee benefits in 2013, just under a quarter (24.9%) of total operating costs. The company does not detail its amount spent on labor by wage group but a conservative analysis can provide an estimate of the increased cost to operations. According to Glassdoor, the company pays an average hourly rate of $7.81 to its employees. I am estimating a maximum increase of 9.9% in payroll expenses if the minimum wage is increased to $9.25 per hour. Even this is likely to be high with a wage hike that would take place over several years and not relevant for many employees.

An increase of 9.9% on payroll costs would increase last year's operating expenses by $477 million and decrease net income by $331 million to $5.25 billion on an after-tax basis. An economist at the University of Kansas recently estimated that McDonald's would increase the price of its products by 17% if the minimum wage were increased to $15 per hour. On an increase in the minimum wage to $9.25 per hour, I estimate that the company would increase prices by 5% at least. An increase of 5% on sales in the United States would have boosted revenue last year by $435 million, nearly negating the entire effect of the wage hike.

Cheaper than peers and a 12% annualized upside

Shares trade for 17.3 times trailing earnings, just slightly higher than the 17.0 times average over the last five years but still well below peers. Shares of Wendy's (NASDAQ:WEN) trade for 36.5 times earnings and Burger King Worldwide (NYSE:BKW) trades for 36.6 times earnings, both offering lower dividend yields.

Earnings are expected just 1.8% higher this year to $5.65 per share on similar growth in sales to $28.62 billion. Expectations for an 8.3% increase in earnings next year may be too high but I believe the company can achieve respectable growth and $6.01 in earnings off of my own estimate for $5.70 per share this year. On a multiple increase to 18.0 times, my earnings forecast leads to a price target of $108.17 over the next 18 months for an annualized gain of nearly 12% including the dividend.

While poor earnings and the recent meat scandal have weakened shares of McDonald's, the company's long record and shareholder cash return should support the stock from here. Increased calls for a higher minimum wage leading up to November elections could limit upside but the ultimate effect will likely prove less consequential than the hit to sentiment. Shares are significantly undervalued relative to peers and earnings expectations support solid returns.

Source: Buy McDonald's Before This Storm Subsides