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Summary

  • McDonald's reported lackluster earnings and is trailing the market.
  • The company faces serious challenges in retaining customers in all regions.
  • Low growth prospects are not yet reflected in the stock price.

In my article on 5/29, I said that McDonald's (NYSE:MCD) stock, which has traditionally been a safe haven in volatile times, is overpriced relative to its growth prospects. The stock performance since then appears to support my view, with McDonald's stock trailing the S&P 500 by 8 percentage points.

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Business performance

McDonald's reported lackluster second-quarter earnings, with flat comparable store sales globally. Average check was higher, but guest traffic was negative in all major markets. Store expansion led to revenue growth of 1%, but operating income was flat and EPS was up 1% driven by share repurchases.

US comps were down 1.5% with operating income up 1%. Guest traffic was negative. In Europe, comps were down 1% and operating income was flat. In the APMEA (APAC, Middle East and Africa) region, comps increased only 1.1% and were weighed down by weakness in Japan. Operating income declined 2%.

Valuation changes

In my prior model, I had arrived at a fair market value of $84 for McDonald's, assuming 1% comp growth for FY14 and 3% thereafter. I also assumed 3% store growth, leading to overall revenue and operating income growth of 4% for FY14. However, results for the first six months have lagged my expectations, with revenue growing only 1% and operating income declining 1%. As a result, I am updating my model to reflect 2% revenue growth for FY14 and reducing my comp growth expectations for FY15 and beyond to 2.5% down from 3%, as the company finds itself increasingly challenged by more upscale rivals such as Chipotle Mexican Grill (NYSE:CMG) and Panera Bread (NASDAQ:PNRA). Even achieving these levels will mean reversing the trend seen over the past two years and take some doing. The updated numbers reduce my valuation to $81, which still represents a downside of 13% to the current share price.

Summary

McDonald's continues to face challenges in retaining users, with guest numbers being challenged in almost all regions. It is trading at a P/E of 17, which is out of whack with its recent and forward-looking growth prospects. Although the recent dip in price post-earnings has brought the valuation closer to my estimates, there is still further downside to owning the stock right now. The company does offer an attractive dividend yield of 3.2% and is focused on returning cash to shareholders, but this cannot hide the operational challenges it faces. My view on McDonald's has not changed post-earnings - investors should stay away.

Source: Update: McDonald's Earnings

Additional disclosure: I am short MCD $70 puts and $115 calls.