McDonald's And Yum Brands: Why Both Can Be Clear Winners

Includes: MCD, YUM
by: Investment Underground

By Kathleen Fitzpatrick

The fast-food industry is somewhat impervious to recessions, making stock market investments in these companies a safer haven for investors during volatile markets. People still need to get food on the go, and when folks are pressed for dough, fast-food outlets are good alternatives to pricier restaurant fare.

Two fast-food companies have weathered the recession well, and each has good long term prospects. When two strong fast-food giants continue to expand domestically and explore abroad, can they both thrive? In this article, I conclude that both can coexist, but McDonald's is the better bet on a valuation and management basis.

McDonald's (NYSE:MCD) needs no introduction as the golden arches, Big Macs, and Whoppers are familiar icons to all but cave-dwelling trolls. YUM! restaurants might not be so obviously linked to the parent company’s name, but its three popular marquee brands, Kentucky Fried Chicken, Taco Bell, and Pizza Hut, compete with McDonald's for fast-food dollars.

Both companies have handily beat the S&P 500 index, which is in the red so far this year with a YTD performance of -3.38%. McDonald's has increased 31.53% YTD, and YUM! 21.21%, and each stock is near its 52-week high range. Both McDonald's and YUM are focused on tremendous international expansion opportunities.

YUM’s 2010 results show 17% earnings growth per share, and was the ninth consecutive year that the company attained at least 13% earnings growth. YUM opened more than 1,400 new restaurants overseas, and maintained a return on investment capital of 20%. The company has targeted international expansion as a main focus with a China division and a YUM! International Restaurants division, which reported $589 million in operating profits for 2010.

Third-quarter 2011 results from October are a mixed bag. The company reported 7% growth in operating profits in China and 3% overall for its international division. U.S. operating profit dropped by 16%. Worldwide sales were up 6% with U.S. sales declining by 3%.

Company Chairman and CEO David C. Novak issued a statement declaring confidence in meeting the company’s expected earnings growth of 12% for the year, and completing ten consecutive years of 10% earnings growth annually. The company raised its dividend for the quarter by 14%.

McDonald's reported third-quarter results in December that showed comparable sales growth at 7.4 %. Earnings growth for the U. S. and Europe each were up 6.5%, and Asia/Middle East/Africa up by 8.1%. The company has a solid framework in place for global expansion. Its “Plan to Win” strategy calls for average annual sales growth of 3 -5%, average annual operating income growth of 6 – 7%, and return on invested capital in the high teens. The plan also calls for capital expenditure of $2.9 billion for 1,300 new restaurants and “re-imagining” of 2,400 existing ones in 2012.

For such a large company, McDonald's has demonstrated surprising agility at adapting to market demand. It has adjusted its food selections to match the trend toward more healthy eating, and added options such as fruit to its menu. It also launched the McCafe concept, complete with free Wi-Fi and fancy coffee drinks, to compete with other popular coffee shops.

Which is the better stock to buy? Both have good solid 2010 balance sheets that show positive cash flow. Side-by-side comparisons of company data do offer some differentiating factors:

McDonald's Yum! Brands
Market Cap $100B $26.8B
PE 19.22 22.85
PEG 1.82 1.79
Beta 0.46 0.95
Gross Margin 39.58% 28.05%
Dividend $2.8 (2.86%) $1.14 (1.96%)
EPS $5.10 $2.55

McDonald's has the larger market capitalization and a lower PE ratio. YUM’s PE is closely aligned to the sector average of 23.23. Both companies have similar PEG ratios related to five-year growth, with the sector average being 1.41.

McDonald's and YUM! have excellent histories of increasing dividends. McDonald's belongs to an elite cadre of companies that have raised dividends for 25 consecutive years. YUM! has raised dividends every year since 2004, including a stock split adjustment in 2007. With its dividend nearly 1% higher, McDonald's trumps YUM!.

One glaring difference is in gross margins, with McDonald's retaining a larger share of profit on sales compared with YUM!. And with a lower beta, McDonald's is less susceptible than YUM! to wide swings when the market is volatile.

Taken as a whole, McDonald's seems to be a better value than YUM!. McDonald's earnings continue to grow in the U.S. whereas YUM! seems to be faltering on its home turf. With a better gross margin, McDonald's demonstrates more effective and efficient operational management. Its lower PE is just under 20, traditionally earmarked as the dividing line between stocks that are fairly valued or overpriced.

Analyst coverage weighs in with similar buy recommendations for McDonald's and YUM!. However, with both stocks close to their 52-week high, value investors should wait for pullbacks and buy on dips.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.