McDonald's: We're Still Skeptics

| About: McDonald's Corporation (MCD)

Summary

We've been skeptical of MCD's "success" over the past 12 months.

The company's valuation leaves room for compression, and we believe financial engineering and "band aids" are covering up a larger secular problem for MCD.

Earnings this morning didn't impress us, we'd be sellers here still.

By Parke Shall

We believe McDonald's (NYSE:MCD) has gotten way out of control over the last year and a half. The multiple has expanded to an area that we believe to be completely overvalued and the business, while being patched up several times over, has yet to deal with some enormous secular problems that it's going to continue to face.

We believe McDonald's should be trading around a 15X multiple based on its inability to grow quickly, global saturation, and unaddressed challenges to the business the company has not worked out yet.

MCD PE Ratio (<a href=

MCD PE Ratio (TTM) data by YCharts

McDonald's has done well to patch up some of its problems over the last two years. We have written about McDonald's several times over the last two years, and we have for the most part been wrong if you were using the stock price as your judge. Our main concerns were a secular change in millennial eating habits as well as the company's already robust valuation.

McDonald's reported earnings this morning, and missed on global comps and U.S. sales. In addition, the company shelled out more than $4 billion in capital deployment for buybacks and dividends. Seeking Alpha reported,

  • McDonald's (MCD) reports global comparable store sales increased 3.1% in Q2 to miss the consensus mark of analysts calling for a 3.6% gain.
  • Comparable store sales were 1.8% higher in the U.S. vs. +3.2% expected. The McPick 2 and the All Day Breakfast initiatives continue to resonate.
  • Comparable-store sales growth of 5.2% was recorded in the International Lead segment. The High Growth segment recorded a +1.6% comp and the Foundational segment comp was +7.7%.
  • EPS fell 1% Y/Y during the quarter which included a $0.20 strategic charge.
  • The company spent $4.1B in share repurchases and dividends.

These deficiencies show that McDonald's is not yet at a true return the form. Rather, we believe the company to have implemented a series of initiatives like All Day Breakfast and the McPick 2 that we think will only serve as temporary solutions to a bigger problem that the company has.

The slowdown versus expected growth in the United States and globally does not come as a surprise to us. We have been harping on and on for the last few quarters about how much more difficult of a company McDonald's is to turn around than other restaurant companies.

Our reasoning for this was obvious. McDonald's is a much larger company that has fully saturated the globe. In order for it to restart its growth in line with expectations, it is going to need somewhat of a full overhaul, versus a few Band-Aids and some financial engineering. $4 billion was spent on deploying capital back to shareholders, when that money could have been invested back into the business to fully transform McDonald's from a company with a notoriously unhealthy reputation to a company with a brand new menu and brand new methods of service.

Automation was talked about today and we know that the company is experimenting with different automated ways to manage its drive-thru and its ordering in stores. Many stores are moving to mobile ordering or ordering through kiosks, and we expect that McDonald's will continue its plans to do the same. This is going to save the company substantial cash on operating costs, but it does not address the bigger problem that we think usurps this entire narrative around the company.

The fact is that McDonald's is a brand that is widely perceived by an up and coming group of consumers as unhealthy and terrible for you. In today's day and age, those who can afford it are making a point to buy all natural and organic, specifically to shy away from the foods that are purchased by those who cannot afford healthier options. McDonald's, in our opinion, needs to find a middle ground between high margin, unhealthy fast food and lower margin, healthier options it can offer to people concerned about what they are putting into their bodies. This is why, for months, we have been advocating that McDonald's needs much larger of an overhaul than the Band-Aid and financial engineering it is performing.

Not only is the company not addressing the core issue at hand here, which is a secular move away from fast food, but it is burning all of the capital that it could otherwise be using to make the big changes that it needs to make.

McDonald's is a staple stock, and will continue to always be a staple stock, there is no doubt about that. But a multiple that is at 20X to 25X is reserved in this market environment for companies that are at least showing that they are matching growth expectations or companies that have the potential to grow more aggressively.

McDonald's is a staple stock, true, but it is also a behemoth in the industry that is like trying to move a mountain at any point you want to make changes.

We continue to believe that McDonald's deserves a multiple more like 15X, which depending on estimates would fairly value the equity at $83 to $93.

Our concerns remain the company's use of capital and the company not addressing what we believe to be the core underlying issue for its stunted growth. After this earnings report, we continue to say skeptical on McDonald's and would not be buyers here.

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

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.