Companies like Nike (NKE), Coca-Cola (KO), and McDonald's (MCD) don't give you too many chances to get in at reasonable valuations, and oftentimes those opportunities come with substantial market worries. While McDonald's present valuation doesn't exactly make it a screaming buy, there are at least a couple of similarities between conditions today and conditions three to four years ago - the period when McDonald's really separated itself from the quick service restaurant (QSR) pack and delivered quite a run.
Q2 Results - Mind The Margins
Second quarter earnings at McDonald's were a definite mixed bag. Flat revenue (up 5% in constant currency) really wasn't bad, and the 3.7% quarterly same-store comps (up 4.4% in the month of June) was better than many analysts expected. While management did talk on the call about unfavorable headwinds building, particularly in Europe, Europe is actually holding up pretty well all things considered.
The more worrisome factor is the company's margins. Operating income fell 2% as reported (up 3% on a constant currency basis), with a 70bp drop in restaurant margins. Like Yum! Brands (YUM) and most other players in the industry (including mega-supplier Sysco (SYY)), food costs are a concern, but so too is an increase in employee costs. I don't want to overplay this theme, but I do wonder about McDonald's poor present leverage while companies like Chipotle (CMG), Sonic (SONC), and Panera (PNRA) seem to be going in a more positive direction.
Is This 2008/2009 Again?
Comp growth is starting to look a little sluggish for many major operators (including Yum and Chipotle) and that has investors understandably worried. Have diners finally reached their point of saturation with eating out, or are economic pressures leading people to pull back a bit?
The last time Chipotle saw a sizable slowdown in comp sales, it proved to be the beginning of a rough patch for many in the dining sector. Arguably many of the sit-down restaurants have yet to recover, while it proved to be a boon to the QSR space - particularly those with value menus like McDonald's.
So I can't help but wonder if this is a similar situation today. I don't think there's as much growth potential from diners switching from sit-down venues to QSR, but there may be a possible industry-wide trade-down if diners turn away from higher-priced QSRs like Panera and Chipotle in favor of cheaper options.
The Differences Do Matter
I don't want to overdo the similarities to 2008/2009 as it pertains to McDonalds. That big upswing in performance (and share price) also had a lot to do with expanding the value menu, adding new products, and really supporting the McCafe concept. While the company certainly has not stopped their attempts to develop new products or continue to grow McCafes, I don't see anything of that magnitude coming around this time.
The 2008/2009 period also marked a significant turn in McDonald's operating margins, with a nearly 10% improvement over the trend rate of prior years. While I would never bet against McDonald's finding new ways to improve profitability, I don't see another jump of that magnitude as especially likely. Food cost may well start to abate (though the ongoing drought may complicate that), but employee costs could be tougher to cut without compromising service and diner experiences.
The Bottom Line
I wish I could be more bullish about McDonald's stock, particularly as I think Don Thompson will do well as CEO, and I think his interest in expanding premium-priced and more nutritious offerings will pay off. I also don't think the advantages of the value menu are going to just vanish.
All of that said, value is value. Over the past decade, McDonald's grew its free cash flow at an adjusted rate of about 9% a year. Assigning a discount rate of 8.5% (the lowest I go for a stock), the company has to do that all over again over the next decade to merit a three-digit stock price and not many companies can maintain that sort of growth pace. I think a 6-7% growth rate is more probable, and at that rate of growth the shares would need to sell off another 10% or so to really look a like a bargain - barring another remarkable post-2008/2009 run.