McDonald's: Recent Earnings Suggest Margin Compression Is Inevitable

| About: McDonald's Corporation (MCD)

Sometimes the simplest explanation is also the correct one. While traders and investors often look for contrarian indicators, sometimes when strong companies report poor numbers its more than a one-time event.

The S&P 500 and its tracking exchange traded fund, SPDR S&P 500 Trust ETF (NYSEARCA:SPY), is up over 20% since the summer lows of last year. Still, the best performing companies over the last several years have consistently been dividend stocks. Investor demand for yield and safety has never been higher, and companies with strong growth and a solid history of consistently raising dividend payouts have never been more popular.

One of the most popular dividend stocks in the market is McDonald's Corporation (NYSE:MCD). McDonald's has consistently grown in the double-digits even over the last couple years, and management has an impressive recent record of consistent dividend raises as well.


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McDonald's has consistently outperformed most of the major indexes over the last several years, and the stock has been one of the strongest performing stocks in the market over the last decade.

Still, McDonald's has consistently lagged the S&P 500 and most broader indexes by a fairly wide margin over the last several months.


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This why I thought the company's earnings report last week was so interesting. I recently wrote that McDonald's was overvalued at $100 dollars a share, and I also more recently wrote that the stock was still likely overvalued at $90. While all traders and investors have good calls and bad ones, these calls were prescient.

Even though companies such as Phillip Morris International (NYSE:PM), IBM (NYSE:IBM), and Microsoft (NASDAQ:MSFT), are often discussed as being heavily levered to Europe, McDonald's has been hurt more than most companies over the last several months by both the slowdown in consumer spending in the eurozone, and the falling euro.

McDonald's gets nearly 40% of its revenues from the eurozone, and the company's recently disappointing European sales numbers were almost identical to the poor same-store sales growth the company reported several weeks ago in the eurozone. McDonald's recently reported a 3.8% increase in year-over-year sales growth in Europe, significantly below analyst expectations for 5.5% sales growth, and the slowest sales growth this company has seen in the EU in 10 quarters. These poor numbers came after the company recently reported just 2.8% same store sales growth in the EU in June.

McDonald's recent sales growth in the U.S. was also fairly poor. While the company reported less than a 3.5% increase in recent North American sales, sales growth slowed significantly year-over-year.

McDonald's has consistently shown strong growth and been able to take market share in the eurozone and the U.S. over the last several years. The fact that McDonald's same store sales growth slowed significantly in June and July suggests the company will also likely continue to face serious challenges in its most important markets over the next several quarters.

Still, McDonald's had already reported that the companies sales were slowing in Europe and North America. What was new information when the company recently reported its earnings several weeks ago was that net income in the EU and U.S. was falling as well. McDonald's has always had industry leading margins, with the company's gross margins over 30%, and the fact that the company's net income was essentially flat in EU, ex-currency, while net income rose just 2% in the U.S., suggests management is increasing using discounts to maintain and grow market share in the company's most important markets.

McDonald's saw net income rise just 2% in the U.S., even though same store sales rose 3.5%, and the company repeatedly emphasized that the value menu was the most important revenue driver during the quarter. The company's increasing focus on value and discounting moving forward also suggest that management believes margins will be pressured in the near term.

McDonald's primary appeal to investors has always been the company's consistent growth, strong cash flow, and industry leading margins. However, with companies such as Phillip Morris International, Chipotle (NYSE:CMG), and even Apple (NASDAQ:AAPL), recently reporting surprisingly weak consumer spending trends in Europe and the U.S., McDonald's will likely continue to emphasize significant discounting as well.

To conclude, McDonald's has been one of the best performing stocks in the market over the last decade, and the company's menu has always been about value. Still, McDonald's recent earnings report and consistently weak recent store sales numbers suggests that the company's efforts to continue to take market share in Europe and in the U.S. are being increasingly challenged, and even companies such as McDonald's can offer significant discounting with promotions such as the dollar menu. With spending trends in the company's most important markets continuing to slow, and McDonald's agriculture and poultry prices rising, McDonald's industry leading margins may contract significantly in the coming quarters.

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