McDonald's (MCD) probably has the strongest brand name when it comes to fast food chains. It has an impressive earnings and dividend growth history, but the prevalent economic slowdown, especially in Europe, seems to be taking a toll on sales. Margins could continue to face pressure due to higher commodity and labor costs. We recommend investors wait for a better entry point, although income investors can invest in MCD's respectable and sustainable dividend yield of 3.1%, which can be expected to increase.
MCD's geographically-spread restaurant franchises enjoy a stable revenue stream, which formed 32% of MCD's total revenue in 2011. However, the European exposure (40% of revenues in 2011) seems to be taking a toll on MCD. U.S. sales account for approximately 32% of revenues.
One of McDonald's key strengths has been the adaptability of its menu in accordance with local tastes, an example of which is its all vegetarian restaurants in India. However, McDonald's recently took a hit due to weak macroeconomic conditions and a slowdown in growth in Asia. Margins could be affected going forward due to higher food costs and tough competition. In 2Q2012, the company missed analyst estimates for EPS of $1.38 by 6 cents. Revenues of $6.92 billion were somewhat above $6.91 billion in 2Q2011, but missed analyst estimates of $7 billion. Operating margin increased by just $0.9 million, or almost 0%, over last year.
Same store sales in July were flat, below analyst expectations of a 2.3% gain. Sales declined in all three regions in which the chain operates (-0.1% in U.S., -0.6% in Europe and -1.5% in Asia Pacific, Middle East and Africa).
MCD has a respectable dividend yield of 3.1%, while its cash flow yield is 7.6%. The payout ratio is 50%. Therefore, dividends are sustainable. The growth rate for dividends over the last 3 years has been 16%. The company also repurchases its stock.
McDonald's has total debt of $13.6 billion. Operating cash flows have grown over the last 5 years, and are $7.07 billion (trailing twelve months). Fitch expects the figure to remain around $7 billion in 2012 and 2013, despite higher food costs and an economic slowdown. The average of free cash flows for the period after 2003 has been $1.6 billion. The interest coverage ratio is 28x, showing that earnings can easily cover interest payments. The company also has an undrawn revolving credit facility of $1.5 billion available. Thus, from a debt point of view, McDonalds faces no problems.
The stock is trading at 12% below its 3 decade highs.
The forward P/E of 15x is roughly the same as the average P/E over the last 5 years. At this multiple, and at consensus analyst estimates, the valuations are:
Burger King's (BKW) forward P/E is 20x, Wendy's (WEN) is 23x, and Yum! Brands' (YUM) is 17x. The next 5-year growth rates for BKW, WEN and YUM are 21%, 15% and 13.5%, respectively. Considering the multiples and growth rates of peers, McDonald's upside seems to be limited. The last 5-year growth rate for MCD was 13%, and the next 5-year growth rate is 9%.
In view of slowing sales, peers getting more competitive with promotions and macroeconomic conditions, along with the currency impact not expected to get better any time soon, we give a hold rating for MCD in the short run. Investors should wait for a better entry point than the current $91. Income investors, however, can benefit from the company's sustainable dividend yield, which can be expected to grow, as the company has continuously raised dividends in the past.