McDonald's: Testing A Multi-Year Trend

Sep.27.12 | About: McDonald's Corporation (MCD)

Shares of McDonald's (NYSE:MCD) have meandered downwards by around 5% year-to-date. This lackluster performance has been slightly offset by a 3.3% dividend yield. The lack of price directly however, has led many to question if McDonald's has concluded its multi-quarter rally. Through this article, I present my belief that McDonald's has a history of fundamental performance and that the recent pull-back in prices may revert upwards in the near future.

Stability of Returns

In order to fundamentally analyze McDonald's, I have relied heavily on two key metrics: return on assets and return on equity. Return on assets is the net income of the firm divided by average total assets and this metric informs the investor as to how effectively the firm uses its assets to generate profits. Return on equity is the profit of the firm divided by directly-invested shareholder equity and this ratio tells the analyst how well the corporation utilizes investments to bring profits into the company. In the chart below, I have included 10 years of return on assets and return on equity for McDonald's.

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There are two traits of returns which the investor should immediately note. The first trait is that both return on assets and return on equity have steadily increased across the past 10 years. As can be seen throughout time, McDonald's has progressively increased its ability to deliver returns and has consistently become better at generating profits. The second trait to note is the magnitude of these ratios. The return on assets and return on equity levels are excellent. Currently, for every $100 invested directly into the company, McDonald's is able to deliver $38 in profits. Likewise, for every $100 in assets the firm owns, it is able to cultivate nearly $17 of net income. These two traits are very important and I base my analysis on the continuation of the decade-long upwards trend in firm performance.

Beginning in 2002, McDonald's recovered from a brief decline in returns. This recovery catapulted the firm into a period of performance in which return on assets and return on equity increased until the financial crisis which began in late 2007. The pullback in returns during the last half of 2007 and the first quarter of 2008 can be directly attributed to the overall market condition: as individuals slashed consumption, firms with widespread exposure to mass-consumption suffered. The driver of this pullback in returns can directly be seen in the below chart of real GDP. Since McDonald's has wide exposure to the common consumer and GDP reflects consumption, change in GDP is a fair metric against which to analyze firm performance.

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The grey area in the chart above denotes times of United States recessions. Notice how the pullback in return on assets and return on equities directly coincides with the first half of the recession. What this essentially means is that the decreased firm performance can be almost directly attributed to a pullback in GDP. The underlying strength of McDonald's was actually such that in the second quarter of 2008, returns catapulted to new highs and the organization once again resumed its upwards trend of increasing performance. This trend has continued consistently with only 4 quarterly pullbacks in the past 4 years.

Since McDonald's has progressively increased its performance, I believe that pullbacks in the stock price may represent investment opportunities. The fundamental landscape of McDonald's is such that throughout the past 10 years, it has more than quadrupled its return on equity and doubled its return on assets. I believe that trends, once in motion, are difficult to reverse. It is my opinion that McDonald's will continue increasing organizational returns and that as these returns progress, shareholders will once again be rewarded. I view the yearly decline of 6% as an excellent investment opportunity which should be taken should the upward price-trend resume.

Technically Speaking

Despite the fact that I view McDonald's as a sound long-term investment, I do not advocate an immediate purchase of the security. Since prices have declined over the past 8 months, I believe that it is possible for further price declines in the future. With this said, I feel that the best time to participate in McDonald's stock is when price has reversed its decline and is once again moving upwards. As can be seen in the chart below, McDonald's is at a critical juncture. Prices are currently testing a descending trend line which was established in the beginning of this year. If price is able to overcome this trend line, then the technical downtrend will have ended and a purchase is warranted. For this reason, I believe that individuals should consider purchasing the stock if a week is able to end above $94 per share. When prices have attained this level, the downtrend will have ended and continued upside is entirely possible. If prices are unable to attain this key level and the current reversal continues, then I believe that this analysis should be cancelled if price declines below $86. If prices decline below $86 per share, then the downtrend will in fact be intact and further selloff could occur.

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Disclosure: I 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.