Recent Trades: Sold McDonald's; Purchased Schlumberger

Includes: MCD, SLB
by: Investing Doc


With shares trading above my fair value estimate, I sold out of McDonald's earlier, as the price seems to completely bake in prospects for a turnaround.

McDonald's competitive advantages appear to be eroding, and even if a turnaround is in place, it will take a considerable amount of time for these trends to be reversed.

In contrast, Schlumberger's competitive position should only strengthen with time, and should external headwinds abate as I think they will, earnings growth should accelerate.

With shares trading well below my fair value estimate, I am taking advantage of what I see as a considerable margin of safety.

Today, I pulled the trigger on a pair of trades on two companies in two different industries--each with its own economic moat, and each with its own set of problems. The difference, as I see it, is that one is being affected by a set of headwinds that will abate in time, and the other by a series of obstacles of its own making.

Recent Sale: McDonald's (NYSE:MCD)

I sold my small position in McDonald's today for a small net gain (after dividends). I had earlier expressed some concerns about McDonald's growth and--more importantly--its strategy to reclaim the mantle of quality and brand that's essential to its durable competitive advantage. Though it's way too early to tell if the company will prove capable of doing this--I think it can, but mainly by focusing on the quality of its core product line--the stock looks more than fully valued at this point. Having previously projected a fair value estimate of $92, the stock trades at a moderate premium to what I'm comfortable with, and at any rate I have a hard time envisioning strong returns in the name for the near-to-intermediate future. A presentation at Morgan Stanley on 19 Nov could bode well for the company in the short term if a change in strategy is delineated, but I'm not holding my breath. Recently highlighted items for the company's strategy seem to weight "customer experience"--expanding payment options, self-order kiosks, and the like--at least as heavily as simplifying the menu and improving the taste and quality of its main line sandwich offerings.

More concerning, and consistent with the longstanding trend, the company posted an October sales report that indicated continued (albeit slowed) comparative sales losses across the globe. US comps were perhaps the "best," with only a 1% decline compared to a 4% decline in September, but the QSR gap remained substantial at nearly 5%. Analysts seem to agree the main thing helping drive this interim improvement in sales was the ever-popular Monopoly promotion, as well as a weak comp from the year before. Results were similarly negative or worse in other geographic segments. Perhaps in response to these results and growing investor unrest, McDonald's management now anticipates shaking up its managerial structure to allow for autonomy at the regional level, the better to allow for localized food choices and customization. This may also reflect a realization that comparative sales at franchised restaurants have consistently outpaced those of company-owned ones, a trend that has grown more pronounced recently.

I'm supportive of this latter move, and I'll be watching closely for the steps McDonald's offers to make at its Morgan Stanley presentation. And with more activist investors disclosing stakes in Mickey D's, it's conceivable that the company indeed may take a listen to investors' calls to make the menu simpler and to streamline store operations.

All that said, though, it will take a long time to determine if these efforts will pay off, and while some of them will no doubt have a positive effect, the stock's price seems to bake in these positive effects completely, and there's little room for the company to err. More broadly, I'm concerned that the company's competitive advantages--broad scale and cost advantages, as well as a tremendous worldwide brand--are under threat. Though the Chinese supplier issue was no doubt a one-off sort of event, it does point to potential weaknesses in McDonalds' supply chain, and the growing scale of McDonald's competitors diminishes the value of this cost advantage. Just as concerning, McDonald's brand appears to have suffered significantly over the past few years, having become synonymous with bad-tasting food that is just as bad for you. The company appears to be flailing to correct this, and I'm not convinced just yet that it can be done.

I may yet buy back into McDonald's, but I'd prefer a wider margin of safety for my money. Should weakness take the price down the high $80's (or better still, the low $80's), I'd be a buyer again. That might not happen imminently. At any rate, until that happens, I'll be content to watch the action from the sidelines.

Recent Purchase: Schlumberger (NYSE:SLB)

As I've said before, my timing for my initial Schlumberger purchase could not have been much worse. I'm down about 15% on the stock and a recovery in the price doesn't seem to be in the offing. Shares continue to encounter resistance as crude oil prices have hit their lowest prices in several years. Oil producers, refiners, drillers, and services firms have uniformly suffered as a result, and Schlumberger has been no different in this regard.

That said, though, near-to-intermediate term weakness in oil prices was already built into both management's guidance and my own fair value estimate, and recent operating results suggest that the company continues to operate well. Negative sentiment seems to be predicated on the notion that oil prices will remain depressed for a considerable time. While that's certainly possible, investors appear to be operating under the assumption that this perfect storm of adverse circumstances represents a new status quo. I disagree. It's unlikely that low-cost producers like OPEC will be willing to curtail their profits for an indefinitely, that the dollar will retain its current strength for forever, and that global demand for oil will remain permanently depressed. Even if they do, though, the job of locating and extracting oil is only going to get more complex, and oil firms like Schlumberger--easily the best of its breed--will continue to have a role.

Recent operating results seem to bear this out, with the company easily hitting revenue and earnings targets. More importantly, management appears to be taking a lower price of crude oil in stride, viewing the changing landscape as merely a shift in opportunity sets, rather than the prospect of permanently diminished profitability. And should crude oil prices recover, as many--including myself--fully expect, then Schlumberger's profits could grow even more quickly than anticipated.

In contrast to McDonald's, Schlumberger's competitive position should only grow in time. If oil prices indeed remain depressed for a while, less profitable and robust oil services firms will be victimized to a greater extent or may find themselves the targets of acquisition and merger activity. And if they don't, Schlumberger's intangible assets and the sheer breadth of its offered services will only become more valuable. With shares trading well below my fair value estimate and offering a considerable margin of safety, I am comfortable making Schlumberger the largest position in my portfolio for the moment.

Disclaimer: This article provides opinions and information, but does not contain recommendations or personal investment advice to any specific person for any particular purpose. The author is not a professional financial adviser. Do your own research or obtain suitable personal advice. You are responsible for your own investment decisions.

Disclosure: The author is long SLB.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.