With price/sales ratio at a record high (currently 7.09) despite declining revenues, is the market banking on McDonald's (MCD) to hit ambitious sales targets over the next few quarters? Or has this expectation of improving top-line growth already been discounted into the current share price?
In this article I want to examine this more closely. My opinion is that most of the expected revenue growth is already factored into the current share price, so any entry would need to be after a pullback (if that happens). In my analysis, I will factor in gross-profit margin as part of the calculation, as GPM has improved in recent quarters.
There is a lot to be said in favor of the McDonald's right now. In a recent note, analyst John Glass (Morgan Stanley) comments:
while the company’s big remodeling campaign is masking top-line growth, that sales strength will soon become evident.
Glass upgraded McDonald’s to Overweight from Equal Weight, raising his price target to $210 from $173.
While sales revenues have declined, one thing McDonald’s can be relied upon is to continue to make the business as lean and efficient as possible, and this is reflected by growth in its gross profit margins (or GPM, in red below).
In the balance of this article I want to try and extrapolate (best guess) where McDonald's share price "should be," in the quarters to come, if GP remains the same, vs. various levels of "projected" GP.
McDonald's Price/Gross-Profit Ratio
Instead of using price/sales (P/S), in the case of McDonald's, I will apply price/gross-profit (P/GP). The metric is similar, in terms of "purity" to P/S, but applied contextually to companies where the gross margins have changed significantly over the past few quarters, hence providing a more meaningful measure than simply P/S.
In the table below, I have calculated the trailing-12-month P/GP ratio’s for McDonald's over the last 16 quarters.
As can be seen, the P/GP ratio has been moving up, in expectation of a growth in sales, and effectively gross profit in the coming quarters. The 16-quarter average P/GP is 10.62 (average of the blue column), with the current P/GP level (based on today's market-cap of $144.85 Billion) running at strong expectations of 13.47 (Source: tradepilot.com)
Investors need to make an independent opinion of where they expect gross-profits to be in the next few quarters. As a long-term investor, holding companies like McDonald's in a portfolio for several years instead of months, I am fully expecting McDonald's sales to return to and surpass the levels achieved in the not-too-distant past. The highest sales revenue number was achieved in mid-2014, recording a trailing-12-month figure of $28.3 Billion.
In his recent note, Glass (Morgan Stanley) writes:
McDonald’s massive store-modernization efforts, first rolled out in select international markets and now in the U.S. (its single largest market), will begin to pay off in 2019 and should produce best in class sales results for more years to come.
It is apparent, despite the downtime at many of the company’s restaurants, during re-fits and re-modelling (which has the tendency to slow revenue), 2018 has not been as bad as some investors presumed, which is further reflected in the surging share price. Indeed, once the new, fully re-vamped stores open, there is a value-impetus for introducing innovative menus (including healthy trend items), which will further result in revenue (and potentially margin) growth.
Glass goes on to comment:
Following completion of the U.S., McDonald’s will be left with a competitively superior asset base versus peers globally, and its business model will be structurally improved.
Effectively, as the capex into remodeling efforts wind down, McDonald’s free cash flow is poised to accelerate in 2020 and beyond.
The Right Time to Add to Positions?
Coming back to our P/GP model, if we consider McDonald's to eventually return to annual sales of $28.3 Billion (TTM record high in June 2014), and apply the current 50.7% gross-margin to the revenue, the gross-profits would be expected to run at $14.35 Billion. At the current market-cap ($144.85 Billion), this would equate to a P/GP ratio of 10.09.
Historically, the average P/GP ratio has been around 10.62 (16 quarter average from above table). If the projected P/GP of 10.09 tends to that equilibrium, McDonald's should, at that time be priced at around $197.76/share, which provides growth of 5.25% from the current levels.
Does this mean most of the expected growth in sales (and gross profits) is already baked into the share-price? In my opinion it probably is at the current share price, with some room for share-price growth of around 5%-10% if everything lines up as expected. I would prefer to exercise patience, looking to build to my existing position should there be a decent pullback. I would stick to a price target of around $200/share, if investors are confident of McDonald's eventually matching its own record sales revenues of around $28.3 Billion (preferably beyond), while maintaining the current gross margins.
Disclosure: I am/we are long MCD. 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.