McDonald's Offers Limited Gains: Slow Growth Defensive Stock - At Best

| About: McDonald's Corporation (MCD)

McDonald's (NYSE:MCD) appears to offer a 7% to 23% potential gain against the risk of a 7% drop. At best, McDonald's is a slow growth defensive stock. The company's guidance is for only a 6% to 7% increase in profits over the next 12 months on a 2% to 3% increase in sales.

At its meeting with analysts, it reportedly said it is trying to introduce higher margin products, including more beverages, over the next couple of years. Downside risks are mostly associated with the overall market. MCD's beta is a low 0.7, which means that if the market drops 10%, MCD, all other things being neutral, would drop about 7%.

At $57, the stock is down 4.87% from its early Nov. 52-week high of $59.92; the ETF for the Dow Jones (NYSEARCA:DIA), is down 7.1% from its late October high.

Cost pressures, which have been hurting MCD and other restaurants over the last year, appear to be moderating in terms of the rate of increases in costs. The company told analysts it's looking for chicken prices to rise 4% to 5%, beef 2% and cheese 6% to 7%. The futures markets are predicting that during the next 11 to 12 months, today's high wheat prices will fall 8.9%; beef prices will rise 2.4% and petroleum prices will fall 11%. MCD sells a lot of breads and spends a fair amount on distribution costs, although the latter probably are passed on to franchisees who account for 78% of McDonald's stores.

Labor costs are likely to be more of a problem as the Feds and local governments enforce laws against hiring illegals. What percentage of McDonald's restaurant workforce are illegals is unknown, but there have to be some behind those counters. MCD's forward PE is 18.2 and it's projected five-year PEG ratio is a rather rich 2.26. The price to sales ratio is a rather low 3.1 while its price to cash flow ratio is a tad high 14.4. The company's return on assets is only 7.4% and it's return on equity is about 14.2%. Analysts are looking for more competition from other chains, but McDonald's has been executing its plan better than its imitators for decades, and its ability to do so is unlikely to change anytime soon. All fast food chains are getting bad PR because of increasing obesity in the U.S.

Eighteen analysts rate the stock a 1.94 on a scale of 1 to 5, basically unchanged from three months ago. That's equivalent to a hold. Five give it a strong buy, nine a buy and four a hold. Nine have raised their ratings in the last four weeks, according to Thompson data published on wsu.com. Among the independent research firms (all but Morningstar are on www.etrade.com), S&P gives the stock a strong five stars, Reuters rates it an outperform, Morningstar gives it three stars, Rochdale a hold, Sabient a hold and Credit Suisse a neutral rating. Marcket Edge's rating of the stock's momentum calls MCD a "long," which is it's top rating. Investor's Business Daily gives the stock a composite rating of 89, with an earnings per share ranking of 84, a relative strength ranking 86 and an accummulation/distribution ranking of "C".

Technically, the stock looks like a hold. Money flow, which had fallen during the last few days, has been in a year-long uptrend as institutions poured money into the stock, and it seems to be recovering at the moment. As shown during the last few weeks, MCD moves with the market. About 75% of stocks go up wihen the market rises and fall with the market. Vanguard's John Bogle, the Vanguard founder and mutual fund guru, said on CNBC Wednesday morning that he sees a 75% chance of recession, and the market looks nervous to him. The market's technicals look weak.

Others are less bearish, but there aren't any raging bulls out there, and that needs to be considered when evaluating MCD. One approach is to buy MCD leaps. The Jan 2010 60 calls are trading for $7.90 bid. Value Line's daily option service says those options are about 10% over valued, with historical volatility at 26% and implied volatility at 27%. The breakeven price for MCD on this trade would be about $67.90, or about 19% above the current price. This suggests that speculators are betting on a longer-term price rise to almost $70 during the next 18 or 19 months. Buyers of puts are speculating the stock could fall to just above $50. If MCD is in your portfolio, as it is in mine in a small way, you might want to write covered calls to generate some additional income above and beyond the 2.6% dividend.

With the stock at $57.05 and Dec. 57.50 calls at $1.55 bid, the potential returns are 2.6%, or 26.7% if the stock closes below the strike price of $57.50. If the stock closes above the strike price and is called, the return would be 3.42%, or 34.7% annualized. If the stock was purchased some time ago, at, say, $46, the annualized uncalled return would be 33% and the annualized called return would be 286.5%.

Of course, if the stock went above $57.50 during the next 35 days, gains would be limited. There is no limit to the downside risk on buy/writes (covered calls). More unknowns remain. What currencies and interest rates will do and how they will affect the stock? And why is McDonald's selling some 1,500 of its stores to franchisees over the next couple of years. Is it bearish on the business, or what? Yesterday, I wrote Dec. 57.50 covered calls against my MCD position.

Sources: Morningstar.com, E-Trade's independent research firms, wsj.com, investors.com, Yahoo.com, and reports on company projections.

Disclosure: Author holds a position in MCD

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