Be Cautious Going Into Mcdonald's Earnings Q4 2015

  • All day breakfast should fuel strong fourth quarter numbers for the restaurant giant. Operating margins need to be observed though.
  • Dividend investors will be watching if free cash flow levels can continue growing.
  • Established markets need to step up their growth levels as hope seems to be lost in the Japanese market. We may not see the consequences of this fall-out for many quarters.

Mcdonald's earnings for its fourth quarter are expected before the bell on 25 January, and the question will be whether the restaurant chain can keep the momentum that it gained from its Q3 2015 earnings numbers. CEO Steve Easterbrook's turnaround plan appears to be gaining traction especially when you consider McDonald's Earnings Per Share (EPS) of $1.40 a share in its latest set of earnings, which was a good 10% above expectations. The consensus EPS for Q4 is $1.22 a share, which if achieved will bring the total EPS number for the year to $4.98. This will be a beat on 2014 numbers when McDonalds (NYSE:MCD) only accomplished $4.82 for the full year.

Although the stock is trading at all time highs, I wouldn't bet against this company reporting a beat for Q4. Why? Well the company undoubtedly has momentum and usually when large caps change direction with their bottom line numbers (EPS of $1.4 last quarter compared to $1.09 in Q3-2014), it is a sign that a new upward trend is forming. As investors, we have to understand whether the recent bull run for McDonald's stock means that there is a lot of future growth priced in. The market is always forward projecting, which is why McDonald's investors should be wary at this moment in time.

Just look at the McDonald's valuations. McDonald's present price to earnings ratio has never been higher over the last 10 years. This to means that the stock could report a beat next week but the share price may not move to the upside all that much because these earnings would have already been priced in by the market. The time to be in this stock was just before Q3 earnings, and the stock has surged 13% since then. The market took those results as an inflection point. In saying that, this company has demonstrated in the past that it's share price will remain elevated despite falling same store sales (like it experienced in the US for 7 straight quarters). I believe the stock will remain range-bound this year due to the company having significant growth triggers across various divisions in its business. So what should you watch out for in its fourth quarter earnings?

It will be interesting to see whether McDonald's finally releases figures about its all day breakfast, as this will be the first full quarter where all day breakfast was being served at U.S. restaurants. If McDonald's don't break this up, investors will be keenly watching out for U.S. same store sales, which grew for the first time last quarter by 1%. I actually think we need a big number here as future growth has already been priced in. The momentum will continue according to CEO Easterbrook, which should really boost top line sales numbers, considering there are over 14,000 stores in the US. This area has to be one of the biggest potential areas for growth when you consider that the initiative has really yet to be rolled out internationally (36,000+ stores).

Research groups such as NPD and Mintel are both bullish on the long term viability of this initiative and Mintel for example, believes that US breakfast sales will grow by a further $8 billion by 2019. However, Mcdonald's bears point to the lower price-point of customers ordering something off the breakfast menu (muffin, coffee and a side) versus a standard meal (burger fries and a drink). A healthy mix of items ordered is good, but margins may be slightly lower on breakfast items due to the lower average prices, so operating margins will be watched closely. McDonald's trailing twelve month operating margins are well under its 5 year average. We need to see a firm change in trend in this metric also to ensure the turnaround plan is definitely working.

One of the main reasons why the stock rocketed higher after its Q3 earnings was the hike in McDonald's free cash flow. Dividend investors value this company more for its cash flows and balance sheet than its quarterly net income statement. So, it is imperative McDonald's reports cash flow growth in its Q4 set of earnings. Why? Well even though free cash flows spiked to $1.53 billion in Q3, the company's cash position is at its lowest since 2010 and long term debt is at its highest. Furthermore, the dividend pay-out ratio has spiked to over 73%, which mean future dividend hikes will probably be less percentage-wise than previous years, unless McDonald's can get back to robust cash flow growth. The ongoing re-franchising efforts and SG&A reductions will undoubtedly help in the near term, but these measures are temporary and probably won't impact the bottom lime meaningfully after 2018.

Mcdonald's may have had declining revenues since 2012, but free cash flow levels have been healthy. This (along with its dividend aristocrat status) is why McDonald's stock remained elevated over the past few years. Nevertheless dividend growth has slowed, and the restaurant chain has decided to take on debt to continue increasing the dividend whilst keeping share repurchase plans on target. McDonald's has a very strong balance sheet, but it can't borrow indefinitely. Investors therefore will be looking for buoyant cash flow growth, which will decrease the pay-out ratio and consequently make it easier for the dividend to be raised meaningfully in 2016.

Another growth trigger that fueled the rally in the share price after the company's Q3 earnings was the performance in China - a whopping 30% in comparable store sales growth. This market has only 2,000+ units, so scaling the business meaningfully there would appear to be the company's main objective, in terms of growing market share in the east. In saying this, Japan seems to be going in the other direction ever since news of the meat scandal broke out last July, and things don't seem to be improving any time soon. Mcdonald's has now decided to limit its exposure in this market and is actually on the lookout for buyers for a part of its stake in the region. This isn't favorable from an investor's point of view, since Japan is the second largest market behind the US in terms of units. Therefore, other established international markets such as the UK, Germany and Australia need to step up and provide stellar growth which can be offset declines in Japan.

To sum up, Mcdonald's has had a strong rally since its last set of earnings and I just feel there is a lot of future growth already priced into the share price. I'd lighten up on McDonald's shares. Even though I expect the restaurant chain to report a strong number, I don't see the stock staying above $120 a share for a sustained period. Don't get sucked in just yet. Wait for the stock to come back to more reasonable valuations, such as a price to earnings ratio of around 19.

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