- McDonalds has become a much more nimble company that can adapt to local tastes much faster. We saw its nimbleness with the 4 month launch (From test to launch) of its All Day Breakfast
- The company's $300 million annual savings goal, its refranchising efforts and 1000+ new stores should all increase cash flow levels meaningfully going forward
- McDonalds has demonstrated that it is an excellent recession proof stock. The stock should outperform to the upside and act as a hedge to the downside like it did in 2008.
McDonalds (NYSE:MCD) came out with a set of excellent earnings numbers last week which has resulted in the share price rallying to a current $112+ a share. Its P/E ratio is now 24.25 and many analysts are now encouraging investors to wait for a pullback in the share price as its current P/E ratio is above its historic average of about 17 but I wouldn't be so cautious in holding back. Why? Well third quarter earnings showed that this stock has some serious momentum behind it now and usually large cap companies (with a market cap of $105 billion and 36,000+ restaurants) follow the underlying trend which is growth. A pullback may very well come in McDonald's but I don't foresee one anytime soon and this was re-iterated by Steve Easterbrook after last week's earnings when he predicted that Q4 would be, overall, a better quarter for the company. Proven dividend aristocrats always sell at a premium so if you missed the 10% move recently, get over it because I'm expecting much more considering that this stock has been basically stagnant since 2013. McDonalds stock, even after its recent sizable move, still deserves your investing dollars.
Firstly, McDonald's bears have repeatedly stated that the sheer size of this company has been a downfall in the recent past because of its inability to adapt to consumer preferences fast enough, as compared to its peers. I acknowledge that some of McDonald's competitors have been able to bring products to market quicker than McDonalds, in the past, due to procurement and red tape restraints. However, I just think Easterbrook's plan of giving more power to the managers of the local restaurants is alleviating this problem. I saw this first hand in Spain where McDonalds serves a popular local cold soup called Gazpacho in the Summer months and quickly takes it off the menu when it is out of season. Another sign which recently demonstrated that the company is becoming more nimble was the roll-out of the "All Day Breakfast" campaign. Under old leadership and more centralized management, this endeavour would have taken many quarters to implement. However, this initiative was only tested in May of this year and was rolled out a short 4 months later. This would have never happened under past management which illustrates to me that if McDonald's sees a new growth trend (as it did with its breakfast offering), it now has the ability to act quickly which should keep earnings more than elevated.
Secondly, the reason why so many investors are attracted to this stock is because it is a pure cash cow. Free cash flow levels reached $2.4 billion in Q3 of this year, which was more than double the same metric in the preceding quarter. Revenue this quarter came in at over $6.6 billion, which is the highest number since the same quarter of 2014. Furthermore, I believe free cash flow levels will rise even further. Why? Well, when Easterbrook took office, two of his first objectives was to refranchise 3,500 locations by the end of 2018 and save $300 million in net annual SG&A expense reductions. The re-franchising issue is key to cash flow. As more the restaurants are operated under this model, McDonald's will receive larger rent and royalties, which will boost cash flow. Furthermore, China has recovered after the meat scare last year. This will be a big boost for the company as China is a high growth market for the company. It is earmarked to grow franchises on mass from 15% presently to 25% in the next few years. Initiatives like this should definitely line the coffers going forward. Why? Because many investors overlook the fact the McDonald's will open more than 1000 restaurants this year. To date, we are not seeing the growth in earnings and revenue (that will come) because of dollar strength, limited price increase opportunities due to stiff competition and changing consumer preferences (which mainly have been brought on by competitors). When these short term headwinds abate, McDonald's new stores (the majority of which will be franchised) should provide more free cash flow, the majority of which will reward shareholders through buy-backs and dividends.
Finally, when you look at the S&P 500 (INDEX:SPAL), the 2 month chart looks very bullish which makes me believe that it could be a possibility that QE4 has already started. The index tested the August lows but has now shot through its 200 day moving average. The technical damage that was inflicted in August has been totally eradicated and the index seems primed to break out to new highs next week (see chart)
Investors need to remember that McDonald's, in the midst of falling revenues over the past few years, still had its share price trading basically flat. What does this mean? Well if revenues can turn up along with a rising stock market, 10%+ annual gains should be quite achievable for this stock going forward. On the other hand if you are expecting a downturn in US equity markets, McDonald's performance in the recessionary years of 2007-2009 should not be underestimated. The company actually grew its earnings per share ($2.91 in 07 to $3.98 in 09) as its share price basically traded flat whilst other stocks fell off a cliff.
To sum up, I wouldn't be waiting for a pull back in this stock especially when you see the current momentum of the S&P500. McDonald's stock now has strong momentum behind it and should push on to $120 a share in the near term. Furthermore, if we get a recession or a steep stock market decline, this stock has shown, from its 2007-2009 performance, that it is an excellent defensive stock.