- 2017 eps estimates is more than a $1 higher than the $4.98 printed in 2015 illustrating robust expected growth.
- Investors should note that McDonald's stock remained elevated from 2012 to 2015 despite falling sales in the US.
- If the US enters a recession, McDonald's would definitely gain market share as it did in 2008.
McDonalds (NYSE:MCD) definitely built on the initial momentum it gained in its third quarter earnings last October when the company finally announced that its same store sales in the US grew for the first time in 7 quarters. Fourth quarter earnings built on that momentum with the restaurant chain's "all day breakfast" becoming the chief instigator of continued growth in the US. However, investors are stating that Mcdonald's valuation is getting on the high side which is definitely true from a historical perspective.
The company now has an earnings multiple of around 25 and a forward earnings multiple of just under 20 which undoubtedly makes McDonald's stock expensive considering revenue growth and earnings growth is still negative on an annual basis. To give you an idea, McDonald's produced net income of $4.53 billion in 2015 and revenues of $25.41 billion which are well below 5 year averages.
Furthermore, since 60% of the company’s revenues come from outside the US, sustained dollar strength has been a major headwind for McDonald's as despite reporting growth in many markets with respect to volume, in dollar terms sales are still down which is all that matters to investors. Nevertheless, analysts are shrugging off negative earnings growth by being optimistically bullish on McDonald's stock over the next few years. Can the stock continue to trade above its historic valuation for a considerable amount of time? Realistically McDonald's stock should fall but the stock clearly has momentum and shorting even here could be very risky for a variety of reasons.
Firstly investors who are currently bearish on McDonald's stock should note that many income investors in a company like McDonald’s concentrate their due diligence more on the company’s cash flow statement than the general income statement. Why? Well, McDonald's is a dividend aristocrat and has a pristine record of returning cash flow to shareholders in terms of buybacks and dividends. This alone plus its stock price history ensures it has many loyal shareholders who undoubtedly buy more McDonald's stock on dips.
We saw this from 2012 all the way to 2015, when the stock price was basically flat, despite revenue in 2015 being substantially down from 2012 levels and earnings per share this year coming in almost $0.40 less than 2012 levels. However despite McDonald's sluggish growth, free cash flow levels are almost 20% higher in 2015 than 3 years ago and ongoing re-franchising efforts ( 4,000 is the goal by 2018) will undoubtedly keep cash flows elevated.
The beauty of re-franchising is that Mcdonald's can simply sell its restaurants and then collect royalty and rent checks from the store owners - a strategy that has worked very well for Burger King. Furthermore, the $500 million target in net annual SG&A reductions seems on track when you see the income statement from its fourth quarter earnings. SG&A expense came in over $400 million lower than last quarter and was the main reason why net income topped estimates at $1.21 billion. What's the takeaway? Well if costs keep on coming down along with more cash flow from re-franchised restaurants, less pressure will be put on the restaurant chain to increase volume. Investors should remember this before thinking of shorting McDonald's stock.
Secondly despite McDonald's stock trading at a historically high earnings multiple, the industry average is over 30 meaning McDonald's in its own sector is actually undervalued. Just look at Chipotle Mexican Grill (NYSE:CMG) stock which is down 33%+ since last October due to the E.Coli outbreak. It is trading at an earnings multiple of 30 despite the steep sell-off in the stock over the last few months. The Wendy's Company (NASDAQ:WEN) is another that springs to mind - currently trading at an earnings multiple of 40.
I acknowledge that the stocks mentioned above are considered as growth stocks and have had much faster stock price growth over the past few years than McDonald's (see chart) but investors need to ask themselves whether now is the time to go long on growth stocks in this sector? Janet Yellen announced last week that the Federal Reserve was studying the possibility of implementing negative interest rates which is a sign of a weakening economy. If indeed the US enters recession, where do you think people are going to eat? I would bet on the cheapest which is McDonald's. Investors should remember that Mcdonald's EPS almost doubled in 2008 which makes this company an excellent recession-proof stock.
Finally, Mcdonald's dividend of around 3% is also much higher than the industry's average which again should attract income investors who want exposure to this sector. However what really could keep McDonald's stock elevated is dollar weakness which is a distinct possibility in my view. Why? Well, the dollar has been propped up by both improving economic activity in the US and also hawkish intent by the Fed. However recent volatility in equity markets along with worse than expected economic data in the US illustrates to me that the Fed will not go through with its scheduled four interest rate hikes in 2016.
If the Fed initiates negative interest rates coupled with another round of quantitative easing, I see equity markets rallying and the dollar selling off substantially. A US recession would mean market share gains for McDonald's whereas dollar weakness would mean international markets would become more profitable (60% of Mcdonald's revenues come from outside the US). Mcdonald's stock price didn't drop a tick in the great recession of 2008 which means its current valuation could stay elevated for far longer than many think.
To sum up, McDonald's stock valuation is historically high but this doesn't necessarily mean that shorting this stock now is the right strategy. The company is really making progress on the costs front plus ongoing re-franchising will keep cash flow levels elevated. Furthermore, McDonald's earnings multiple is actually well under the industry average plus its dividend is a full percentage point bigger than the fast food restaurant sector. Moreover, McDonald's stock is recession proof and will see gains in the US if a recession comes to pass and dollar weakness will boost its international earnings.