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New on the value menu: McDonald's stock
Investors, get in the drive-through lane. After a huge comeback, recent weakness in McDonald's stock makes it look like a buy.
By Michael Brush
Following a supersize run that started in early 2003 and saw McDonald's shares almost triple, the fast-food giant's stock fell into the fryer.
Investors have knocked McDonald's stock price down 14% since early March in part because the company did so well in the first half of last year. The hard-to-match numbers it posted then make this year's growth rates look anemic. Investors also are concerned that an emerging turnaround in Europe has stalled.
But given the head of steam this fast-food giant has built up on the comeback trail, the recent stock-price weakness is probably just a pothole in the drive-through lane. And at these levels the stock looks cheap, relative to other fast-food chains.
That makes McDonald's (MCD, news, msgs) shares look like a buy. Investors who get in now can anticipate 20% gains or more on a ride to $36-$40 in a year to 18 months. McDonalds also pays a 55-cent annual dividend, for another 1.85% in yield.
Heres a closer look at what may help McDonalds shareholders get their Happy Meal.
Better not bigger
The worlds biggest burger joint stumbled at the turn of the century, when McDonald's focused so much on growth that quality was neglected. In 2003, management reassessed and went for a better, not bigger strategy, concentrating on improving service and quality and forgoing rapid new store growth.
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The change is steadily winning back customers.
McDonalds decided it should limit the store growth and operate the existing stores more effectively by focusing on several factors, says Michael Johnson, a co-manager at the Mason Street Growth Fund (MGSAX), which owns shares of the company. And that is starting to bear fruit. They are exceeding the expectations they laid down.
In April, McDonalds turned in its 24th consecutive month of growth -- a feat the company hasnt pulled off in 25 years. For the first quarter, comparable-store sales (sales at stores open for more than one year) advanced 4.6% globally. Sales grew 5.2% in the U.S. and 2.9% in Europe.
While growth at existing stores has rebounded, new store openings have slowed to a crawl. McDonalds will probably increase its number of stores by just 350 this year, compared to growth of 1,000 stores in 2002. The chain has about 31,000 stores worldwide.
Although a return to store growth isnt out of the question, the focus for now remains decidedly on boosting sales at existing stores. Heres a look at the game plan that should keep this turnaround alive.
Supersize PR problem
A few years back, Wendy's International (WEN, news, msgs) ate McDonalds lunch in the fast-food fight when it stole business by rolling out better salads. Then, in early 2004, a movie called Super Size Me hit the screens. A scathing critique of McDonalds, the movie offered a look at what happens when a young and healthy New York City dude stops exercising and dines exclusively on McDonalds food for a month. Naturally, he gains weight and experiences health problems.
Super Size Me may have been little more than a brilliant publicity stunt by a filmmaker, Morgan Spurlock, looking to advance his career -- as opposed to any kind of fair assessment of the health risks of McDonalds food. After all, who in their right mind eats at McDonalds three meals a day for a month? But the film -- and an emerging threat of lawsuits against McDonalds from people who blame the chain for their obesity -- was followed by a shift towards a healthier McDonalds menu.
The super size menu option promptly vanished. And a richer selection of more health-oriented vittles appeared -- from fresh salads and fruit-and-walnut desserts to a wider selection of chicken alternatives.
None of these new meals is going to win over any health-food zealots. But they are attracting new customers. The new meals also offer alternatives for anyone stuck tagging along with burger fans headed to the golden arches for a fix.
Before, many parents who took the kids to McDonalds couldnt find anything they wanted, says Johnson. But now they can have options like a Caesar salad with chicken. The healthier part of the menu has really improved visits to the store.
McDonalds isnt finished tweaking its lineup. There will be coffee from Seattles Best, a division of Starbucks (SBUX, news, msgs). And McDonalds is developing a new line of deli-style sandwiches called Oven Selects.
Menu changes reflecting broader consumer trends help make the golden arches a little more current and keeps customers engaged, says Johnson. Its a way to be more relevant, he says. To bring people in, it always helps to have new products. And new markets. The deli-sandwich market is worth $17 billion annually, says CIBC World Markets analyst John Glass. To put that in context, consumers spend about $40 billion a year on burger meals.
This old store
McDonalds turns 50 this year. At middle age, more than a few outlets look worse for the wear. So as part of its back-to-basics plan, the chain is remodeling a big chunk of the store base.
Refurbished stores typically ring up 5% more sales. That in turn brings a 15% return on the makeover investment, says Morningstar analyst Carl Sibilski. So the impact on the bottom line is real. McDonalds refurbished 1,100 units last year. It will redo 1,300 this year.
The store makeovers are part of larger effort to improve hospitality -- aided by a customer-service hotline printed on each bag. Feedback shows the hospitality drive is working. Compliments are up and complaints are down. We're beginning to see concrete evidence that McDonald's relationship with consumers is improving, says Sibilski. McDonalds is also keeping more U.S. stores open 24 hours a day, a consumer-friendly move that boosts sales, too.
Waiting for a continental comeback
Adjusted for holidays, comparable-store sales at European stores edged up just 1% in April. Since Europe represents more than 40% of total operating profits, a continental comeback would be big for shareholders.
Part of the challenge is the weak economy -- especially in Germany, a major market for McDonalds. To deal with that, the fast-food chain rolled out a value menu in Germany. This hurts margins at first, but the effect should reverse once consumers start migrating to more expensive parts of the menu. Will they? No one knows for sure, but it usually takes about six months when they do. That means well know in the second half of the year.
In Europe, the fast-food chain is offering healthier menu options and remodeling stores, just like in the U.S. Its also rolling out a cooking platform thats faster.
More bang for your fast-food buck
McDonalds stock peaked at about $34 in March. At about $29.70 now, it trades at just 13.9 times next years earnings of $2.13 per share. In contrast, competitors like Wendy's and Yum! Brands (YUM, news, msgs), which operates Taco Bell and Pizza Hut, among other chains, each recently sold for 16.6 times 2006 earnings. Indeed, fast-food stocks typically go for between 16 and 17 times forward earnings, points out Keith Gangl, portfolio manager at Thrivent Large Cap Growth (AAAGX), which holds the stock.
So all McDonalds has to do is trade up to the bottom of the normal range and investors have a $34 stock, Gangl says. He thinks the stock is a buy anywhere below $30.
McDonalds looks even cheaper if you adjust earnings for the value of employee stock options. Unlike its competitors, McDonalds subtracts the value of options when calculating earnings. So analysts do the same thing when making projections. Add back the options and you increase earnings, which drives down McDonalds stock price to 13.4 times 2006 profits. (Competitors have to start accounting for options at the start of next year.)
Meanwhile, McDonalds produces healthy cash flow, and new chief executive Jim Skinner appears committed to shareholders. McDonalds expects to return $1.3 billion to shareholders in 2005 through share buybacks and dividends.
Ready to grow when the time's right
Thrivents Gangl worries most about a failure in the European turnaround, and higher prices for meat and gasoline in the U.S. On the other hand, if gas prices keep declining, that could provide an unexpected lift. If it goes below $2 a gallon, that could be the incremental positive that people are not expecting, says Gangl.
Another big reversal could occur further on if McDonalds ever goes back into growth mode. Its already expanding fairly rapidly in China, where it hopes to operate 1,000 units by the 2008 Olympics. And the company has the ability to grow quickly again if the climate is right, says Morningstars Sibilski.
Until they get everything under control with their existing operations, I dont think they feel they are allowed to say growth in the conference calls, or the analysts will start beating them up again, says Sibilski. But there are international growth opportunities available that really arent available to anyone else. They have the infrastructure to add a lot of stores when they are ready.
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