Drip Portfolio Run From McDonald's

With its stock at eight-year lows, McDonald's still doesn't look cheap, especially when you consider its multiple to free cash flow, mounting debt, slowing sales, intense competition, and the enormous challenges ahead. It may not be a market beater again for a long time.

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By Jeff Fischer (TMF Jeff)
January 2, 2003

Plenty of black ink has been splashed onto the golden arches that is McDonald's (NYSE: MCD) in the last year. In fact, McDonald's was one of our top 10 business stories for 2002. The 50-year-old, 30,000-location, $15-billion-in-annual-sales restaurant mammoth has more than a bad case of indigestion. It has food poisoning.

Earnings have declined at McDonald's seven of its last eight quarters, sales growth is down, operating income, profit margins, and same-store sales are down, long-term debt is� up, and you probably don't even think of Ronald McDonald anymore when you hear the name "Ronald." (You probably think of Reagan.)

Somebody get this company some marketing! It's pulling a Coca-Cola (NYSE: KO).

But even as it goes stale, many market watchers, stock pickers, and french-fry lovers are dipping a toe into McDonald's tepid, greasy waters and saying, "Hey, this stock may be a great deal here." Fool writers have contemplated the same possibility. I'm here to say, "No. No, it is not a great deal. Run. Run from the arches. Turn your gaze. Turn away!"

Slowing to gawk at an accident
If you'd never considered owning McDonald's before, but you find the thought creeping into your head lately, you may be suffering from a syndrome called "It Can't Get Much Worse, It's [insert big company name here]" syndrome. This costly syndrome makes otherwise smart investors buy the falling stocks of big, well-known companies mainly because they're big, well-known companies.

Thousands of investors fell prey to the syndrome with Motorola (NYSE: MOT). "It can't get much worse, it's Motorola!" And with AT&T (NYSE: T). And Lucent (NYSE: LU). And Xerox (NYSE: XRX). And Enron. Dozens of other fallen giants (that I can't remember because it's January 1) have sucked in thousands of new investors, only to never recover their former luster. McDonald's might be another such "suckee."

A bleeding giant -- and it's not a Big Mac
For the first time, McDonald's is closing restaurants en masse. In late 2002, management said it would close 175 locations, surrender capital investments in four markets, and completely abandon three markets in the Middle East and Latin America. When you're abandoning markets completely and you're McDonald's, you're hurting. The company is expected to post its first quarterly loss, after charges, this month.

We all know what's cooking. Competition is rife. Food options are everywhere. Healthier eating is beginning to interest America. Price wars have hurt McDonald's while helping low-price veteran Wendy's (NYSE: WEN). New kitchens, menu options, and promotions have cost McDonald's hundreds of millions without result -- and soon the company's new CEO will outline still more new plans.

Will yet more facelifts save McDonald's, or only make it uglier? Has the fast food king's reign, like that of Michael Jackson's, come and finally gone? Stranger things have happened. So, yes, it could have peaked. Tastes change over time. Old concepts become� old. And old rulers almost always have a hard time becoming something new, especially in a timely fashion that serves investors. I personally believe that McDonald's most profitable days are behind it, at least for several years, if not longer. Therefore, I wouldn't buy the stock.

But I can't just say, "Look, my intuition is that people are moving on to other things. McDonald's looks like a fading giant. It has staying power, but it won't grow well, if at all. It lacks pricing power. Its products are tired. Its brand is muddy. Its stores are uneven. Rushed parents will always take their children there, and millions will continue to stop in daily, but the magic charm that McDonald's once had over the world is dying." I can't just say that, although I believe it. I need to offer other reasons to avoid the stock. Fundamental reasons. So here we go.

"What price mediocrity?"
How is McDonald's a great deal at $16 a share? Analysts are pointing to the company's P/E of 13 and saying things like, "Look at that P/E! And this giant keeps throwing off big cash flow." Whoop-de-do, people. Its 2001 free cash flow (FCF) was 31% below results in 1999, was also below 1998 results, and now 2002 can't be much better. At $16, this non-grower has an enterprise value of $29.3 billion. That puts it at 37 times 2001 FCF, not even excluding non-cash items. How is that cheap?

Johnson & Johnson (NYSE: JNJ), growing 15% per annum, trades at 24 times trailing FCF. Pepsi (NYSE: PEP), growing 12%, trades at 20 times FCF.

Its steep valuation aside, there's nothing thrilling about McDonald's cash flow numbers:

          OCF          FCF
1997     $2,442       $331
1998      2,766        887
1999      3,008      1,141
2000      2,751        381
2001      2,688        782
2002*     2,203        917

(in millions)
OCF = Operating Cash Flow
*2002 through September

Opening hundreds of new restaurants the last six years only kept operating cash flow in a range and FCF sporadic. Not good.

Additionally, McDonald's is saddled with debt. Big debt. Big, big debt. Debt to the tune of $9.4 billion, compared to just $423 million in cash and equivalents. Tell me you can't find better elsewhere. This trend should make investors itchy to flee:

        L.T. Debt       Cash & Equiv.
1997     $4,834             $341
1998      6,188              299
1999      5,632              419
2000      7,843              421
2001      8,555              418
2002*     9,484              423

(in millions)
*2002 through September

McDonald's nearly doubled its long-term debt in six years without seeing lasting improvement in operating cash flow. So, what did the debt gain it? From 1997 to 2001, sales rose a cumulative 30% (about 4.5% per year), while operating expenses raced ahead 42%. As a result, margins shrunk and return on investment (ROI) tanked from a respectable 10% five-year average to 7.5% the last 12 months. Heck, the Fool, with MBNA, offers a CD yielding 3.15% without any risk (and we explain our secret sauce).

Looking at more nuanced numbers, McDonald's cash conversion cycle (CCC) suggests that its financial position with outside parties has weakened -- although I'm speculating here. I'm not sure what these worsening numbers mean exactly, except that the company is financially weaker.

The CCC measures how quickly a company turns a dollar spent on inventory (or cost of goods sold) into a dollar of sales. In 1997, McDonald's had a very strong negative cash conversion cycle (you want a negative number), which indicated that customers were funding its daily operations. By 2001, its CCC was positive. It took 1.2 days for a dollar spent on inventory to turn into a dollar of revenue. And for the first nine months of 2002, the number jumped to 5.1 days.

          CCC 
1997    -13.5 days
2001      1.2
2002*     5.1

*through 9/30/02

So, now when McDonald's spends a dollar on inventory, it takes 5.1 days for it to get that dollar back. That's still good, but it's a big difference from 1997, when it was paid 13.5 days before it paid for its product. With $40 million in daily sales, the cash flow difference is enormous. What happened is McDonald's accounts receivables jumped. From 1997 to 2001, year-end accounts receivables rose 82% while revenue only rose 30%. Whatever the reason, this isn't good.

When Lucent's CCC soared in the late '90s, it was a precursor of disaster. Its accounts receivables and inventory soared. McDonald's inventory hasn't soared, although from '97 to 2001, its year-end inventory did rise 50% while sales only rose 30%. Its inventory levels remain modest, but these results do point to lessened efficiency.

In the end, though, it's got to come back to valuation. We know McDonald's is very unlikely to have strong FCF for at least the next few years as it remakes itself and tries new menus, new marketing, and new approaches to business. But let's assume it all works out. Despite store closures, declining same-store sales, stronger competitors, and mounting debt, let's assume that in three short years McDonald's has righted its massive ship and recaptured our hearts and wallets.

Now, let's assume it sees record FCF in 2006 of $1.5 billion to $1.8 billion, 30% to 60% above 1999's record. At today's price, the stock would already be valued at 20 times to 16 times this record FCF -- or right around historic market averages. Obviously, this is a random assumption, but it suggests that investors may need to wait a long time for substantial returns, if they're in the cards at all.

My big, bad opinion
You can do better than to buy McDonald's. The share price is far below its high, but it still doesn't look cheap. Once a giant becomes unbalanced, it can take a long time for it to regain its feet -- or fall. And the wind is blowing against this giant. It's hard to change your formula without alienating your most devoted customers, and it's even harder to convince former customers that you're new again. Near-term bounce or not, this former market crusher may remain a market laggard a long while.

Jeff Fischer thinks McDonald's may have jumped the shark when it started calling itself "Mickey D's," thereby institutionalizing its customers' affectionate term for the chain. Hey, didn't J. Lo do this, too? Bad move, Jennifer. Call us to learn why. Jeff "Smitty" Fischer doesn't have a stake in McDonald's. The Fool has full metal disclosure.

Drip Portfolio

  Ticker Company Price
 Change
 Daily Price
 % Change
 Price 
  MEL MELLON FINL CORP 1.19 4.56% 27.30 
  PEP PEPSICO, INC. 0.88 2.08% 43.10 
  JNJ JOHNSON & JOHNSON 1.62 3.02% 55.33 
  INTC INTEL CORPORATION 1.12 7.19% 16.69 
  PAYX PAYCHEX INC 1.02 3.66% 28.92 
      
  Trade Date # Shares Ticker Cost/Share Price  Total % Ret  
 10/07/98 50.5452 MEL 34.29 27.30  -19.69%
 07/28/00 15.2182 PEP 45.57 43.10  -3.33%
 11/14/97 39.403 JNJ 42.32 55.33  31.93%
 09/08/97 59.9456 INTC 25.10 16.69  -32.83%
 02/05/02 10.275 PAYX 34.06 28.92  -15.10%
      
  Trade Date # Shares Ticker Total Cost Current Value  Total Gain  
 10/07/98 50.5452 MEL 1,733.06 1,379.86  -353.20 
 07/28/00 15.2182 PEP 693.53 655.91  -37.63 
 11/14/97 39.403 JNJ 1,667.59 2,180.17  512.56 
 09/08/97 59.9456 INTC 1,504.68 1,000.51  -504.17 
 02/05/02 10.275 PAYX 350.02 297.15  -52.86 
Cash:883.04 
Total:6,396.64 


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