McDonald's Not Cheap But Digestible

The word "innovation" is constantly thrown around in the tech sector. Very rarely are other company's beyond tech get credit for their outside-the-box thinking. To that end, the evolution of McDonald's (NYSE: MCD  ) over the years have been impressive. When it comes to innovation, the company is unparalleled with its strategic pricing and its evolving menu. However, concerns about decreasing margins has compelled Mickey D's to rethink its offerings. But will it be enough?

The company recently decided to drop a few items from its menu, including Chicken Selects and its Fruit & Walnuts salad. McDonald's is hoping to prolong what appears to be a revival in its stock price, which has gained 9% so far on the year after a lackluster 2012. But will these moves be enough to expect gourmet returns for the entire year, especially since fourth-quarter results didn't exactly wow investors.

Looking for better margins
For that matter, the entire service sector has been unimpressive. But McDonald's did what it had to do to show the long-term growth capabilities that still remain. Revenue increased roughly 2% year over year. It's not a robust number. But not much more is expected from a company this size. In constant currencies, however, systemwide sales grew 5% as total comparable sales advanced 3.1% year over year. This metric tracks sales performances for restaurants opened at least a year.

However, comps arrived flat for the quarter, which is why the company is looking to adjust its menu. It's not as easy as it use to be to beat Burger King (NYSE: BKW  ) and Wendy's (NASDAQ: WEN  ) just by having the golden arches illuminating brightly from the skies. Both rivals have ramped up their marketing and menu to compete head-on with McDonald's, which has resulted in margin pressure due to the soft economy. Consequently, McDonald's has begun to place an emphasis on the bottom line.

To that end, profitability was OK, despite the 60-basis-point decline in gross margin. The company said this was due to higher franchise expenses. But this was offset by a 4% increase in operating income, which advanced due to better cost management and lowered expenses. Likewise, though company-operated margins declined by almost 1% year over year, McDonald's did slightly worse relative to Burger King, whose company-operated margins were down about a half a percent year over year. Likewise, Wendy's 14.2-.5% company-operated margin was slightly up year over year.

Is there still growth ahead?
I started off by discussing the tough 2012 environment. Relative to expectations, however, McDonald's didn't perform that badly. The company's ability to adapt continues to make a difference. But the climate in 2013 is not going to get any easier. Last month, McDonald's announced a 2% decline in global comps, with U.S. being the only one among the geographic regions showing growth.

This means one of two things: either the competition is taking a toll or the economic slowdown abroad has gotten worse. Plus, it could be a combination factor that has caused the reduction in foot traffic. While there's no evidence to suggest that Burger King or Wendy's is causing damage to McDonald's, it's hard to ignore the impressive performance of Yum! Brands (NYSE: YUM  ) , which outgrew McDonald's across the global systems by almost 2% (3.1% vs. 5%).

This may very well change in the coming quarters, however. Yum! is working to repair its reputation after a recent PR nightmare, where two of its suppliers were reported to have used excessive levels of antibiotics in chickens. While Yum! has done a good job of facing the issue, investors won't know the extent of the damage until the company reports earnings for at least a couple of quarters. In the meantime, this may have opened the door for McDonald's to steal some market share.

Not on the value menu yet but tasty
McDonald's understands the nature of tis business and it is an expert at enticipating what consumers will want. To that end, the company's emphasis on value and its unique promotional food events will continue to drive traffic. 

In the meantime, recent attention to menu items is the first step toward returning value to shareholders. I'm going to miss the Chicken Selects, but investors should be rewarded with improved margins and a stronger balance sheet going forward. The stock is not cheap, but there's still tremendous value to come.

 

After making investors rich in 2011, McDonald's has been one of the worst-performing blue-chip stocks of 2012. Our top analyst on the company will tell you whether you should be worried by this trend, and he'll shed light on whether McDonald's is a buy at today's prices. Click here now to read our premium research report on the company.


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  • Report this Comment On March 07, 2013, at 1:11 PM, Darwood11 wrote:

    My crystal ball is as dysfunctional as ever.

    So will the next 10 years look like the last 10 for MCD? I don't know. [disclaimer; I do own MCD stock].

    So how did the last 10 years turn out?

    MCD blew away Whole Foods and many Emerging Market funds. Yum brands is close with MCD at 506% and YUM at 426%. However, that excludes any dividends.

    In the last 5 years, WFM has done better, with 147% versus 80% for MCD and 82% for YUM.

    All of the above ignores dividends. MCD currently yields about 3%, WFM about 0.75% and YUM about 1.85%.

    Who will the winner be in 5 years? Well, place your bets. Or, via a diversified portfolio, buy your stocks. The choice is yours and mine!

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