Weakness at McDonald’s Might Present an Investment Opportunity

McDonald's (NYSE: MCD  )  once ruled the fast-food world. Today, instead of sitting at the top of a mountain enjoying the view of all the lowly, peasant-like companies attempting to compete, this quick-service restaurant has been forced to make room for others at the peak. McDonald's is none too pleased about this turn of events, but it's also not the type of company to sit back and allow new trends to eat into its business.

Changing landscape

McDonald's has battled against the likes of Burger King Worldwide (NYSE: BKW  ) and Wendy's (NASDAQ: WEN  ) for decades. Meanwhile other companies, such as Yum! Brands, Chipotle Mexican Grill, Subway, and Panera Bread have been around for long periods of time, their growth has led to stolen market share from McDonald's. Most people don't want to eat burgers and fries every time they want an affordable meal out--they want variety. This is why McDonald's has put such a large emphasis on menu innovation and variety.

In addition to increased competition, McDonald's must contend with a weak macroeconomic environment, where consumers are eating at home as opposed to dining out -- even if it only saves a few dollars. Though more jobs are being added throughout the United States, lower wage growth is a big concern, and payroll taxes and gas prices haven't helped the situation.

These trends have prevented McDonald's from raising prices, which impedes the company's top-line potential. McDonald's likely just wants to maintain its traffic at this point. Unfortunately, comp-guest counts declined 1.2% in the second quarter. But not all news is bad news.

Simple yet impressive strategy

McDonald's has its name on a total of 34,734 restaurants, 28,107 of which are franchised. With so many franchisee locations, McDonald's costs remain low, which greatly helps profitability. Franchisees also purchase equipment, marketing tools, and are basically responsible for the entire business. Most people don't think of McDonald's as a franchiser, but that's essentially what McDonald's is and how the company views itself.

McDonald's has 6,627 company-owned restaurants, and it wants to keep the majority of these restaurants for franchiser-credibility purposes. These locations can also give new franchisees restaurant-operating experience, and assist with marketing concepts and materials. Franchisee deals are often made for a 20-year time frame, and McDonald's collects fees, rent, and royalties throughout that entire time frame.

Overall, this is what you would call a top-notch business model.

Geographical performance

You might be surprised to learn that the majority of the company's revenue stems from Europe (40%). The United States is second (32%), while the Asia Pacific/Middle East/Africa region is third (23%). Therefore, a 0.1% decline in comps in Europe for the second quarter is a big negative. While the U.K. and Russia have performed well, France and Germany have been weak.

U.S. comps improved 1% for the second quarter. While this is a positive, it's not terrific. And as far as the Asia Pacific/Middle East/Africa region is concerned, comps dropped 0.3%, mostly due to weakness in China and, to a lesser extent, Japan. Overall, comps increased 1%, but this was weaker than a 3.7% jump in the year-ago quarter.

McDonald's will continue to innovate its menu, upgrade restaurants, expand internationally, and focus on value, but management expects the challenging economic environment to continue. This will put pressure on comps and negatively impact results for the remainder of the year.

Rising threats or false hopes?

McDonald's and Burger King are often brought up in conversation together. Burger King's stock has appreciated 19% year-to-date, which is better than McDonald's at 10%. Nonetheless, Burger King is facing similar headwinds in its business, as well as re-imaging costs. Burger King re-imaged 600 stores in 2012, which led to an average 10% to 15% sales boost at those locations. Re-imaging, however, is costly, and Burger King plans on renovating 40% of its stores by 2015.

Burger King's comps improved 0.6% in the second quarter, but just like McDonald's, comps weren't as impressive as last year when results increased by a much higher 4.4%. This is a big drop-off, and with Burger Kind trading at 45 times earnings versus McDonald's at 17 times earnings, Burger King doesn't look to be a better investment than McDonald's.

Wendy's has blown away its peers year-to-date for stock appreciation, as the stock has advanced 66%. Wendy's has focused on an expansive remodeling, and it looks as though the investment has paid off thus far. Comps improved just 0.4% for the second quarter, but Wendy's expects the second half of the year to be strong. The company projects comps will improve 2% to 3% by year's end.

Wendy's recently reduced its advertising campaign, which lowered costs. If Wendy's can see continued momentum while keeping costs low, then the stock has the potential to run higher. However, Wendy's might be a little ahead of itself at this point, as it's now trading at 209 times earnings. While upside potential for Wendy's is clearly evident, it would be a much riskier play then McDonald's at this point in time. 

Conclusion

McDonald's is facing many headwinds. Management is concerned about the macroeconomic environment, competition is consistently increasing, and price increases don't look to be a potential reality for a considerable amount of time. That said, McDonald's is still a low-cost operation with one of the strongest brands in the world, and in the long run it should be capable of fighting off competition that's attempting to steal significant market share.

This doesn't look to be the ideal time to invest in this quick-service restaurant. But McDonald's remains a high-quality company that should make for a good long-term investment. Therefore, it's recommended that you only buy a small amount of shares now and then buy slowly and incrementally if the stock suffers. 

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