Is McDonald's at Risk of Following Yum! Brands Into Mediocrity?

After reporting mixed results for its fourth quarter, the situation at McDonald's is beginning to look questionable. In the face of competition from companies like Chipotle and Panera, can McDonald's thrive, or will it follow the path of Yum! Brands?

Jan 28, 2014 at 2:50PM

Last week McDonald's (NYSE:MCD) announced its full-year results for 2013. The company, which operates the largest restaurant chain in the world and has a market cap of $94.8 billion, reported fourth-quarter earnings per share that exceeded analyst expectations but fell short on revenue. In response to these mixed results, how should investors act? Is McDonald's an excellent prospect because of its earnings beat, or is the company's revenue shortfall a sign of trouble to come?

What Mr. Market expected versus how McDonald's delivered
For the quarter, analysts expected McDonald's to bring in revenue of $7.1 billion, 2.3% higher than the $6.9 billion that the company reported the same quarter a year earlier. The company did report revenue that beat last year's results but fell short of estimates at $7.09 billion.

According to the company's earnings release, the primary driver behind lackluster revenue was a decrease in comparable-store sales of 0.1%. This decline was led by the company's U.S. segment and APMEA segment (which includes the company's operations in the Asia/Pacific, Middle East, and African regions) . During the quarter, U.S. comparable-store sales fell 1.4% while international sales declined by 2.4%. It was only the company's Europe segment that performed well during the quarter, as demonstrated by the region's 1% rise in comparable-store sales.

For the year, the restaurant chain's revenue came in at $28.11 billion, 1.9% higher than what it reported in 2012 but lower than the $28.13 billion anticipated. For the year, management reported a comparable-store sales increase of 0.2%, which helped the company's top line, but the primary driver behind rising sales was an increase in restaurant count. In 2014 alone, McDonald's expects to open between 1,500 and 1,600 locations at a cost ranging between $2.9 billion and $3 billion.

Despite seeing revenue fall shy of expectations, the company did report earnings that exceeded analyst estimates. For the quarter, McDonald's saw its earnings per share come in at $1.40. This was 1.4% higher than the $1.38 the company reported last year and above the $1.39 that Mr. Market predicted. Although this sounds positive, the source of the extra $0.02 above last years' results was not due to improved profitability. While the company's net income rose by 0.06%, the main driver behind increased earnings per share was a 1.1% reduction in shares outstanding.

On a full-year basis, the company performed slightly stronger. A combination of 1.4% fewer shares outstanding for the year and a 2.2% rise in net income allowed McDonald's to report earnings per share of $5.55. This fell in line with analyst expectations and was 3.5% higher than the $5.36 the company reported in 2012.

McDonald's has done well but might be in trouble
Just because a company is the largest in its industry doesn't mean that it's invincible. Right now, companies like Chipotle Mexican Grill (NYSE:CMG) and Panera Bread (NASDAQ:PNRA) are growing rapidly as consumers move away from fast-food companies like McDonald's and Yum! Brands (NYSE:YUM). This is best shown in the revenue and net income growth of these companies over time.

For instance, over the past four years (excluding 2013 for issues of comparability), revenue at McDonald's has grown a respectable 21.2%. Yum! has done even better, with the company's top-line growth coming in at 25.8%.

In comparison, Panera has seen its revenue rise 57.4% over this time frame, while Chipotle has done even better with a 79.9% increase in revenue. Admittedly, both Panera and Chipotle should be growing faster than industry giants like McDonald's and Yum! because of their size difference.  However, both companies are getting large enough and growing fast enough that they are starting to pose serious problems for McDonald's and Yum!.

During the first three quarters of 2013, Chipotle saw its revenue climb 16.7% while its net income rose 14.4%. Over the same time frame, Panera's revenue rose 10.6% and its net income increased 16.5%. Results from both of these companies are superior to what was reported by Yum! and McDonald's in their respective three quarters.

As an example, McDonald's reported an increase in revenue for the first three quarters last year of 1.9% and a 3% jump in net income. Yum! performed even worse, with revenue falling 6.1% and net income declining a jaw-dropping 38.9% (22.7% if you exclude a $310 million write-off and account for taxes accordingly).

Foolish takeaway
At this point in time, the situation for both Yum! and McDonald's doesn't look too pretty. Currently, Yum! appears to be in trouble, but McDonald's is barely holding its ground. In the long run, this could mean that both companies could face more challenging times if consumers continue moving toward fast-casual chains like Chipotle and Panera. With that being said, though, Foolish investors should keep in mind that investing in either fast-casual business comes at a cost.

With a price/earnings ratio of about 51, Chipotle is an expensive company to invest in. Luckily, investors have the opportunity to buy Panera for half that at 25.5 times earnings, but they have to settle for a business that isn't growing as rapidly.

In comparison, McDonald's can be purchased for 17.2 times earnings, which is pricey but nowhere near the level that smaller (and less fundamentally sound) Yum! trades at with a price/earnings ratio of 29.2.

Moving forward, investors need to keep the issue of growth in mind, but they should be mindful of how much they are paying for that growth. Right now, Chipotle looks to be the best opportunity of the bunch, but the Foolish investor should ask himself or herself if they are comfortable paying such a high premium for the stock.

Looking for other great dividend picks?
McDonald's currently offers a 3.4% yield.  While this is nice for any company, does it place it in the top 9 dividend stocks picked out by The Motley Fool?  You see, one of the dirty secrets that few finance professionals will openly admit is the fact that dividend stocks as a group handily outperform their non-dividend paying brethren. The reasons for this are too numerous to list here, but you can rest assured that it's true. However, knowing this is only half the battle. The other half is identifying which dividend stocks in particular are the best. With this in mind, our top analysts put together a free list of nine high-yielding stocks that should be in every income investor's portfolio. To learn the identity of these stocks instantly and for free, all you have to do is click here now.

Daniel Jones has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill, McDonald's, and Panera Bread. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald's, and Panera Bread. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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