Don’t Count McDonald’s Out Yet; Just Ask Starbucks

McDonald's is going through a transitional phase just like Starbucks did in 2008. Long-term investors need to have a closer look at McDonald's.

Jul 29, 2014 at 3:15PM

To say that McDonald's (NYSE:MCD) latest earnings report was a disappointment would be an understatement. Earnings per share of $1.40 missed estimates by $0.04, and revenue came in $100 million lower than expected as well. As a result, shares dropped 1.3% and are now 6% off their all-time highs hit in May.


Source: McDonald's

The chain has seen a number of menu items like Mighty Wings and Seasoned Fries flop. Most of McDonald's recent problems have been self-inflicted, as it let a number of opportunities get away while the competition ate into its business.

One of the problems facing McDonald's is that the sentiment surrounding the company is quite bearish. Many feel that McDonald's will continue to struggle in today's environment. After all, eating habits are changing, and there are more dining options available than ever before. McDonald's is no longer the only game in town.

Most notably, McDonald's has struggled against its one-time subsidiary Chipotle Mexican Grill (NYSE:CMG). Chipotle has come to dominate the fast-casual category that customers are showing an increased preference for. Chipotle just reported a blockbuster quarter and saw its same-store sales rise more than 17%.


Source: Chipotle Mexican Grill

But, now might be the time to seriously consider shares of McDonald's due to the recent sell-off. The reason I'm saying this is because Starbucks (NASDAQ:SBUX) was facing many of the same challenges back in 2008. Starbucks had to make a lot of hard choices back then, and CEO Howard Schultz guided the coffee giant back on track. The question becomes: Can McDonald's CEO Don Thompson get McDonald's back on track and engineer a turnaround like Howard Schultz did for Starbucks?

A closer look at same-store sales
Global same-store sales were flat in the second quarter. McDonald's saw negative guest traffic in all of its major regions. Revenue increased 1% due to the opening of new restaurants. Earnings per share increased 1%, but that was primarily due to a lower share count as a result of McDonald's aggressive share- buyback program. US same-store sales fell 1.5%, and European restaurants reported a 1% drop. In the Asia/Pacific, Middle East, and Africa region, same-store sales rose 1.1%.

Ronald Mcdonald

Source: McDonald's

The problem with these numbers is that McDonald's results were lower than what analysts were expecting. Expectations were for global same-store sales to increase 0.8%. Expectations were for US sales to be negative, but they came in far worse than many had expected. European operations were most startling since they came in negative when the expectations were for growth of 0.7%. McDonald's Thompson clearly has his work cut out for him.

Starbucks proves a turnaround is possible
Not many people remember the problems Starbucks faced in 2008. Back then, the headline at CNN was "Wishing on a fallen Starbucks." Starbucks was forced to layoff employees, close stores, and was deeply affected by the financial crisis. After all, in a tough economic environment, cutting back on Starbucks' trips is one of the easiest ways to save money.


Source: Starbucks

What had happened is that Starbucks expanded too fast. The expansion plan was based on opening stores without regard to location or profits. After an eight-year hiatus, Schultz came back as CEO and sought to bring back what he called the "distinctive Starbucks experience." It worked, and for those who bought shares, they were richly rewarded.  Shares are up from a low of less than $10 in 2008.

Shares of McDonald's look to be on the value menu
While Chipotle's results were impressive, its net income in the quarter was only $110 million. Its operating margin was only 16%, and its return on equity (ROE) was 22%. And after its price run-up after following its latest earnings release, Chipotle has a market cap of more than $20 billion.

McDonald's, on the other hand, had net income of approximately $1.4 billion in the quarter. McDonald's earned more than 12 times what Chipotle earned yet has a market cap of only 4.7 times Chipotle's at $95 billion. McDonald's operating margin is 30%, or almost double Chipotle's. If that weren't enough, McDonald's ROE trumps Chipotle's as well coming in at 35%.

Foolish final thoughts
It is important for long term investors to remember that great companies go through transitional phases. It's happened to both Starbucks and McDonald's in the past. Unfortunately, McDonald's is hitting one of those transition spots again.

CEO Don Thompson and his team will eventually get everything worked out. It'll just take some time. Along the way, investors should enjoy the 3.2% dividend yield, the share buybacks, and wait for the inevitable turnaround to come. It eventually will, we just don't know when.

Mark Yagalla has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill, McDonald's, and Starbucks. The Motley Fool owns shares of Chipotle Mexican Grill and Starbucks. 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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