Fast-food giant McDonald's (MCD -0.91%) has thrived, outperforming the S&P 500 over the past decade. Price increases have helped fuel sales growth, including a double-digit leap forward in the first quarter of 2023.
However, its pricing power might be running low. Management noted that customers have begun trimming their orders, with fries being a common budget casualty.
Investors might find themselves at a crossroads. Is McDonald's running out of pricing power? Or does the stock still have more to give your portfolio? According to the data, its future might not be as bright as its storied past. Here is what you need to know.
Are consumers getting sick of price increases?
Investors shouldn't panic like the roof is on fire at McDonald's. After all, the business grew global comparable-restaurant sales by 12.3% year over year in the first quarter, a significant number. But investors should heed management's observations about pricing.
Executives noted that customers are trimming their orders in response to price increases, omitting extras like fries to save money. Management said these reductions were minor but were happening in most of its markets. Sales from company-owned restaurants fell by 3% year over year.
MCD Net Income (TTM) data by YCharts. TTM = trailing 12 months.
This is something to keep an eye on. Revenue is still down more than 15% from a decade ago, and pushback on price increases could stunt revenue growth. When revenue slows, earnings growth depends more on financial engineering, like cutting expenses and share repurchases.
Share repurchases could become tighter
This isn't a new scenario for McDonald's, which has dealt with stagnant revenue by buying up its shares. You can see below that net income has grown 25% over the past decade, but earnings per share (EPS) have almost doubled because the company reduced its outstanding shares by 27% during that time.
MCD net income (TTM) data by YCharts.
McDonald's borrowed to fund many of these repurchases; the company's debt has increased by 177% over the past decade to $37 billion. That's a leverage ratio of three times earnings before interest, taxes, depreciation, and amortization (EBITDA) -- about as high as I like to see this metric go before getting concerned.
In other words, it's not only unlikely that McDonald's can repeat the past decade of buying back shares, but it also would arguably be financially irresponsible to do it. EPS growth could more closely resemble its slower net income growth without repurchasing shares.
Could the stock fall?
Slowing EPS growth could put pressure on the stock's valuation. Today, shares trade at a price-to-earnings ratio (P/E) of 30, about 20% above the long-term average. Just reverting to its average P/E over the past decade would imply a 20% downside from the current share price -- or no upside until the company's earnings grow enough to lower the valuation.
MCD PE ratio; data by YCharts.
Remember that debt is much easier to accumulate than to pay off; the dividend costs the company $4.25 billion each year, leaving about $1.4 billion in cash flow. It would take 10 years to pay down what it's borrowed over the past decade, and that assumes management halts repurchases and puts every extra dollar into the balance sheet.
McDonald's has outperformed the S&P 500 for much of its corporate life. But a high valuation and bloated balance sheet could mean investors are in for some lackluster years, especially with the stock at an abnormally high valuation. The company will likely need healthy revenue growth to earn its way out of its tight corner. Look closely at management's comments around pricing in future quarters.
