Two iconic food chains recently joined forces. McDonald's (MCD 0.06%) and Krispy Kreme will partner nationwide over the next few years.
McDonald's will begin carrying a selection of Krispy Kreme donuts at its restaurants, hoping to boost its traffic during breakfast hours. Shares of Krispy Kreme surged on the news. Is McDonald's stock likely to follow suit?
While it's a fantastic partnership, financial implications for McDonald's might not be what you expect. Instead, investors should focus on the company's base business and valuation to make an investment decision.
Here is what you need to know.
Donuts coming to a McDonald's near you
The announcement came after a test run of about 160 stores in the Louisville, Kentucky, area. McDonald's will roll the donuts out to all U.S. stores by 2026, featuring three flavors: glazed, frosted, and Kreme-filled. This could boost traffic during breakfast hours. McDonald's has emphasized its coffee products and has experimented with 24-hour breakfast. It's a clear sign that management is trying to grow here.
A boost in donut sales will trickle back to McDonald's as sales royalties, but the overall financial impact of this partnership is probably overstated. For one, McDonald's gets 38% of its revenue from the rent that franchisees pay the company. Next, it will be a gradual rollout that will take a couple of years to complete. The financial impact will likely be minimal for a while yet.
Investors can still applaud the partnership and showing a willingness to experiment to attract consumers. McDonald's has partnered with celebrities in the past to offer limited-edition menu items, and this partnership takes things a step further.
The stock is still quite hot
Shares of McDonald's have backed off from their 52-week highs and are roughly flat over the past 12 months. Does that mean the stock's a buy today? It's not that simple. Wall Street values the company's resilient business model and 49-year record of dividend growth.
The stock averaged a price-to-earnings ratio of almost 26 over the past decade, and shares are trading at a forward P/E ratio of 23 today. Despite the discount, I'm not sure McDonald's is an obvious buy.
MCD PE Ratio data by YCharts
Growth must be factored into a stock's valuation to give investors the whole picture. I like using the PEG ratio for this purpose. At a PEG ratio of 3, McDonald's stock is still expensive for its expected earnings growth, which analysts believe will average 7% to 8% annually over the next three to five years.
Share repurchases could slow down
The company's balance sheet is why I don't find McDonald's valuation attractive enough despite its discount to historical norms. The company has repurchased a ton of stock, lowering the share count by more than 26% over the past 10 years. To accomplish that, McDonald's had to borrow money at times, which has steadily leveraged the company to 2.6 times its EBITDA.
MCD Free Cash Flow data by YCharts
I don't think McDonald's is fundamentally weakened at its current debt level -- this is manageable. But I also don't expect McDonald's to be able to replicate its actions over the past decade. There isn't enough room to borrow money like that again. Earnings growth will likely be slower moving forward than it was with the repurchases, which warrants a lower valuation.
That said, McDonald's is a fantastic stock that investors can buy and hold forever while sleeping well at night. If you're buying and holding for years, sure. The stock is reasonably valued enough that you'll still make money over the long term. However, investors who want a good deal are better off waiting for a lower entry point.
