Please ensure Javascript is enabled for purposes of website accessibility

McDonald's Looks Undervalued: Buying Opportunity?

By Andrés Cardenal – Jan 23, 2014 at 1:20PM

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

McDonald's looks undervalued... is it a buying opportunity, or will competitors like Chipotle, Burger King, and Wendy's continue eating its lunch?

McDonald's (MCD 0.63%) is reporting uninspiring sales growth lately, and competitors like Chipotle (CMG -0.51%), Burger King (BKW.DL), and Wendy's (WEN 1.20%) are clearly outperforming the company. However, the stock looks attractively valued at current levels. Should you capitalize on the opportunity to invest in a solid company at a convenient valuation, or is the worst yet to come for investors in McDonald's?

Not so yummy anymore
McDonald's reported results for the fourth quarter of 2013 on Thursday. Earnings per share where marginally above analyst's expectations, but sales growth has become a recurring problem for the company during the last quarters. Global comparable sales increased by a lackluster 0.1% during the quarter; the average check was higher, but traffic declined versus the prior year.

Like many of its peers, McDonald's has turned to product innovation in order to differentiate its offerings in a highly saturated and competitive market. The company launched new products like its McWrap and Mighty Chicken Wings, and it also added more variety and different price alternatives to its Dollar Menu in order to compete more effectively in pricing.

However, customers seem to prefer other alternatives lately, and management recognizes that it needs to step up its efforts if the company is going to turn things around: optimizing the menu, modernizing the customer experience, and broadening accessibility are the three pillars in the company's plan to reignite growth in the middle term.

The competition
Fast-casual restaurants are gaining a lot of ground versus traditional fast-food chains lately, as customers seem more than willing to pay a few extra dollars in exchange for superior ingredients and a more sophisticated atmosphere. Chipotle is a growth leader in that category; the organic burrito company is outgrowing McDonald's by a considerable margin, and delivered explosive revenue growth in the area of 18% during the third quarter of 2013.

Burger King has made an impressive comeback during the last years; the company is remodeling its stores and introducing successful products like its lower-calorie french fries, Satisfries. Customers seem to be responding nicely to the company's initiatives: Global comparable sales increased by 0.9% during the third quarter of 2013, but total system-wide revenue grew by a stronger 4.9% on a constant currency basis.

Menu innovation seems to be the name of the game among fast-food chains, and Wendy's is proving to its competitors that effective innovation can bear its fruits. Offerings like its new Pretzel Bacon Cheeseburger and Pretzel Pub Chicken sandwich have been quite productive for Wendy's lately, and the company is forecasting a robust growth rate of between 2.5% and 3.5% in same-restaurant sales at company-operated restaurants during 2014.

Many companies in the consumer sector are experiencing lackluster demand lately, and the trend toward healthier nutrition is clearly not helping fast-food chains. However, competitors like Chipotle, Burger King, and Wendy's are doing much better than McDonald's, so the company can't entirely blame its uninspiring performance on outside factors like the economic environment or changing consumer habits.

Attractive valuation
Comparing valuation levels for McDonald's versus Chipotle, Burger King, and Wendy's, it's easy to see that the company is priced at a significant discount to its peers. McDonald's is cheaper than its competitors when looking at P/E ratios, forward P/E levels, and dividend yield, so the market is pricing McDonald's for slower growth.

Data Source: FinViz

The dividend yield of 3.25% looks quite tempting for a financially solid company with an outstanding track record of dividend payments. McDonald's has raised its dividend in each and every year since 1976, and the current payout ratio around 55% of earnings is quite safe for a big and stable business like McDonald's. The company's dividend yield and dividend growth track record should provide some downside protection from current levels.

Bottom line
McDonald's is finding it hard to generate sales growth, and competitors like Chipotle, Burger King, and Wendy's are doing considerably better and gaining market share against the fast-food giant. On the other hand, the stock is attractively valued, so downside risk seems to be limited unless things become materially worse for the company. If McDonald's manages to reinvigorate sales growth -- and that's quite a big "if"-- the company is offering considerable upside potential.

Fool contributor Andres Cardenal has no position in any stocks mentioned. The Motley Fool recommends Burger King Worldwide, Chipotle Mexican Grill, and McDonald's. The Motley Fool owns shares of Chipotle Mexican Grill and McDonald's. 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.

Premium Investing Services

Invest better with The Motley Fool. Get stock recommendations, portfolio guidance, and more from The Motley Fool's premium services.