You'd never know by looking at McDonald's (NYSE:MCD) stock that its business was in deep trouble.
Sales are in the midst of a three-year slump, its international business is falling alongside domestic operations, and now its franchisees appear to be on the verge of open revolt following what is being described as a shaky national rollout of the new all-day breakfast program. Yet McDonald's stock has never been better. Shares are up 15% so far in 2015 and have jumped more than 20% over the past year, hitting an all-time high of $104 a stub.
So, why the disconnect between how the business is going and what the market's response has been?
The problems with McDonald's are legion. The growth of better-burger shops like Shake Shack and In-N-Out Burger helped siphon away customers while higher commodity costs, particularly beef, hit earnings. Then there are the higher labor costs McDonald's is incurring due to unilaterally increasing the minimum wage of its employees.
Despite CEO Steve Easterbrook's pledge to transform McDonald's into a "modern, progressive burger company," sales are still falling. Global comparable sales fell 0.7% in the second quarter and were down 2% in the U.S., the seventh straight quarter comps fell. It's reporting third-quarter sales this week, and no one's expecting much -- if any -- improvement.
Still, there are some reasons McDonald's is able to maintain a lofty stock price.
- Still profitable. Despite its troubles, McDonald's remains a highly profitable business, generating over $2 billion in net profits in the first six months of 2015, and almost $4.8 billion last year.
- Global footprint. There are about 35,000 McDonald's restaurants worldwide, 14,000 in the U.S., that, should it get the formula right, can quickly turn things around.
- Substantial marketing power. McDonald's is still the straw that stirs the drink in fast food, and even doing something small has a large impact on how the competition responds.
- A sickbed, not a deathbed. The burger joint's business is broken right now, and though many of its prescriptions seem wrong-headed at the moment, we're not witnessing McDonald's last days.
In short, the reason McDonald's stock continues to soar is that investors realize it will only take small steps to make a dramatic difference, and they continue to expect CEO Easterbrook to come through.
A blind spot
Yet that can prove to be their downfall. All they need to do is look at Yum! Brands (NYSE:YUM) to see how quickly things can unravel.
The owner of KFC, Taco Bell, and Pizza Hut is in many respects similar to McDonald's: both have a large, global presence, and aside from the burger chain, only Yum! Brands has successfully tapped into the fast-food market in China. In fact, it's the largest fast-food chain in that country, with more than 6,800 restaurants (McDonald's has less than a third of that number).
Yum! Brands is undergoing its own set of troubles. While it's U.S.-based Taco Bell chain has largely been performing ahead of expectations, particularly with the introduction of a breakfast menu that's challenging McDonald's ownership of the daypart, much of the rest of its operations have been sluggish at best, and only just recently has it begun reporting better results.
Overseas, though, is a different story, especially in China, which accounts for more than half of Yum! Brands revenues and a third of its operating profits. When it was hit by its second food scandals in as many years last year, Chinese customers fled in droves. But management maintained a brave front for investors, saying it expected customers to return in the back half of this year, and it would hit its 10% earnings growth target.
Shares of the restaurant operator soared, peaking at a record high of $95 each. This lasted until Yum! Brands reported third-quarter results and was forced to admit its recovery in China was going much slower than expected, and rather than 10% growth, earnings would only expand in the low single digits at best. Then its stock cratered, falling 20% in a day, and has lost a quarter of its value from those highs.
The coming comeuppance
McDonald's investors have been forewarned. With the chain reporting earnings this week, and expectations elevated that Easterbrook's reforms will start gaining traction, the market may be sorely disappointed if they fail to materialize.
It's been my contention that McDonald's under Easterbrook is on the wrong path, that Shake Shack and Chipotle Mexican Grill are not its main problem. McDonald's attempts at emulating them are doomed to fail because it's always been viewed as a value meal, and customers won't want to pay up for fast food.
But that doesn't mean McDonald's is going out of business. It only means investors who were hoping for a change in direction from a few of the ideas management has been throwing at the wall may find the stock going in the opposite direction instead.
Rich Duprey has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Chipotle Mexican Grill. 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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