It seems as if we were toasting the turnaround at McDonald's (NYSE:MCD) just a few months ago, and now at least one former bull is changing his tune. Argus analyst John Staszak downgraded the stock on Monday -- taking it from buy to hold -- on concerns that Mickey D's will be challenged by slower comps growth, rising labor costs, and the improving value proposition of eating at home.
The stock had already started to stage a retreat since hitting an all-time high in May, down nearly 10% ahead of yesterday's Argus downgrade. Investors, one would think, have already started to move on from the McDonald's turnaround story. However, there are a few reasons why the recovery may just be getting started.
1. Rising labor costs are an advantage for McDonald's
Between minimum wages moving higher and healthcare costs escalating, it's getting more expensive to keep employees around. This is naturally something that will continue to weigh across all retail establishments, but let's not assume that this is a disadvantage for McDonald's.
For starters, the typical McDonald's store rakes in roughly $2.5 million a year in sales. That's twice as much as Restaurant Brands International's (NYSE:QSR) Burger King. It's also better than most of the smaller "better burger" chains. Heavy sales volume makes it easier to absorb an uptick in labor costs.
McDonald's also has the advantage of scale. As the world's largest burger chain -- and the world's largest restaurant operator in terms of revenue -- it can afford to invest in automation. From testing ordering tablets to the rollout of soda systems that automatically dispense fountain drinks as they are ordered, few chains have embraced technology as a way to trim human labor requirements like McDonald's. It has the means to keep investing on that front.
More importantly for investor purposes, it's important to remember that more than 80% of its locations are franchisee-operator. It's the franchisees footing the payroll with McDonald's collecting the high-margin royalties and licensing fees.
2. Cheaper eats at home is another plus for McDonald's
Commodity food costs have been inching higher this year, but it's undeniable that it's still cheaper to eat at home. In a somewhat ironic twist, Argus' Staszak upgraded McDonald's in January, partly on the benefits of lower food costs. It's odd that cheap food at home is now a key piece in the neutral thesis seven months later, but even McDonald's management has conceded that the gap is growing between restaurant food and the food folks prepare at home.
It's easy to see why pricier quick-service chains and tip-hungry casual-dining establishments will be at the mercy of folks eating in to save some dough. The argument doesn't hold up so well at the low end where McDonald's, Restaurant Brands International's Burger King, and other entry-level burger flippers offer several items for as little as a buck.
3. McDonald's may be cheaper than you think
After two years of negative quarterly comps, McDonald's finally turned the corner late last year. It's now on a streak of three consecutive quarters of positive same-store sales growth. The comparisons will get harder by the time we get to the fourth quarter when it's no longer pitted against sandbagged results, but that's not a deal breaker.
Staszak points to the stock's "relatively high valuation" as another reason to go from bullish to neutral, but is that really the case? He does point out that reported revenue is declining, but that's actually the result of McDonald's transferring more company-owned stores to franchisees, a process that will actually make it less susceptible to rising food and labor overhead and improve its already impressive net margins.
The 10% sell-off since May's peak and earnings improvement also makes the stock less expensive. McDonald's stock is now fetching 21 times this year's projected profit and 19 times next year's target. That may not seem cheap given the mature chain's slow growth, but investors expect to pay a premium for the McDonald's brand.
Let's also not forget the stock's attractive 3% yield. Even if the stock goes nowhere, that yield should inch higher later this year when McDonald's bumps its payout higher the way it has for the past 39 years.
Mickey D's isn't perfect. No stock is perfect. However, this downgrade seems to come at a time when the slowdown is already discounted and some positive potential catalysts are being ignored by the market.