McDonald's Future Is Hard to Digest (NYSE: MCD)

May 20th, 2015
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Money Morning Article of the Week

by Shah Gilani, Money Morning

I love McDonald's burgers, fries, and shakes. What I don't love is its current stock price.

Don't get me wrong, the stock's been a huge gainer over the past decade. It's risen more than 230% in the past ten years while throwing off decent dividend income.

Follow up:

But what's hard to digest, with the stock 5% from its all-time highs, is where it goes next.

If you own McDonald's (NYSE: MCD) or are thinking about buying it, here's what I suggest: tread carefully and put in a few simple hedges - like put options. There's definitely upside here, but investors have to protect themselves. And I'll tell you how.

Getting the Recipe Right

The first thing I look at when I'm analyzing a food company is the food. Like I said, I love McDonald's, at least the same few items I always get. As far as their other menu items, there may be too many.

Although it's nice to have a lot of options, McDonald's is a fast food joint, so I don't want to be overwhelmed by too many menu items.

In fact, analysts say McDonald's has too many menu items. In order to be more things to more people the company has been adding more and more items for years. But the Wall Street pro consensus is they've diluted their core higher-margin brand items with too many cheaper options.

When the company added "Dollar Menu" items, most of their regular patrons opted for the cheaper offerings and haven't ventured back to higher-margin menu items.

That plan backfired because while they originally planned on a limited Dollar Menu run to get back cost-conscious diners, business fell off every time the company tried to phase out Dollar Menu offerings.

Now company big-wigs are talking about changing the menu again.

The last two menu changes didn't help the company's slipping sales. So an investor in the stock has to wonder if company management has a clue what to offer their customers.

They might go more "wholesome," more "organic," more "socially and calorie conscious," or more "made-to-order." The problem with those changes is, while they may make sense on paper, they'll put Mickey D's into more direct competition with a host of casual-dining and hot-trendy competitors.

That's likely to turn off more traditional customers before it brings in enough new customers to give new items a try, especially if more "organically sourced" ingredients end up costing customers more. As far as revenues, that's a slippery slope.

The Advantage of More Global Franchises

What McDonald's has going for it is it's in 119 countries. Its 36,290 stores dwarf any competitor.

McDonald's has announced one strategic change that should benefit investors: it's going to add more franchise stores and cut back on company-owned stores. That's good news for the stock in the longer-run because company-owned stores have a much lower profit margin than franchised stores.

Although no actual timeframe was given by the company, the company plans to reduce company-owned stores to only 10% of all stores over the next couple of years. That would be a reduction of about 2,400 stores out of the 6,734 the company now owns outright.

One big reason the company is cutting back on 100%-owned stores is because franchisees put in a lot of capital and pay for equipment and leases, which doesn't impact net profits, but results in higher margins for all those restaurants.

Another big problem with company-owned stores is they too often dictate terms across the whole business. The company's recent big public relations gambit to increase wages for McDonald's workers wasn't company-wide. It was only mandated at company-owned stores. Franchisees are livid. The company is now facing a huge battle with the vast majority of its store owner-operators, who aren't employees, but effectively partners.

S&P, Moody's, and Fitch have all recently downgraded McDonald's debt, which is fairly substantial at $14.29 billion.

One way to better capitalize the debt load, which is mostly real estate acquisition related, is for the company to spin off its real estate holdings into a real estate investment trust. Some activists say that's a good idea and would greatly improve McDonald's true value. The company hasn't embraced any talk on the subject.

A Time for Caution

While McDonald's stock has been a stellar performer over time, I'm not sure it's worth an investment at this juncture.

The stock over the past decade trades at an average price-to-earnings (PE) multiple of 15.9; today its PE is more than 22. That's relatively pricey in historical terms and up there with the rest of the market.

I'm not in favor of spending billions of dollars every year to buy back stock. If cash flow is so great and so regular, why not reward stockholders with higher dividends? Dividends are more tangible. All that money spent on buybacks can go down the drain if the stock collapses in a market rout. If cash flow is strong enough to keep up healthy dividend payments and the stock drops, it becomes more enticing for existing stockholders to average down, knowing they will increase their dividend yield, and the stock becomes more attractive to new investors for the same reason.

Buybacks, to me, are a signal that management is more inclined towards financial engineering to support the stock price as opposed to good-old company growth and margin expansion moves.

I'm going to wait to see what happens with McDonald's menu changes, see how their profit margins go, see how they apply their cash, see how new CEO Steve Easterbrook handles the franchisee backlash and wage issues, and see what Mickey D's competitors do before considering the stock.

There's a lot to like about McDonald's, if management gets it right. The play for me will be seeing if changes create instability in the stock and an opportunity to buy it lower.

I'll buy shares if it slides enough and if, at the same time, I like what management is doing to "recreate and refresh" the global icon McDonald's used to be.

If I owned the stock, I'd certainly want to put in a floor in case the price falls on account of questions about what changes are coming, or not coming. Below $94 the stock would start to worry me. One protective play would be to buy $94 strike price put options a few months out. They're cheap insurance in case the stock falters at that level.

Generally, I'm inclined to take profits - especially when my stocks have had a nice run, as McDonald's has. If I owned the stock and it moves higher I'd be looking to take profits near its highs around or over $103 and consider re-entering at lower levels.

While McDonald's can do a lot with its stores and menu, the stock isn't likely to jump substantially any time soon. That's why taking some profits or protecting your gains now makes sense.

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