By Kris Rosemann
McDonald’s (MCD) shares took a hit after the burger giant reported second quarter results July 26, and we can’t say we are the least bit surprised. In fact, if we did, we would be flat out lying; we’ve been skeptical of its turnaround plan since it was released in May 2015, “Turnaround Plan at McDonald’s Does Not Fly With Franchisees.”
It seems as though we’re beginning to see what we had been expecting, and what bullish McDonald’s investors had been hoping they wouldn’t so soon; that is a slowdown in comparable-store sales growth, particularly in the US. Global comparable store sales growth came in at 3.1%, not a bad number in itself, but short of consensus expectations of 3.6%. Meanwhile, US comparable store sales growth left even more to be desired at 1.8%, compared to expectations of 3.2%. Similarly unimpressive was the 1.6% comparable store sales growth in the firm’s ‘High Growth’ segment, hardly high growth at all.
However, the issues in McDonald’s US growth may not be firm-specific. Same-store traffic across the entire restaurant industry in the US in the second quarter of 2015 fell 3% on a year-over-year basis. With traffic falling, promotions and other marketing gimmicks are likely to increase, which will likely impact menu pricing strength (and franchisee satistfaction) moving forward. Generally speaking, we think McDonald’s brand power should give it a leg up in this area, but we continue to warn of the firm’s need to sustain impressive bottom-line growth for at least the next few years to grow into its current valuation, if ever. Shares, for example, are trading at more than 20 times fiscal 2017 earnings, which implies significant expansion over 2016 numbers (on the basis of consensus forecasts). The market is way ahead of itself, in our view.
Though we’ve downplayed it a bit, it may now be worth noting that Brexit has the potential to be meaningfully harmful to McDonald’s bottom-line results as well. Coming to light is that the firm has the highest exposure to the UK and Europe of any US-based restaurant with 37% and 9% of revenue coming from Europe and the UK, respectively. Not only does consumer confidence rest in the balance with the looming economic uncertainty in the region, but outsize currency headwinds could provide a material drag on reported results as well. McDonald’s may now be fighting an uphill battle.
Still, “Mickey D’s” continued to work to boost operating margins via refranchising efforts in the second quarter of 2016, but operating income growth slowed materially from recent quarters and was up only 3% in constant currency–we were expecting a lot more and so was the market! Operating income growth on a constant-currency, year-over-year basis came in at 28% and 16% in the two prior quarters, respectively. Diluted earnings per share fell 1% from the year-ago period on an as-reported basis, though a number of one-time charges were largely responsible for the disappointment.
McDonald’s poor quarterly results play directly into our thesis on the firm, and the outside pressure from weakness in the US restaurant industry only adds to investor concern around the fast-food giant. Our opinion on the company remains the same as it was following its first quarter earnings report, “Restaurant Roundup; Valuations Overcooked.”
If McDonald’s is to grow into its current share-price trajectory and valuation, it will need to continue to put up impressive comps growth and execute flawlessly to continue its bottom line strength. The ongoing refranchising will certainly help expand margins, but will the improvement be enough? We don’t have enough confidence to make that call at the moment. The sustainability of the fundamental drivers behind McDonald’s performance over the past year is not likely replicable over the long haul, and eventually investors will realize the biggest draw to the firm remains its brand name, not the “growth potential” behind egg sandwiches now being available all day.
The biggest difference between our reaction to McDonald’s first-quarter 2016 report and now the second quarter report is that what were once merely concerns a few months ago now appear to be becoming a reality for the fast-food giant. The company may very well catch another “comp growth” updraft in the future thanks to its impressive brand strength (and easier lapping of weak quarters), but even so, its valuation is making our nose bleed. Surely McDonald’s is a fantastic company with a very nice dividend yield, but its stock may be just starting to slip. Caution. Our fair value estimate remains unchanged at this time.
Related tickers: BITE, ARCO