Valuentum Exclusive Analysis for the Discerning Investor

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1. Difficult Comps to Come in Late 2016/Early 2017

McDonald’s (MCD) has come roaring back to life.

The company reported strong third-quarter performance October 22 and posted an impressive 4% global comparable sales growth rate in the period. We thought the fundamental performance was great, even though consolidated revenue and consolidated operating income dropped 5% and 2% in the quarter on a reported basis, respectively. On a year-over-year basis, constant-currency performance showed 7% top-line growth and 10% operating-income growth, both of which we thought were solid.

That said, the market seems to be accepting the report as evidence that McDonald’s is permanently back on track, but we’re striking a more cautious tone. We think the quarterly results and a few more good reports to follow represent a short-lived shot-in-the-arm from recent promotional initiatives than any sustainable dynamic that can or should be extrapolated into the perp with respect to the company’s valuation. McDonald’s all-day-breakfast initiatives have in part acted as a marketing tool to bring customers back to the Golden Arches, but once the fast-food giant starts to anniversary current performance of this year’s third and fourth quarter in the back half of 2016, excitement will fizzle out, in our opinion.

Where might we be wrong? If McDonald’s posts a consistent 4%+ global comparable sales comp in the third and fourth quarters of 2016 and into 2017, then we’ll likely have to revisit our fundamental assessment of the aging burger restaurant. Until that happens, we think caution is the word on the Street.

2. The “REIT” Catalyst Is Off the Table…for Now

We eventually believe McDonald’s will put the REIT idea for its real estate back on the table come 2017, when comparable store sales performance starts to wane again, which we expect to happen.

The Wall Street Journal had reported that board member Miles D. White stated the fast-food behemoth was nearing a decision on whether to create a “McREIT,” and November 10 brought news that the idea has been shot down, at least for now. We posit that management is very pleased with the share-price performance as of late—the stock is at all-time highs—and the board may be saving this “card” for when shares are under pressure, a reasonable assumption. That REIT stocks haven’t been performing well as a result of concerns of a drawn-out contractionary monetary cycle likely played a role in not pursuing a REIT, too.

Why do we think the “REIT” conversation is not over yet? McDonald’s is pulling out all the stops, and we think investors will be pushing for the spin-off of a REIT once shares come under pressure again. Right now, however, investors are happy, even if franchises aren’t.

3. The World Has Changed – McDonald’s Cost Structure

Let’s face it – the world has changed.

No longer do those working minimum wage jobs view the opportunity as a stepping stone to ascend the ladder of the universal dream. Individuals working for the lowest pay legally allowable want a “living” wage, and we believe there’s nothing that’s going to stop them from getting what they want.

On November 10, the Toronto Sun reported that US fast-food workers went on strike in 270 cities in a protest for higher wages and union rights. The “Fight for $15” campaign is real, and we think the workers are going to win. Berkeley was the latest city to raise its minimum wage to $15, and we think the tide will encapsulate most of the nation. Franchises simply can’t afford strikes and walk-offs, and certainly not subpar service from disgruntled employees.

Higher wages will prevail, and McDonald’s, just like WalMart (WMT) may feel tremendous pain in coming years. Here’s what WalMart is going through, and there’s nothing stopping McDonald’s from being next in line:

“…Walmart is at the center of a political upheaval in America that is challenging its business model. The company has become the poster child for all of what many workers believe is unfair pay, and such a tainted perception, fair or not, will be difficult to overcome as the ranks of millennials swell and demand their definition of “a living wage” after suffering through a very painful Great Recession. We talked about the upward path of labor expenses before, and we don’t see a scenario where they will abate…at least not anytime soon...

…On May 19, the US' second-largest city Los Angeles announced that it will raise its minimum wage to $15 per hour over time, following the lead set by Seattle and San Francisco. The wave for social change isn’t just transitory, and from our perspective, the “minimum wage” revolution has staying power. We’re hearing that there is a “minimum wage arms race” across the state of California. According to some reports, pizza places adopting the new wage hikes have to charge as much as $30 for a pizza and eliminate lunch hours, only to see sales fall 25%...

…The social avalanche for change and a higher minimum wage has not been an isolated event. Two years ago, dozens of New York fast food workers went on strike, and many believed that change wasn’t in the cards. But just last month, New York City raised “the minimum wage for fast-food workers to $15 an hour by the end of 2018.” Washington DC may be next in line for $15 per hour, and other major cities in the US may be next. With the social media waves overflowing with workers pushing for more and more, the ability of groups to exert pressure on organizations has reached a pinnacle in the history of time…

…Change is accelerating with each passing day, and we think Walmart may be the biggest loser in the court of social opinion. For one, we doubt employees are happy with Walmart’s plans to ensure that current Walmart associates will earn at least $10 per hour by February 2016, when the minimum wage in some of the largest cities in the US is 50% higher. The company’s employees and their families are essentially its customers, too, and frankly, it may not have a choice but to sacrifice margins to retain share. Playing hardball may only result in lower sales, creating what we would describe to be a not-so-virtuous employee/customer relations cycle.”

4. McDonald’s Valuation Is Stretched

We use a three-stage discounted cash flow model to value shares of McDonald’s and any other company in our coverage, save entities in the financials industry. The company’s share price has gotten far ahead of its fundamentals, in our view.

Not only are we building in some nice profit growth for Mickey D’s in coming years, but we’re also factoring in a comparatively low cost of equity (discount rate) within the valuation process. Even if you may not agree with us that McDonald’s shares are starting to get pricey, it’s difficult to say that the company’s shares are a bargain.

The fast-food giant is trading at ~22 times fiscal 2016 earnings, which factor in benefits related to recent promotional initiatives. Shares are definitely not on the “value” menu.

5. The Dividend Is a Distraction; Buybacks Will Be Value-Destructive

Savvy investors know that the board can do whatever it wants with the dividend until it can’t.

Sometimes the board uses the dividend to distract investors from what’s really happening in the business. Yum! Brands (YUM) and Kinder Morgan (KMI) are probably two of the more recent examples; both reported abysmal results but raised their dividend all the same. Investors have to be careful—management knows that you’re viewing the dividend as a signal, so don’t fall into the trap of accepting increases at face value. Stay focused on the fundamentals, not on arbitrary payout levels set by management.

Further, investors sometimes forget that they already own everything that management could ever give them. Entities that engage in massive capital return projects are merely moving money around. What’s most important, however, is that management does not destroy "economic value" when pursuing such endeavors. McDonald’s is loading up on debt, which has resulted in a credit-rating downgrade, and it is using the newly-raised capital to buy back its own stock in droves.

In no way do we view McDonald’s shares as a bargain, so by extension, we'd view buying stock back at all-time highs as a foolish use of the cash. Said differently, the move is value-destructive, and while shareholders may benefit from a short-term boost in the stock price from open market purchases, investors are not getting the biggest bang for their buck. Don't get us wrong: There’s nothing wrong with optimizing the capital structure, but such a move is better completed when shares are trading at a bargain than when they are pricey and at all-time highs.

The company plans to spend $30 billion for the three-year period ending 2016 in share buybacks and dividends, nearly double the $16.4 billion in the three-year period ending 2013. Management spent ~$4.7 billion in share repurchases year-to-date through the end of September.

We value shares of McDonald’s at $85 each. Any repurchases made above this level increases the risk of destroying shareholder capital. You wouldn't buy overpriced stock, right? So why should management? The concept is the same.