Does McDonald’s Have Anywhere Left to Expand?

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On Monday morning, the world’s largest fast food provider, McDonald’s (NYSE:MCD), reported its same store sales figures and total system sales figures (including new stores) for May. Here are the results:

  • Same store sales grew 0.9 percent worldwide.
  • Same store sales in the United States declined 1 percent.
  • Same store sales in Europe rose 0.4 percent.
  • Same store sales in the Asia/Pacific/Middle East/Africa region (APMEA) grew 2.5 percent.
  • Systemwide sales grew 2.4 percent worldwide, or 3.4 percent in constant currencies (remember that the dollar has been strong relative to APMEA currencies).

On this news, McDonald’s shares declined about 0.5 percent in a market that was slightly up, which reflects general investor disappointment in these figures despite the fact that the analyst consensus for the company’s worldwide same store sales growth was 0.8 percent.

There isn’t much to be surprised about in these numbers. In short, sales grew in the economies where populations and salaries are generally growing, and they were weaker in Europe and in the United States, where populations and salaries generally are not growing. Given these points, a bet on McDonald’s seems to be a bet on population growth.

McDonald’s, as an investment, is a pillar of stability. The company has pretty much expanded to the point where it simply cannot add enough stores to satisfy growth investors. This is why, for instance, companies such as Domino’s Pizza (NYSE:DPZ) and Yum! Brands (NYSE:YUM) are growing much more quickly in APMEA countries.

With regards to sales in the United States and in Europe, McDonald’s has nowhere left to expand, and this makes it difficult to grow sales. But investors have another reason to be worried when it comes to sales in the U.S. and in Europe: People who live in APMEA countries are just now being exposed to the “American Dream,” and McDonald’s offers them an inexpensive way to experience it. People in the United States and in developed Europe have been exposed to this for decades, and they have concepts of health-consciousness that are anathema to McDonald’s.

This is why fast food companies such as Chipotle Mexican Grill (NYSE:CMG) and Panera Bread (NYSE:PNRA) are growing their U. S. same store sales while McDonald’s is not. These companies offer healthy fast food that includes fruits and vegetables, as well as non-genetically modified products. While McDonald’s has tried to appear to be more health conscious, it is plagued by scandals such as “pink slime” or YouTube videos showing that McDonald’s food doesn’t decompose like “normal” food.

With that being said, as an investor you shouldn’t buy McDonald’s for the growth. You are essentially buying it as a bond-proxy. With shares trading at 18-times earnings and with the company paying a 3.2 percent yield, McDonald’s shares offer better value than Treasury Bonds or investment-grade bonds. This value disparity is greater when you consider that your gains earned in McDonald’s’ dividends and capital gains are taxed at the lower capital gains rate.

McDonald’s offers investors another advantage over bonds that makes it intriguing despite its lack of growth, namely that it can borrow money very inexpensively. Because of the company’s stable sales and consistent profitability, it can borrow money with an interest rate — less than 3.5 percent long term – that makes it rational to repurchase its own shares at 18-times earnings, especially since interest payments are tax-deductible. Remember that 18-times earnings is akin to a 5.5 percent earnings yield.

McDonald’s management is well aware of this, and as a result, it recently announced its intention to increase stock repurchases to the point where dividends paid plus stock repurchases exceed the company’s profitability. In short, the company’s management said that it is going to borrow money to repurchase shares.

This strategy may work for a while, but keep in mind that it is not a permanent strategy. Interest rates can rise, and given how low interest rates are historically, this is a reasonable possibility. Also, McDonald’s can see its profits decline. There is a lot of competition in the fast food space, and as we have seen, at least in the U. S., McDonald’s may not hold the best cards.

With these points in mind, McDonald’s may not be such a risky investment, but it is risky enough to want to question its merit at $101 per share. The company has highly restricted growth, and it is generating more shareholder value through financial engineering — borrowing money in order to buy back stock — than it is through growing its business.

Ultimately, I think the stock works best as a trading vehicle. If you think that bond yields will decline and that the overall stock market will be weak, then McDonald’s should do very well. But in a strong stock market environment, McDonald’s is a name to avoid. As we have seen, the stock topped out in May even though the S&P 500 has continued to climb, and the stock is no longer outperforming the S&P 500 as it was in the earlier parts of the year.

Disclosure: Ben Kramer-Miller has no position in McDonald’s or in any of the stocks mentioned in this article.

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