Investors Are Paying a Big Price for McDonald's Growth

McDonald's (MCD) earnings were better than expected, but the results re-exposed the lingering weaknesses in the firm's fundamental business. The company reported year-over-year revenue growth of only 2% to $7.2 billion, slightly better than analysts' average expectation of $7.15 billion. EPS of $1.38 beat expectations of $1.33 -- estimates were lowered several times by analysts before the earnings. The firm reported $5.36 EPS for the full year.

Higher commodities and labor costs reduced McDonald's margin to 19.5% in the US. Margins continue to remain in a downward trend -- McDonald's reported U.S. margins of 21.3% in 2010 and 20.6% in 2011. Similarly, in Europe, margins have fallen from 19.8% in 2010 to 19.1% in 2012, and APMEA margins fell to 15.9% in 2012 from 17.8% in 2010.

McDonald's introduced several new value offerings and expanded its Dollar Menu in 2012. This has translated into higher sales volume globally, but is eroding margins as consumers are now purchasing less expensive items from the menu. Offering cheaper items in the menu is squeezing margins that could have a serious negative effect on McDoanld's bottom-line going forward. Moreover, McDonald's increased prices by only 2% during the entire year, when the inflation for the entire sector stood at around 3%, exacerbating margins that were already under pressure from the rising costs of commodities.

McDonald's also faces fierce competition in the value market from Wendy's, which will make the planned expansion of the US business even more difficult. Moreover, Wendy's is improving its inventory turn (cost of goods sold divided by the average inventory value) at a faster rate than McDonald's. Though Wendy's still goes through its entire inventory at a slower rate than McDoanld's, Wendy's is making it efficient at a much faster rate.

Higher inventory turn can have a significant positive impact on the bottom line of a company. By decreasing the amount of capital tied to inventory, a company can use the excessive cash on hand to expand the business by opening more stores and increasing its advertising budget. It eases the strain on cash flow and grants management much more flexibility in operating the business more efficiently.

Consolidated revenue in the quarter amounted to $630 million, which was a 2.4% raise compared to the previous year's consolidated revenue of $615 million. Full-year same-store sales increased 1.6%. But most notably, and unlike McDonald's, operating margins rose to 15.9%, compared to 15% in the same quarter of the previous year. Moreover, Wendy's has forecasted full year operating margin of 14.5%. This improving operating margin and forecast clearly show that Wendy's is performing much better than McDonald's.

Moreover, McDonald's faces competition from Burger King as well. Both McDonald's and Burger King are lowering their coffee prices in order to get more business from people who start their day with a cup of coffee. Compared with McDonald's coffee price of a dollar, Burger King has started offering coffee for just a quarter. Burger King is also attracting more business by introducing more family-oriented foods on its menu, which is traditionally a McDonald's core strength. This rising competition in the US has led to McDonald's reporting its first monthly sales decline in over nine years in 2012.

The company reported that global same-store sales increase of 2.7%, compared to an increase of 1.2% in the year-ago quarter, and completely eclipsing McDonald's dismal global same-store sales growth for the same period, which increased just 0.1%. Overall, Burger King completed the year with a global same-store sales increase of 3.2%.

Moreover, McDonald's long-term guidance of 3%-5% revenue growth and 6%-7% operating income growth was a real disappointment. Before the earnings, analysts on average were expecting fiscal year 2013 sales growth of over 5% and operating income growth of around 8%. Historically, Mcdonald's has managed to get into the high-teens with their free cash flow margins. Due to rising capital expenditure expenses, I don't think the company has any potential for improvement here -- however, I do think high-20s operating cash flow margins are attainable, but getting into the low-30s would be quite a feat.

Not all is bad for McDonald's. The firm currently pays a dividend that has grown rapidly since it was first started. Moreover, the total share count has fallen from 1.16 billion in fiscal 2008 to almost a billion at the end of 2012, and considering management's plan to spend a big chunk of the future cash flow on buybacks and dividends, this trend should continue.

Conclusion

All told, I think McDonald's can grow its free cash flow at a 6%-7% rate for the long term -- discounting that back, it suggests a fair value of about $103. Admittedly, that's not a compelling target relative to today's price. Moreover, fears of competitors eating into McDonald's operating margins make me a little nervous about paying too close to my suggested fair value, especially since the discount has now shrunk -- as the shares trade near a 52-week high.

Consequently, I'm indifferent about buying shares at these levels. However, I would certainly consider a purchase if a broader market sell-off sends the shares down into the low $80s, as the shares present an attractive risk/reward there. But McDonald's is generally regarded as a top-notch company and the shares rarely get cheap. So, waiting in the hopes of getting McDonald's at a substantial discount could be a long wait.

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