If you remember, back in 2014 or so, McDonald’s Corporation (NYSE:MCD) was struggling. Comparable store sales were declining. Competition from other chains was increasing. The CEO seemed afraid to mess with the formula that had worked for a generation, yet MCD stock was in trouble.
A new CEO was brought in from the European operations side. He knew what to do and executed brilliantly. In short, he needed to change McDonald’s while still keeping it the same. The formula wasn’t all that difficult. Like other chains, he just needed to create different variations on the same theme McDonald’s had used for decades.
And everyone was overjoyed that, finally, breakfast was available all day.
Comps improved. Customers returned. MCD stock responded. Even though the entire market has been on fire, McDonald’s stock has just about doubled from its lowest point during that difficult time.
Therein lies the current problem with MCD stock — it got ahead of itself.
MCD Stock Valuation Is Too High
The new CEO wanted to sell off company-owned store and get McDonald’s to the point where 95% of the base was franchised. There are many reasons for this. First, margins at franchised stores are higher. Also, franchised stores means the parent isn’t paying for store overhead. In addition, franchise stores generate lots and lots of free money: royalties.
With this approach, McDonald’s stock loses the revenue from the stores it once owned, but receives the higher-margin franchise revenue I alluded to earlier. Hence, if MCD can get more margin from franchised stores than owned stores, the plan wins.
So far, the plan is working.
Gross margin in 2017 is 51% compared to 48% in 2016. Meanwhile, expenses have declined slightly. That’s great, but this portion of the plan is going to die out once the franchising efforts reach their goal. Management has even said to expect earnings-per-share (EPS) growth in the high single digits going forward.
Bottom Line on MCD Stock
This means that growth will come from continued reliance on menu offerings and changes in that experience — which is fine. The problem, however, is that the rise in MCD stock has been so pronounced that it is difficult to justify its 24 trailing-twelve-months-net-income multiple. If EPS growth comes in at, say, 8% annually, is it really a good idea to pay a PEG ratio of 3.0 for McDonald’s stock?
I don’t think so.
If you read my column, you know that’s been the song for most stocks. They are trading at multiples that are way out of whack. Sure, some stalwarts like MCD maybe deserve a premium over the standard PEG ratio calculation — but not triple what that number should be.
So, like most stocks, I suggest waiting for the inevitable large correction that will take this market down 30% or more and, then, you can grab that burger.
Lawrence Meyers is the CEO of PDL Capital, a specialty lender focusing on consumer finance and is the Manager of The Liberty Portfolio at www.thelibertyportfolio.com. He does not own any stock mentioned. He has 23 years’ experience in the stock market, and has written more than 2,000 articles on investing. Lawrence Meyers can be reached at TheLibertyPortfolio@gmail.com.
