McDonald’s (MCD) has made its way on to my defensive screen that I have setup at GuruFocus. The 10 percent drop in price for McDonald’s since May has caused its P/E to fall to 17.
The screen is designed to find stocks with strong financials and low volatility and valuations when compared with the S&P 500, so that it can better retain its value during a downturn in the markets. Petsmart (PETM) and Ross Stores (ROST) are the other two stocks on the list. Petsmart received attention from activist investors about a month after its appearance on the screen, and Ross Stores has rebounded from $62.15 to $65.38 since my article on July 16.
Here are the criteria for the defensive screen:
Business Predictability: Minimum of 5 out of 5 stars
Financial Strength: Minimum of 7 out of 10
Warning Signs: Maximum of 0
Altman Z-Score: Minimum of 2.99
P/E: Maximum of 17
Beta: Maximum of 1.0
Dividend Yield: Minimum of 0.10%
High business predictability indicates that a company has a strong history of producing operating profits. The companies have not had an operating loss in the past 10 years. 5-star stocks have had an average annual return of 12.1 percent over the past 10 years. Only 3 percent have had a loss if held for the full 10 years. The criteria for warning signs can be related to both the financial statements and issues concerning the characteristics of the stock. The Altman Z-Score is an accurate forecaster of failure up to two years prior to distress. A score above 2.99 indicates a safe level. I chose to screen for a P/E of 17 or less in order to find stocks that were not trading with higher valuations than the S&P 500. Finding stocks with beta of less than 1 will result in companies that are less volatile than the S&P 500. The dividend yield will help provide support for the stock if the overall markets are in a downturn. Let’s take a look at how McDonald’s fits the criteria.
Company Background:
McDonald’s is the largest and most well-known fast food restaurant in the world. Its first hamburger restaurant opened in 1948, and the company now serves over 70 million daily customers in 119 countries. According to the latest annual report there are 35,429 restaurants with 28,691 of them being franchises. Across all of its restaurants, there were $89.13 billion in sales. The company is still growing and is planning on expanding its restaurant count by about 3.8 percent throughout the year.
Financial Strength:
McDonald’s scores an 8/10 for Financial Strength. Its equity-to-asset ratio is in line with the Global Restaurant industry, but its high interest coverage of 16.79 is higher than 66 percent of the companies in the industry. The strong “A” rating on McDonald’s bonds led to lower interest rates on its debt. Cash on the balance sheet has been increasing at an annual rate of 9.04 percent compared to annual increases in debt of 7.82 percent over the past five years.
The company also ranks an 8/10 for Profitability & Growth. It has higher margins and return on equity than 96 percent of the Global Restaurant industry. McDonald’s has a net margin of 19.87 percent and a return on equity of 34.89 percent. Both of the measures have been steady over the past five years. The company has been struggling lately, and its growth has largely been coming from new store expansion. Same-store sales have been relatively flat for the past year. EPS only increased 1.45 percent year-over-year for the second quarter of 2014. McDonald’s will need to figure out how to restart its engine and drive some more growth into the company.
McDonald’s has a commitment of returning all free cash flow back to investors through dividends and stock buybacks. The stock is on the list of S&P 500 Dividend Aristocrats, meaning that the dividend payout has increased for 25 consecutive years. The dividend yield is currently 3.39 percent, and its payout has been increasing at an annual rate of 11.39 percent over the past five years. The dividend is safe with a payout ratio of 0.58. Shares outstanding have been decreasing at an annual rate of 2.46 percent over the past five years. Overall, $4.9 billion was returned to shareholders last year, a 5.3 percent return of capital based on today’s market cap of 92.35 billion.
Management:
Donald Thompson has been the president and CEO since July of 2012 and has been with the company for 23 years. He was previously the chief operating officer. His other positions include president, executive vice president, and chief operations officer of McDonald’s USA. The stock has largely underperformed since he has taken over with it being up about 5.5 percent compared to the S&P 500’s increase of over 40 percent. He addressed the company’s slow growth in the latest earnings release with the following comment:
“During the quarter, we evolved our strategic Plan to Win framework to enhance our focus on the customer through insights, planning and actions. To reignite momentum over the next 18 months, we’re focused on fortifying the foundational elements of our business by concentrating our efforts on compelling value, marketing and operations excellence to become a more relevant and trusted brand.”
The chairman of the board is Andrew McKenna. He has held the position since 2004, and the stock has increased 256 percent since he took charge ten years ago. He is getting up there in age and is 84 years old. There will soon be a time for a new chairman to take over, or he could be chairman of McDonald’s for as long as Warren Buffet is chairman of Berkshire Hathaway who has no plans of ever stepping down. They are both the same age.
Valuation:
On a P/E basis, McDonald’s is trading near its lowest valuation in three years. Its P/E is lower than 90 percent of the 327 companies in the Global Restaurant industry, and its PEG is lower than 87 percent of the companies. The P/E is 16.9 and PEG is 1.9 when comparing its P/E ratio with its 5-year average EBITDA growth rate. The stock’s 10-year median P/E ratio is 18.1. At its median P/E, the stock is valued at $100.02 making it undervalued by about 6.6 percent.
| Ă‚ | Market Cap (Billion) | P/E | PEG | Business Predictability | Financial Strength | Profitability & Growth |
| McDonald's | 92.71 | 16.9 | 1.9 | 5 | 8 | 8 |
| Starbucks | 57.65 | 29.7 | 1.3 | 1 | 8 | 6 |
| Yum Brands | 30.66 | 26.6 | 4.1 | 4 | 8 | 8 |
| Chipotle | 20.88 | 59.3 | 2.5 | 1 | 7 | 8 |
| Burger King | 9.33 | 35 | N/A | Not Rated | 6 | 5 |
| Tim Hortons | 7.35 | 20.6 | 2.8 | Not Rated | 8 | 8 |
Risks:
There are plenty of risks currently associated with McDonald’s from changes in consumer tastes to American backlash in Russia. The population is becoming more conscious of the food it eats and is moving away from food that is genetically modified and full of chemical fillers. Sales at Chipotle, known for its health conscious foods, had same-store sales increase 15.5 percent for the first half of the year. It is ironic that McDonald’s once owned Chipotle.
Russia is pushing back on U.S. sanctions and is looking to increase its own sanctions on the U.S. McDonald’s has closed its three company-owned restaurants in Crimea and currently has no plans to reopen them. Some Russian politicians are calling for all 400 of the McDonald’s in Russia to be closed. That move could backfire on the country since it would hurt the Russian food suppliers.
McDonald’s is counting on China to help fuel growth in the company but suffered a setback when a meat supplier in the country was repackaging expired products for resale in the restaurants. Burgers and McNuggets were pulled from the menus and ties were cut with the supplier. It is now working with existing suppliers to increase capacity, so burgers and McNuggets can make their way back to the menu.
The inability to increase sales is also a risk. The CEO mentioned an 18-month plan to reignite momentum, but if that momentum does not materialize, calls for management change could begin to surface. Mr. Thompson has only been on the job for two years, and it takes time to change the direction of a $92 billion company. The worst case scenario I see is a combination of lagging sales and a possible retirement of Andrew McKenna at the end of the 18 months. If this happens, there will be uncertainty at the two highest positions in the company.
Outlook:
McDonald’s is expected to maintain its dominance in the fast food industry. Janney Capital Markets recently released a report predicting that McDonald’s will easily remain the top restaurant in America throughout the rest of the decade. The risks listed above have brought the stock’s price down into correction territory and is now trading near its lowest P/E ratio in three years. Its high business predictability, strong financial condition, high returns on equity, high returns of capital and low relative valuations make McDonald’s a safe bet to ride out a downturn in the markets.
Of the investing gurus we follow, Bill Gates controls the largest position of 10.9 million shares through the Bill and Melinda Gates Foundation Trust. The position represents 1.1 percent of the shares outstanding. You can follow the gurus to see how they are trading McDonald’s: McDonald’s Guru Trades. You can also follow the defensive screen through the following link to see if any new companies appear: Defensive Screen.
