Source: PaxForex Premium Analytics Portal, Fundamental Insight
McDonald's, the popular fast-food chain, has experienced significant success in the past decade, surpassing the performance of the S&P 500. The company's sales growth has been fueled by price increases, resulting in a notable double-digit surge in the first quarter of 2023.
However, there are indications that McDonald's pricing power may be waning. Management has observed a trend of customers reducing their orders, with fries being a common casualty due to budget constraints.
Investors now face a decision. Is McDonald's losing its ability to raise prices, or does the stock still hold potential for their portfolios? The available data suggests that the company's future may not be as promising as its illustrious past. Here's what you need to be aware of.
Investors need not overreact and panic as if there is a crisis at McDonald's. The company demonstrated substantial growth in global comparable-restaurant sales, recording a remarkable 12.3% increase year over year in the first quarter. However, it is crucial for investors to take note of management's observations regarding pricing.
McDonald's executives have acknowledged that customers are adjusting their orders in response to price hikes, opting to exclude extras such as fries in an effort to save money. While these reductions were relatively minor, they were observed across most of the company's markets. Sales from company-owned restaurants experienced a decline of 3% compared to the previous year.
It is important to closely monitor this situation. Despite recent improvements, McDonald's revenue remains over 15% lower than it was a decade ago, and resistance to price increases could potentially hinder revenue growth. When revenue growth slows, the company relies more on financial tactics such as expense reduction and share repurchases to drive earnings growth.
McDonald's has previously employed this strategy to combat stagnant revenue. As illustrated below, while net income has grown by 25% over the past decade, earnings per share (EPS) have nearly doubled due to a 27% reduction in outstanding shares during that period.
McDonald's relied on borrowing to finance a significant portion of these share repurchases, resulting in a 177% increase in the company's debt over the past decade, reaching $37 billion. This translates to a leverage ratio of three times earnings before interest, taxes, depreciation, and amortization (EBITDA), a level that typically raises concerns.
In essence, it is improbable for McDonald's to replicate the share buyback activity seen in the past decade, and doing so would potentially be financially imprudent. Without the significant impact of share repurchases, the growth of earnings per share (EPS) may more closely align with the slower growth rate of net income.
Slowing EPS growth has the potential to create downward pressure on the valuation of McDonald's stock. Presently, the shares are trading at a price-to-earnings ratio (P/E) of 30, which is approximately 20% higher than the long-term average. If the P/E were to revert to its average level over the past decade, it would imply a downside of 20% from the current share price. In other words, there may be no upside until the company's earnings increase sufficiently to lower the valuation.
It is important to keep in mind that accumulating debt is much easier than paying it off. McDonald's spends $4.25 billion annually on dividends, leaving approximately $1.4 billion in cash flow. At this rate, it would take the company 10 years to pay off the debt accumulated over the past decade, assuming that management ceases share repurchases and directs every additional dollar towards debt reduction.
While McDonald's has historically outperformed the S&P 500, its current high valuation and bloated balance sheet suggest that investors might experience lackluster performance in the coming years. The company will likely need robust revenue growth to navigate its current challenging situation. Pay close attention to management's remarks on pricing in future quarters for further insights.
As long as the price is above 275.00, follow the recommendations below:
- Time frame: D1
- Recommendation: long position
- Entry point: 285.99
- Take Profit 1: 300.00
- Take Profit 2: 320.00
Alternative scenario:
If the 275.00 level is broken-down, follow the recommendations below:
- Time frame: D1
- Recommendation: short position
- Entry point: 275.00
- Take Profit 1: 270.00
- Take Profit 2: 260.00
