Sell stock pick McDonald's on cost squeeze, to raise cash

09/06/2013 7:15 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

It looks like McDonald’s (MCD) is facing a big price/cost squeeze. The latest evidence is the chain’s test of a new Dollar Menu that would include items selling for as much as $5 and simmering discontent among franchisees who say that that company is increasing the fees that it charges them in an effort to bolster the parent company’s bottom line.

It’s hard for any company to raise prices in the current non-inflationary environment. But it’s especially hard right now for operators of fast food restaurants given the intense price competition in a very crowded marketplace. McDonald’s sales growth in recent quarters has been driven by the success of its Dollar Menu so raising prices in that segment are a big deal for the company. In addition, pushback from franchisees who say they can’t afford to refurbish their stores given higher charges from McDonald’s hits at one of McDonald’s key advantages in its market—it’s ability to refresh stores more frequently than competitors. A McDonald’s refresh at $600,000 on average, according to the company, costs substantially more than a remodel at Burger King (BKW) at $300,000 or Wendy’s (WEN) at $375,000 for the least expensive version. McDonald’s restaurants average $2.5 million in annual sales.

I don’t think those trends are fatal in the long run but they do present significant short-term headwinds for the stock. I’m looking to raise some more cash in case a volatile September and October creates some bargains—and longer term to put to work in emerging markets if I can see something that looks like a bottom. So I’m selling McDonald’s out of my Jubak’s Picks portfolio http://jubakpicks.com/ . As of the close on September 6, I have a 7.1% gain on these shares since I added them to that portfolio in My 2012. The company will pay its most recent quarterly dividend—the stock shows a current yield of 3.2%--on September 17 to shareholders of record on September 3.

The new Dollar Menu—to be called the “Dollar Menu and More”—has been under test in five U.S. markets. One test includes $1, $2, and $5 items; the other has $1, $1.79, and $4.99 offerings. Isn’t this just a price increase? Absolutely. But McDonald’s has run into the brute force rules of economics. Yes, the Dollar Menu increases traffic at its restaurants but the prices on that menu mean that extra traffic doesn’t generate much in the way of margins. That’s especially true for franchisees that pay fees to McDonald’s rather than collecting them. That arrangement lets McDonald’s make money even if franchise owners are seeing their margins cut to the bone and beyond. According to notes that Bloomberg saw from a meeting of franchisees, some franchisees are paying as much as 12% of store revenue in rent. That’s an increase from a historical rate near 8.5%. Revenue to McDonald’s from franchised stores, which includes rent and royalties, increased an average of 8% annually over the past five years, according to Bloomberg. Total revenue at the company grew by an average annual 4%

McDonald’s and its franchisees have been through this battle before. In the mid-1990s, for example, franchisees protested that the company was opening too many restaurants near existing franchise operations and cannibalizing their sales. In response McDonald’s slowed its rate of domestic expansion.

I expect that that the company will work through these latest difficulties on the cost and franchise fronts. I just think it’s going to take a while and during that time I expect that I can find better opportunities.

Full disclosure: I don’t own shares of any of the companies mentioned in this post in my personal portfolio. When in 2010 I started the mutual fund I manage, Jubak Global Equity Fund http://jubakfund.com/ , I liquidated all my individual stock holdings and put the money into the fund. The fund did own shares of McDonald’s as of the end of June. For a complete list of the fund’s holdings as of the end of June see the fund’s portfolio at http://jubakfund.com/about-the-fund/holdings/

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