For a Slow- to No-Growth Stock, McDonald's Is Expensive

10/21/2014 5:55 pm EST

Focus: COMMODITIES

Jim Jubak

Founder and Editor, JubakPicks.com

Pressure looks to get worse rather than easier for this former fast food champ for the rest of the year, and MoneyShow's Jim Jubak thinks the fact that the stock is expensive right now doesn't make its problems any easier to swallow.

So how would you turn McDonald's (MCD) around? If you've got a strategy, I'm pretty sure the company would be glad to hear from you because the old strategy-low prices and an expanded menu with something for everyone-sure isn't working.

Yesterday, the company reported earnings of $1.51 a share-if you subtracted a supplier issue in China, additions to tax reserves, and closings of stores in Russia in retaliation for US sanctions over Ukraine. That beat Wall Street estimates of $1.36 a share.

But I'm not sure this number is especially relevant and it sure obscures the really bad news of the quarter. Revenue fell 4.6% and global comparable sales dropped 3.3% as store traffic fell pretty much across the McDonald's empire. With commodity costs projected by the company to rise by 3% in 2014, up from a July forecast of a 2% increase, pressure on the company looks to get worse rather than easier for the rest of the year.

The problem seems to be two-fold.

First, having pitched its appeal on low prices, the company is facing intense competition from other chains that have cut prices too. With commodity prices rising, McDonald's hasn't been able to keep its food cheap enough to gain share in the market on pricing. Very few items on the Dollar Menu actually sell for a dollar and McDonald's prices were up through June 2014 by 3% from June 2013. That's more than the 2.5% increase in prices for food purchased away from home in the latest figures from the Bureau of Labor Statistics. In some parts of its menu, McDonald's prices are now high enough that the company is actually losing sales to casual-dining chains. Chili's, for example, has been selling lunch combo meals-a double cheeseburger with soup or salad for $8-for prices that compete with McDonald's combos-at $7.50 for a Double Quarter Pounder with cheese, fries, and a drink at a McDonald's in Chicago's Loop.

Second, a good portion of younger millennial customers is willing to pay a little more for food that's a little better. Hence the growth of chains such as Chipotle Mexican Grill (CMG) and Five Guys Burgers and Fries that make a point of caring about where the ingredients in their food come from. That perceived quality difference lets Five Guys sell a cheeseburger, (a big order of) fries, and a regular drink for $14 in my New York neighborhood. Think about what that says about McDonald's competitive fix.

In yesterday's conference call, the company didn't have a clear solution. The company is working to become more efficient in operations, more effective at marketing, and more attractive to customers. All good goals but a little light on strategy, no? Some parts of this emphasis are already apparent in the market-in the company's attempt to show how its food is made so that it can fight back against negative perceptions of quality-but I don't see a quick turnaround in that formula.

Which is a problem because-despite its struggles-McDonald's is an expensive stock at the moment. It trades at a forward price to earnings ratio (PE) of 17.2 times projected 2014 earnings. The price to sales ratio is a whopping 3.22.

To me, this looks like a stock that is being supported on its dividend-a 3.7% yield-and the memories of investors who still think of it as an earnings growth machine. Those high multiples are especially worrying to me since so much of the company's future growth is projected to come from developing economies, such as China, where recent quarters for McDonald's and its competitors have demonstrated exactly how volatile growth can be in those economies and how difficult it is to operate in these markets.

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