Is This the End of McDonald's As a Growth Stock?

01/29/2015 8:15 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Signs seem to suggest this former fast food king believes it can work itself out of its current long, painful slump in sales growth by competing in both a price and a food quality war, but MoneyShow’s Jim Jubak thinks this could mean the company loses them both.

“Two roads diverged in a yellow wood/And sorry I could not travel both/And be one traveler….”

McDonald’s (MCD), which reported fourth quarter earnings before the New York market open on January 23 should keep Frost’s poem in mind. All the signs are that the company believes it can work its way out of its current long and painful slump in sales growth by competing with Burger King to see who can sell the cheapest chicken nuggets and by competing with Chipotle Mexican Grill on the quality of its food.

Not a chance in the world.

And by going after two such different markets, McDonald’s risks losing both the fast-food burger wars and the battle for mindshare among a new generation of somewhat more ingredient conscious consumers.

I think it’s reasonable to ask if we’re finally witnessing the end of McDonald’s as a growth stock—remember that for decades that’s how investors thought of these shares—and a transition to a value or dividend stock.

That’s a path traversed by a stock like Microsoft (MSFT). Microsoft, once the quintessential growth stock, now trades at a trailing 12-month price to earnings ratio of 15.51 and a projected PE of 16.05 on earnings for the fiscal year that ends in July 2015. The shares, with a dividend of 3.01%, trade at 88% of the PE of the stocks in the Standard & Poor’s 500.

The comparison suggests that—despite the drop in its share price on lackluster sales growth—McDonald’s might still be over valued. The trailing 12-month PE on McDonald’s shares is 19.25 and the forward PE on projected earnings for the year that ends in December 2015 is 18.14. That means the shares, which pay a dividend of 3.66%, trade at 108% of the PE of the stocks in the S&P 500.

In other words, investors are still betting on a turnaround in the company’s fortunes. And on a day, January 29, when the company announced that Steve Easterbrook would take over as CEO from Don Thompson on March 1, it’s a good time to look at how likely a turnaround might be.

For the full 2014 year, McDonald's saw a 1% drop in global comparable store sales and flat consolidated revenue in constant currencies. Consolidated operating income fell 9% and diluted earnings per share decreased by 13%. Excluding one-time items, McDonald’s earnings fell 3% from 2013.

This was the first drop in annual same store sales in a dozen years.

McDonald’s first announced response was a kind of placeholder while the company figures out how to get same store sales growing again. The company said it would cut new store openings to 1,000 in 2015 from 1,300 in 2014. That would result in a decline in spending on new stores of about $800 million.

McDonald’s efforts to return to growth looked in two different directions.

First, is what I’d call an effort to get back to its fast food roots. McDonald’s will continue to work to simplify its menu and continue an emphasis on low prices or what the company calls “value.” That’s best exemplified currently by McDonald’s food fight with Burger King Worldwide (BKW) in The Great Chicken Nuggets Price War.  My local McDonald’s today advertised a special of 50 chicken nuggets for $9.99. Burger King had been selling ten nuggets for $2.99 but lowered that to 10 for $1.49 so that its
price of 15 cents a nugget undercut McDonald’s 20 cents a nugget.

Second, McDonald’s will continue an effort to convince ingredient conscious consumers that it cares about its food in the same way that Chipotle Mexican Grill (CMG) does. For example, there’s the viral video ad explaining that McDonald’s French fries don’t have 17 ingredients—they actually have 19. In the spirit of full disclosure and honesty in eating, the company notes that besides potatoes and seven different kinds of oils, its fries are also made with dimethylpolysiloxane. “I know that sounds scary,” the video admits, “but it’s actually an anti-foaming agent.”

There are two sets of problems in this two-pronged approach.

First, in the fast food roots campaign, McDonald’s isn’t doing battle with just Burger King and Wendy’s anymore. It’s facing new competitors such as Sonic (SONC), soon to be public Shake Shack (pending symbol SHAK) and still private Five Guys.  These chains capture the original McDonald’s roadside menu and ethos that McDonald’s is now talking about recapturing. I frankly don’t know how McDonald’s goes from its menu of burgers and fries—and filet-o-fish and McWraps and salads and…—to something like the burger, fries, and dogs menu at Five Guys, or the roadside ambience of Sonic, or the simple but ‘we care about our ingredients approach’ of Shake Shack.

If there’s growth in the burger segment, it’s growth in the Five Guys, Sonic, and Shake Shack approach, not in the McDonald’s and Burger King approach.

Second, it’s tough enough for McDonald’s to compete with the natural burgers at Shake Shack or the hand-cut French fries sourced from specific potato farms at Five Guys. But also think about the distance that McDonald’s has to go to win mindshare with the ingredient conscious customers who flock to Chipotle Mexican Grill (CMG).

Consider that company’s January 15 reaction to an audit that revealed that one of its pork suppliers failed to meet Chipotle’s standards for animal welfare. Chipotle suspended the supplier and stopped selling pork at 600 of its 1,700 restaurants because of the pork shortage that resulted from suspending the supplier. Pork makes up about 6% of sales at Chipotle and it’s likely that the company lost some sales as a result of suspending this supplier.

In the short run.

In the long run, I can’t think of a more effective way of demonstrating to the company’s target demographic that it takes its “Responsibly Raised” standard seriously.

It’s way more effective than Web ads promising transparency about the 19 ingredients that McDonald’s uses to make its French fries.

And it’s hard for me to see a way for McDonald’s to win over the Chipotle’s demographic without a redesign that guts the company.

While he headed McDonald’s United Kingdom unit, incoming CEO Easterbrook supervised the creation of a Web site, makeupyourownmind.co.uk, where customers could ask questions. He also debated Eric Schlosser, the author of Fast Food Nation, on television. And it seems clear that at least in the near term, he plans to continue to speed up service and to simplify the McDonald’s menu. (How that will fit with plans to expand McDonald’s ‘customize your burger’ program is an interesting question.)

Does any of that amount to a convincing plan for a turnaround? To me it seems like change at the margins. And I don’t think that’s enough for a company facing two such different and large scale challenges.

Shares of McDonald’s rose 5.06% today, January 29, on news of the new CEO and on hopes that he’ll engineer a return to growth.

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