Bite into Big Mac

12/23/2005 12:00 am EST


Richard Moroney

Editor, Dow Theory Forecasts

With a history that dates back some five decades, Dow Theory Forecasts is among the most established and respected newsletters. The service is noted for its focus on well-established, blue chip names. Here, editor Richard Moroney looks at McDonald's.

"McDonald’s (MCD NYSE) has shifted its focus to building sales at existing restaurants rather than aggressively opening new stores. The strategy has sparked improved cash flow and a rebound in sales in the US and several large European markets. At 16 times estimated year-ahead earnings of $2.10 per share, the stock trades in line with its five-year average forward P/E ratio. Rumors of a spin-off could impact the stock in coming months, though such a move seems unlikely unless the company’s current strategy stops working. MCD is a long-term buy.

"McDonald’s, the largest fast-food chain in the world, operates or licenses more than 30,000 restaurants in about 120 countries. The company operates 27% of the locations, while franchisees operate 60% and affiliates with joint-venture agreements run the remainder. The US accounts for 48% of systemwide sales; Europe represents 28%; Asia, the Middle East, and Africa generate 16%; and Canada and Latin America combine for 7%.

"In 2005, McDonald’s plans to increase its worldwide store base by about 350, or roughly 1% growth, down from an increase of more than 1,000 stores in 2002. More than half of this year’s planned $1.7 billion in capital spending was earmarked for improvements at existing locations. The strategy of developing additional menu items and investing in existing restaurants has boosted operating results.

"US sales began rebounding in 2003 after several years of weakness, and same-store sales have increased in each of the last 30 months. McDonald’s remodeled about 1,100 US stores in 2004 and plans to remodel 1,300 more this year. Europe continues its turnaround, driven by strong results in Germany, France, and Russia. To address weakness in the U.K., McDonald’s has improved service and food quality and introduced new food choices.

"Although McDonald’s has said it plans no corporate restructuring that involves its real-estate holdings, some industry watchers speculate that the restaurateur might spin off the division that runs company-owned restaurants. Hedge fund Pershing Square Capital Management, which owns 4.9% of McDonald’s, has proposed the sale of about two-thirds of company-owned restaurants. Pershing believes the real estate is undervalued. Management has acknowledged that the move could result in a ‘tiny’ improvement in the combined valuation of the two potential businesses, but not enough to warrant the implementation costs and risks of a spin-off. Vornado Realty Trust acquired a 1.2% stake in McDonald’s between July and September.

"In the first nine months of the year, revenues grew 8% and per-share earnings rose 5%. Consensus estimates project per-share-profit growth of 5% in 2005 and 6% in 2006, targets McDonald’s should be able to beat. The company has shown a commitment to sharing its improving cash flow with stockholders. So far this year, McDonald’s has raised its annual dividend 22% to $0.67 per share and repurchased about $1.2 billion in stock. It plans to spend at least $2 billion on dividends and share repurchases this year."

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