Can McDonalds Turn Around?

10/27/2014 12:01 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Another poor earning's report from this former fast-food champ has many, like MoneyShow's Jim Jubak, wondering what they can do to become competitive and start to grow again.

Ronald McDonald is not very happy right now and McDonald's (MCD) has got this huge problem. They just reported third quarter earnings, which, if you take out the right stuff, they've got problems in Russia, they've got problems in China, so you sort of take that out, then your earnings look like you beat Wall Street estimates but the real problem is you had a 4% decline in revenue year-over-year, you had a 3.3% decline year-over-year in comparable store sales, which are stores that have been open for a year or more. What you're seeing is this incredible pressure that the strategies that McDonald's had been pursuing, which is the dollar menus or the cheap food strategy, a) you've got a lot of companies doing it, Burger King is doing it, Wendy's is doing it, everybody in the space is doing it, you can't keep driving prices lower if your commodity costs are going higher. Commodity costs, according to McDonald's most recent projections, are going to go up 3%, 3.3% in 2014. That's up from a 2% increase that they projected back in July, so you see the price pressure that's going on.

You look at the McDonald's dollar menu and there's nothing on the McDonald's dollar menu that costs a dollar anymore so you're seeing prices rise. If you go in and look where they are positioned, you've got competitors coming in from the top side, so you've got well we can call them fast casual restaurant like Chili's, which is doing a promotion for a combo, that's a cheeseburger, fries, and a drink, for $8.50. That's not that different than the $7.50 that you're paying at a McDonald's in the Chicago Loop for a double quarter pounder combo, so that's one problem.

The second problem is that, if you're a company that has a reputation for caring about your food, so, like a Chipotle (CMG) or a Five Guys, you can charge more. There's a market out there of young millennials as well as people of all generations that care a little bit more about food, they're willing to pay a little bit more or a lot more, depending on how you look at it, so, if you go to Five Guys and you get a cheeseburger, which is two patties, and a large order of fries, which is their regular order but there's a lot of fries in it, and a drink, you're spending $14 as opposed to the $7.50 or $8 that you're spending at McDonald's. The fact that people are willing to spend more, that Chipotle can raise its prices and doesn't see its traffic go down says that, hey, if you've got a reputation for caring about your food, there's a growing market for that.

The problem, of course, is that McDonald's doesn't have a reputation for quality ingredients or quality processing, the company is trying to find a way to fight back against that, but it's really hard to reposition yourself in the market. If you're running McDonald's, what do you do? McDonald's has talked about, well, they're going to get more efficient, they're going to try to do better marketing, which is part of this whole campaign they've got right now that does videos that show you how McDonald's prepares its food to counter the perception that McDonald's doesn't do a very good job at that, so they're going to try that and then, where's your growth come from. Well, your growth comes from China, it comes from the developing world, and what we know about that is that, yes, there indeed is a lot of growth there but it's very, very volatile, you get supply chain problems that can shut you down repeatedly, as has happened to Yum! (YUM) in China, so all of that you put together and you say, okay, so what is McDonald's trading for.

PE on McDonald's is about 17.2 times forward 2014 earnings, that's a little more than the market as a whole but not a whole lot so it's basic a market multiple, if you look at price to sales, about 3.2. On price to sales, McDonald's is very, very expensive. If you look at this compared to growth and say, okay, this is a company without a lot of growth, you've got to say this is an expensive stock that's so expensive because it pays a 3.7% dividend and people still have memories of the days when McDonald's was a growth machine and you've got to wonder whether this should sell at a different multiple because it's really, now, a value or a dividend play rather than it being about growth.

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