Buying McDonald’s Stock Is Approaching No-Brainer Territory

It’s weird living in a world where the stock demands 30x earnings for a share of Brown Forman to give you a 1.3% dividend yield while shares of McDonald’s trade at 17x profits and give you a starting dividend yield of nearly 3.5%. For comparison purposes, 2009 was the only year in McDonald’s history when the stock averaged yielding above 3.5% for the entirety of the year.

What’s the cause? From 2011 through 2013, the input costs for food ingredients at McDonald’s rose, and the company largely absorbed the cost to accept lower profit margins on its food items but hoped to make it up through higher volume and the continued opening of new stores internationally. Over the past twelve months, the company said, “Enough” and started raising the prices on its dollar menu and increased the prices on its value meals.

When you’re the low-cost producer in the industry, and you raise prices, you tend to have trouble growing sales volume for a little bit in the aftermath because some customers want to protest the price hikes (even if it means going to McDonald’s twice per week instead of three times per week). Eventually, over a two or three year period, people start to think, “You know, paying $1.29 for a double cheeseburger still isn’t that bad of a deal” and they start coming back to the company once they realize there’s no better place to get a hamburger, fries, and soft drink in your belly from a cost perspective.

When they start coming back, sales rise, and growth becomes easier. Right now, McDonald’s is at the tail end of dealing with customer losses from its price hikes over the past year and is coming close to turning the page towards growing sales figures significantly again (although revenues are going from $28.1 billion to $29.0, so even the current status quo may not be as bad as made out to be).

Because McDonald’s only pays out a little over half its profits as dividends, it has a lot of free cash flow available to buy back stock, so you’re in this interesting situation right now where even if it takes sales longer to grow than you’d think, you’re still getting 5-6% returns over half of which comes from the stock buyback and the other from earnings per share growth resulting from cost efficiencies and the higher profits on the slowly growing sales figures. It’s an example of companies with inherent downside protection that tend to get favored on my site.

Within a couple years, things will get back on track and you’ll be seeing 4-5% sales growth again in line with McDonald’s historical norms since becoming a large-cap company and you’ll suddenly be seeing 10-11% annual returns again when you combine the dividend with the earnings per share figures that are benefitting from the buyback and return to top-line growth.

The problem is, when you wait for a few quarters of that growth to happen, you won’t be able to buy the stock at $94 per share. In a rising economy, it’s historically unheard of for McDonald’s to offer a starting dividend yield of 3.5%. By the time you wait for things to rebound, you lose your margin of safety and you end up paying 19-20x profits to get a starting yield somewhere around 3%. It’s what Buffett was talking about when he said you pay a high price for certainty.

A technique out of the Peter Lynch playbook is that you buy blue-chip companies when they have solvable problems that are placing a drag on the current share price. After all, in an economy trending upwards, you’re not going to get discounts on Colgate-Palmolive, Brown-Forman, or Hershey during times when they’re getting everything right. Instead, you look to BP getting dragged down by its lawsuit yet still generating $14 billion in profits even after its asset sales. You look to IBM growing profits at 8-9% annually even though revenues are stagnating. You look to McDonald’s with its slow sales growth that have been the result of price increases over the past year. Those difficulties are the reason why you are able to get in at a good price, and five years from now, you’ll be wondering what people seemed so worried about in 2014. It seems pretty self-evident that business conditions will improve for these companies, and the trick is to buy the stock before they do. The temporary struggles is wherein the opportunities are created.


Originally posted 2014-08-02 06:42:49.

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