McDonalds Stock: The Cost Of Good News

McDonalds stock has delivered 14% annual returns dating back to the 1960s. What makes the company so impressive is that not only has it trounced its competitors since that time, but it actually has no fast food peer from the 1960s that is still solvent and publicly traded. Funny enough, the only real competitor that has continued to make money for its owners is White Castle, which is privately held.

Among many advantages for McDonalds is the fact that it is essentially a real estate empire in disguise. Ray Kroc insisted upon buying up centrally located real estate near major roads in town and right off of major highways. This land was purchased at a time when land was cheap in the United States, giving McDonalds a sort of perpetual advantage among the set of customers that spontaneously decide to eat based upon what is nearby and that which is in view.

The other advantage is in terms of cost. It is the largest purchaser of chicken in the United States. It is over 10% of the chicken market. Since it buys chicken in such bulk amounts, it would be quite difficult for any competitor to meaningfully engage in a pricing war because McDonalds’ costs are so much lower than its peers.

Given these advantages, McDonald’s is able to charge its franchisees a higher premium amount (in addition to higher franchise fee) because it is inherently more lucrative to be a McDonald’s franchisee than a Subway franchisee and hence the McDonald’s parent company is able to charge 8% overrides accordingly.

With all this said, there was a point in 2014 when McDonalds stock fell to $87 per share because net profit had fallen from $5.5 billion to $4.6 billion over the trailing two years. At the time, McDonalds was dealing with falling foot traffic as it raised prices, labor unrest as calls for minimum wage hikes intensified, and price wars among its competitors.

At a valuation of around 17x earnings, the stock was becoming somewhat attractively priced because impatient investors didn’t want to own something that was report 1-3% negative earnings growth while many double-digit growth options were regularly discussed in the media.

The problem is? When great companies are dealing with the inevitable bad news that is inherent in their own business cycle, the stock is often trading at a price that best positions the investors for future growth.

In the past couple years, McDonald’s has ramped up its advertising, launched all-day breakfast with accompanying deals, and rolled out self-service kiosks as its move to keep labor costs at bay. As a result, profits have climbed from $4.82 in 2014 to an expected $8.20 per share in 2019.

And the stock? It has climbed from $87 to $197 per share with almost $15 in dividends along the way (for $212 in total value at the end period, or $218 in total end value with dividends reinvested).

Now that earnings per share are back to growing at a high single digit pace, the stock is currently trading at 24x earnings. This is a business that will be earning $11 per share five years from now and typically trades at around 20x earnings. It should be worth about $220 in 2023 or 2024.

The “certainty” of seeing McDonald’s prosper right before your eyes and buying shares at $197 per share means you are going to be getting 3-7% returns over the medium term. Meanwhile, the investors that bought the stock five years ago while the return to growth was predicted but not yet manifested, will reap returns in the neighborhood of 15% from the 2014-2024 investment period. Warren Buffett was right. You pay a high price for a cheery consensus. I suspect McDonald’s will be another case study entry proving that point.

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