McDonald’s Sees Weakness After Double Dose of Bad News

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McDonald’s (NYSE:MCD) has been heralded as one of the best safe-haven stocks to own given its strong, consistent cash flow, its shareholder-friendly policies, and its strong balance sheet. However, in just the past couple of days, the company has been hit with bad news that has sent the stock falling. On Monday, we learned that McDonald’s restaurants in China were being supplied expired meats from a now disgraced supplier to both McDonald’s and KFC, which is owned by Yum Brands (NYSE:YUM).

On Tuesday morning the company reported disappointing earnings that show continued weakness in the U.S. and Japanese markets. Globally, the company reported flat same-store sales, and it grew revenues at just 1 percent, which reflects its market saturation. Operating income was flat, although earnings per share rose slightly, at 1 percent, given that management has been retiring stock.

Given this weakness and given the recent strength we’ve seen in riskier equities, McDonald’s shares have been fairly weak, having fallen nearly 8 percent after peaking in May. This is a pretty dramatic fall for a stock such as McDonald’s, which is generally a low beta stock fit for widows and orphans.

I think it is difficult to deny that the company has some problems, evidenced in its lack of growth. While the company is growing in emerging markets in Africa, the Middle East, and Asia, it is struggling in the West as more and more people simply don’t want to eat at McDonald’s given their newfound health concerns.

The fact that the company had its Chinese safety concern on Monday only adds to this concern and to the image of McDonald’s as the “old guard” of fast food. The “new guard,” which is led by Chipotle (NYSE:CMG), can play against this image with its fresh, healthy ingredients (e.g., its green vegetables versus McDonald’s iceberg lettuce, its GMO-free foods versus McDonald’s notoriously non-biodegradable food), and McDonald’s is having trouble growing in this world.

Nevertheless, with the share price down, McDonald’s appears to be compelling, and it might make for a good contrarian trade. Here’s why.

First, the company may have no growth given its problems in the West, but it does have growth in parts of the world. While westerners may be concerned about their health, people in emerging economies see eating at McDonald’s as a sign of success and prestige, and as more people in these regions become “middle class,” McDonald’s should benefit. This benefit should be augmented by the fact that as emerging economies grow, their currencies should be relatively strong as the dollar begins to play a diminished role in the world. It follows that McDonald’s earnings can be driven by emerging markets in the longer term.

Second, McDonald’s may not be growing its earnings, but these earnings certainly aren’t shrinking. So long as this is the case and so long as interest rates remain depressed, McDonald’s is attractively priced on a relative basis if we treat it as a bond. It trades at about 17.3 times earnings, meaning that it has a 5.8 percent earnings yield while the 10-year Treasury yields less than 3 percent. The difference is large when you consider that capital gains are taxed at a lower rate than bond coupons.

This brings me to my third point. With interest rates so low, it makes sense for McDonald’s to borrow money in order to repurchase its own stock. The company even announced a couple of months ago that it intends to do this. This means that there is demand for the stock and that each share will represent a greater portion of the company. Also, as the company buys back stock, its dividend obligation falls, as it doesn’t have to pay dividends on retired shares. This frees up capital to raise dividends for existing shareholders or for additional buybacks and expansion.

Given these points, it is evident that McDonald’s shares aren’t going to rocket higher. But at $96 per share, there are worse places to put your money. The company is generating a lot of cash flow, and it is paying a nice 3.4 percent dividend that should be sustainable in nearly every market condition. So if you feel the need to take some profits out of some of these high fliers, you may want to park some of it in McDonald’s for a while.

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Disclosure: Ben Kramer-Miller has no position in McDonald’s or in any of the stocks mentioned in this article.

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