McDonald’s Riding High By Pricing Low

McDonald’s Corp. (MCD) reported perhaps not surprising but certainly spectacular earnings for its third quarter. McDonald’s has obviously benefited from consumers “trading down” to its cheap alternative to dining out. Of course, it is perfectly logical that when the economy hits a rough patch people will look for cost savings were they can. Discount retailers like Wal-Mart (WMT) have avoided the worst of the bear market by offering consumers more bang for their buck. However, as impressive as Wal-Mart’s earnings performance has been, we believe that McDonald’s just-reported quarterly results were exceptional.

McDonald’s posted an increase in net income of 11% which amounts to $1.19 billion or $1.05 per share. This impressively outpaced last year’s results of $1.07 billion or $.89 per share and destroyed the analysts’ consensus estimate of $.98. Earnings grew by 9% domestically, but much of this quarter’s strength came from earnings overseas as European operations saw earnings rise 23% and Asia, Mid-East and Africa experienced a whopping 28% earnings growth. To us the most impressive part about these results was that gross margins improved from 25.8% to 29.1%. These dramatic growth results are quite impressive for a company the size of McDonald’s—which is more than just some “Mom and Pop” restaurant.

McDonald's Chart

We expect that McDonald’s will continue this trend as long as the economy remains in the dumps. So, with a dividend yield of almost 4%, these shares are a nice hedge against the economy worsening. Likewise, when the stock market begins to rise anticipating improving economic fundamentals, MCD would likely participate in the bullish trend in the market, at least over the short term. Often when people think of McDonald’s, it is associated with the negative perception of lazy and fat American’s but, as its recent results show, the company’s overseas growth is better than ever. McDonald’s global presence is as strong now as it ever has been and people all over the world are becoming more accustomed to eating McDonald’s fast and inexpensive meals on the go.

It came as a surprise to us that restaurants as a group have actually fared better than the broad market during this bear market. Over the last 52 weeks the restaurant group has fallen 15%, which looks rather tame compared to the nearly 40% drop in the S&P 500. As far as McDonald’s valuation, we have MCD rated Greatly Undervalued. However, this is due more to oversold conditions in the broader market rather than MCD’s current stock price. Price-to-cash flow and price-to-sales for MCD are both within the historically normal range. Furthermore, with MCD trading around $55, it is trading fairly close to our rationally expected price of $57. However, as stated before, this is an exceptionally good hedge against further macro-economic troubles, which the company’s stellar results from the third quarter only serve to confirm.

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Ockham Research is an independent equity research provider based in Atlanta, Georgia. Security analysis at Ockham Research is based upon the principle known as Ockham's Razor, named for the 14th- century Franciscan friar, William of Ockham. The principle states that a useful theory should utilize as few elements as possible, because efficiency is valuable. In this spirit, our goal is to make the investing environment as simple and understandable as possible, yet no simpler than is necessary.

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