Fast-food might no longer be a value investment because of recent happenings at McDonald’s (NYSE: MCD). The iconic burger joint’s revenues are caught in what looks like a death spiral, even though it is still delivering a lot of income to investors.
A death spiral occurs when a business’s revenues drop to a point where it can no longer cover its expenses. This is what is happening at Sears Holdings (NASDAQ: SHLD) and there is a possibility it might occur at McDonald’s at some point.
Is McDonald’s in the Death Spiral?
The problem at McDonald’s is that its revenues are in freefall; and have been for some time. Over the two years between June 2014 and June 2016, revenues under the Golden Archers fell by $3.17 billion, or by around 11%. McDonald’s reported revenues of $28.3 billion in June 2014 and $25.13 billion in June 2016.
The losses slowed over the past year, McDonald’s reported revenues of $26.06 billion in June 2016. Yet they have not stopped dropping and that fall might be accelerating again. During the first half of 2016, McDonald’s revenue shrank by $280 million. It started the year with $25.41 billion in revenues; that fell $25.36 billion in March 2016 and $25.13 billion in June 2016.
This means that McDonald’s revenue declined by $130 million during the second quarter of 2016. One has to wonder; how long can a company survive if its revenue drops by over $100 million each quarter. If McDonald’s reports another such revenue drop this quarter, value investors need to reconsider its presence in their portfolios.
McDonald’s is Still Making Money
Now for the truly surprising part in all this McDonald’s is still making a lot of money because of its high profit margin (17.44% on June 30, 2016). The June 30 financial numbers indicates that McDonalds still generates a lot of cash in the form of:
- A net income of $4.707 billion.
- A free cash flow of $922 million.
- $3.128 billion in cash and short-term investments.
- $6.320 billion in cash from operations.
As you see McDonald’s still has a lot of float, but how long can that float last given the revenue drops? The net income in June 2016 was $804 million below that of June 2014 when it was $5.511 billion but definitely better than June 2015 when it was $4.18 billion. Interestingly enough McDonald’s income recovery might be over; the net income dropped by $109 million during second quarter 2016, falling from $4.816 billion to $4.707 billion between March and June of 2016.
Cash from operations also took a big drop in second quarter 2016. It fell by $239 million, dropping from $6.559 billion in March to $6.320 billion in June. So McDonald’s is making less money, and taking in less cash.
It looks as if the company’s float is slowly but steadily eroding. In other words a slow decline rather than the epic collapse we’ve seen over at Sears.
McDonald’s Still has a Lot of Value
Despite the decline McDonald’s still has a lot of value it reported assets of $33.15 billion on June 30, 2016. The company also reported a market capitalization of $98.90 billion and an enterprise value of $121.17 billion on September 29, 2016.
Beyond the monetary value McDonald’s also has a vast amount of the unquantifiable but invaluable commodity known as brand loyalty. There are vast numbers of people who still believe in this brand and eat its food. Although there seems to be an equally large number of that loathe McDonalds; and have contempt for its burgers and Happy Meals.
Like a number of iconic brands, McDonald’s has hit hard by changing tastes and a paradigm shift in the media landscape. Vast numbers of people; particularly Americans, want more quality and variety in their food as well as healthier cuisine. This hits McDonald’s; which is widely viewed as a cheap place to eat that sells substandard products, hard.
The collapse in viewership for broadcast television makes it hard for brands like McDonald’s to reach the younger customers it needs most. There is now an entire generation of kids that does not know who Ronald McDonald is because they’ve never seen his commercials.
An even greater problem McDonald’s faces on its home turf in the United States is an almost limitless number of competitors. In addition to the sea of fast-food joints engulfing almost every American city, the Golden Arches now has to compete with supermarkets, drug stores and convenience stores.
How Supermarkets Threaten McDonald’s
Three supermarket operators in particular; Whole Foods Market (NASDAQ: WFM), Kroger (NYSE: KR) and the privately-held Safeway, have made a major foray into the prepared-food business.
Whole Foods even has grills that cook burgers and hot dogs in its stores. It also offers soup and salad bars. Some Kroger locations now boast sushi bars, taco counters, pizzerias, cheese-themed restaurants and Panasian Cafes.
Kroger in particular is a strong position to match or undercut McDonald’s prices; while offering greater variety and better quality. Some Kroger Marketplace stores have special-fast checkouts and drink dispensers like those at McDonald’s. The idea is clearly to attract the lunch crowd, which is McDonald’s prime clientele.
A major problem that McDonald’s might face; is Kroger or Safeway using prepared meals as a loss leader to attract customers. The hope being that the person who comes into grab a slice of pizza or a bowl of soup; will walk out with a gallon of milk or a block of cheese.
The potential supermarket competition might be part of the reason for McDonald’s decision to offer breakfast all day. Egg McMuffins and Pancakes are two foods Kroger and Whole Foods are not selling – yet.
McDonald’s is a Good Income Investment
Now for the strangest part of our story; McDonald’s shareholders are still making a lot of money. They received a mouthwatering return on equity of 77.26% on June 30, 2016, and a tasty dividend yield of 3.07% on September 29, 2016.
The shareholders also took home a dividend of 89¢ on August 30, 2016. That dividend yield has been fairly reliable it paid out every quarter since November 2012. The dividend has also been growing it was 85¢ in May 2015, 81¢ in May 2014, 77¢ in August 2013, and 70¢ in May 2012, according to Ycharts.
Skeptics will wonder how long that can last given McDonald’s revenue collapse. To make matters worse most of its return on equity seems to be based on stock performance rather than the money the restaurants are taking in. McDonald’s was trading at $115.88 a share on September 29, 2016, which seems overpriced to me.
My advice would be to stay away from McDonald’s stock it is way overpriced and has a long way to fall. A major problem is that McDonald’s revenue has not stabilized.
My prediction is that the revenue drops will continue for a while but stop at some point. When that happens; McDonalds will be a value investment again, because I think this company is still capable of making a lot of money – even if it loses a lot of its revenue. What it needs right now is a realistic stock price.