Should McDonald’s be priced for high growth?


Background

Wall Street got excited yesterday as fast-food group McDonald’s delivered first-quarter results that were better than expected. Q1 revenue was $5.68 billion, beating analysts’ average estimate of $5.53 billion, and EPS was $1.47, above a market expectation of $1.34. But investors were most satisfied with Q1 global comparable sales growth of 4% year-on-year, which was above the market’s estimate of. 1.3% y/y, showing a healthy rebound in existing locations driven partly by higher guest counts and the Big Mac makeover. China delivered the highest expansion rate among growth countries. The shares jumped 5.6% on Tuesday. (MCD 10-minute share chart pictured above, source: Saxo Bank).

Although the market enjoyed the result, we do not see how the valuation can be justified. The 12-month trailing EV/EBITDA is around 14, which is about 40% above the long-term average since 2003. The valuation premium is given to McDonald’s share price despite 11 quarters of negative revenue growth (see revenue chart) and material shifts in consumer behavior towards healthier eating. In addition, net debt to EBITDA has increased to 2.6 from around 1.3 in 2003-05.

McDonald’s Corp 12-month trailing EV/EBITDA is well above long-term average

The main driver behind McDonald’s strong momentum is faith in the company’s new strategy and turnaround, but also an EBITDA margin that has increased from 35% in the full year 2014 to around 40% in the past 12 months. Wall Street sees a more efficient McDonald’s on lower activity and less capital. However, this adventure will not last as management said on the conference call that the US labor market is tightening, which will put pressure on operating margins down the road.

Many investors now see a successful turnaround and glimpse of growth on top of strong price momentum. We see historically high valuations, the lowest growth in more than a decade, changing consumer patterns towards healthy food, increased competition in fast food, margins that have peaked, higher leverage and more buybacks of already expensive shares. In total, a dangerous cocktail that we are not buying. So we are recommending selling McDonald’s shares after yesterday’s Q1 earnings release.

Management and risk description

It’s always risky to sell something that is hot and being bought like there’s no tomorrow. This is the biggest risk to our short trading idea. But we think the risk-reward ratio is favorable as we are implementing this strategy with a stop at $150.75 and a target at $120.

More growth in China and further improvements in guest counts would obviously ruin our trade idea so sentiment is going to be key. A weaker US dollar would also create a tailwind for the stock price.

Parameters

Entry: Sell limit in the range of $140-147. Aggressive traders could enter a fill sell market order, which would then be filled at the open price.

Stop: we are setting the stop at $150.75 to protect our capital if the $150 level is broken as that could lead to short-covering and forceful short-term momentum.

Target: $120, which is the mid price from 2016 and a more realistic level taking the growth outlook, potential margin expansion and valuation premium to the S&P 500 into account.

Time horizon: this is a medium-term trade idea that we expect to play out over a couple of months unless our stop is hit in a melt-up scenario.

— Edited by John Acher

Non-independent investment research disclaimer applies. Read more
A compiled overview of Trade Views provided on TradingFloor.com is found here.

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Should McDonald's be priced for high growth?

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