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McDonald’s Stock (NYSE:MCD): Likely to Underperform from Here
Stock Analysis & Ideas

McDonald’s Stock (NYSE:MCD): Likely to Underperform from Here

Story Highlights

McDonald’s stock outperformed during a year when the S&P 500 recorded major losses. Meanwhile, despite high profitability, MCD lacks growth, and its valuation remains high, limiting its upside potential.

McDonald’s (NYSE:MCD) needs no introduction. Founded in 1940, it is one of the oldest and most successful fast-food chains in the United States and across the world. The company is generally viewed as a stable, dividend-paying choice for long-term investors. Still, it’s likely to underperform in the short-to-medium term due to its elevated valuation. Therefore, I am neutral on the stock.

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Despite increased volatility and some major price swings lately, MCD has performed relatively well. For the trailing year, the stock has returned 8.8%, while the S&P 500 (SPX) has recorded losses of about 6.4%. Currently, MCD trades at $272.46, near its 52-week high of $281.67, and pays a 2.23%-yielding dividend.

McDonald’s Lacks Growth but is Very Profitable

McDonald’s has recorded minimal revenue growth over the past decade. For the trailing 10-year period, sales have decreased by -1.64% compound annual growth rate (CAGR). EBITDA and net income, on the other hand, have recorded small positive growth, at 2.1% and 0.83% CAGRs.

Additionally, diluted earnings per share (EPS) have grown at a 4.1% CAGR, mainly due to share repurchases. Competitive pressures in the industry are mostly to blame for the company’s lack of substantial growth.

When it comes to profitability, McDonald’s maintains high margins, well above almost all competitors in the sector. Its gross margin stands at an impressive 56%, with EBITDA and net margins at 51.8% and 25.4%, respectively. Meanwhile, its FCF margin stands somewhat lower, shy of 20%. Nonetheless, MCD displays strong profitability overall, making up, in the eyes of many investors and analysts, for the lack of revenue growth.

Over the next few years, analysts expect minimal revenue growth and high- single-digit EPS growth, aided by share repurchases. Annual revenue is expected to reach $25 billion by the end of 2024, compared to $22.8 billion for Fiscal 2021, while earnings per share are expected to reach $11.4 (compared to $7.93 diluted EPS in 2021).

Liquidity for MCD remains strong, with the company recording current and quick ratios of 1.65x and 1.35x, respectively, indicating that McDonald’s has enough short-term liquidity to cover its short-term liabilities.

Is McDonald’s a Safe Dividend Stock?

McDonald’s corporation has a long-standing record of dividend payments and is viewed by many as an obvious dividend choice. Also, MCD’s 2.23% yield is in line with the sector median of around 2.2%.

Over the past 10 years, the company has increased its dividend payments at moderate rates. For the trailing 10-year and five-year periods, dividends have increased at 7.0% and 8.1% CAGRs, respectively. The company is clearly committed to rewarding its long-term, dividend-oriented investors.

Considering its market cap of ~$200 billion, its 2.23% yield consumes ~$4.45 billion of cash flow annually. Comparing this figure with the company’s total free cash flow productivity of $5.79 billion for the trailing 12 months or $7.1 billion for 2021, it is clear that dividend payments consume the majority of the FCF the company generates.

While MCD is not yet stretching its cash to meet its dividend payments, if cash flow growth continues to lag in the future, the company may encounter difficulties raising its dividend. That risk is elevated when we consider that McDonald’s also commits cash flow toward share repurchases.

Is a Debt Problem Quietly Forming?

As explored in the previous segment, McDonald’s has been increasing its debt levels consistently over the past decade. The company’s long-term debt obligations have increased from $14 billion in 2013 to $35 billion as of the most recent quarter (a 150% increase) compared to a 32.5% increase in total assets over the same time period.

As a result, debt involvement in the company’s capital structure has been increasing quite significantly. However, still, debt amounts to around 24% of MCD’s market cap, implying debt levels that are not alarming just yet, especially considering the stability and longevity of the company’s business model. Bottom-line profitability and the long-term risk profile for the business are somewhat negatively affected, though.

MCD’s Valuation Remains Pricy

McDonald’s Corporation trades at expensive valuation multiples despite a broader rerating in the market in 2022. Currently, MCD trades at 27.5x P/E ratio and a 27x forward P/E ratio, significantly higher than the market average of around 17x and the consumer staples average of around 14x. The same is true for both the P/S ratio (8.5x forward) and EV/EBITDA (20x forward).

McDonald’s valuation multiples are also significantly higher than their respective 10-year averages despite the company failing to record good revenue and earnings growth. On a peer-comparison basis, MCD trades at multiples close to Starbucks (NASDAQ:SBUX) and Yum! Brands (NYSE:YUM), while both companies are recording much better growth.

Is MCD a Good Stock to Buy, According to Analysts? 

Turning to Wall Street, McDonald’s has a Strong Buy consensus rating based on 19 Buys and four Holds assigned over the past three months.

The average MCD stock price forecast of $292.17 represents 7.2% upside potential, with a high price forecast of $328 and a low forecast of $260.

The Takeaway

After all things are considered, McDonald’s, despite the lack of revenue growth, displays strong profitability and liquidity, while increasing debt levels cause somewhat of a concern. Nonetheless, the most concerning issue for MCD appears to be its valuation.

The company seems to be valued expensively compared to sector averages and its own historical averages, leaving little room for price appreciation in the short or medium term.

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