McDonald's: Earnings vs. Revenues
McDonald's (MCD) might be one of the bright spots in the markets today; but I still worry about long term revenues. Their earnings results for the third quarter demonstrate a successful turnaround that I truthfully didn't believe could be done. Through re-franchising a ton of corporate stores, they lowered their costs. Through streamlining their menu, the company has created a more convenient and efficient experience. Excluding some onetime charges from last year, the company increased diluted earnings by 19%. It's all good news, I simply worry that it isn't sustainable. If you're a short termer my argument is mute. If you like investing for the long haul, my concerns are something to think about.
McDonald's reported revenues of $5.37 billion; outpacing estimates of $5.32 billion. This is where my critique comes in. Company run store sales decreased 18% to $2.51 billion, while total revenue for franchise stores only increased 6% to $2.86 billion. As the company has increased franchised locations, and cut down on company run stores, the shift in revenue has not been equal. I have feared, and continue to fear over the long term, that the company may come to miss that revenue. It cuts their piece of same store sales growth. For now, the MCD is getting a lot more out of its revenue, regardless of that revenue stream being lower overall; so it supersedes the issue currently.
McDonald's had to report an operating income loss of 21% in the third quarter. The stat is misleading though, as this is based off last year's sale of Chinese assets, as well as charges from restructuring and impairment. If you exclude these items, the company actually had a 2% increase in consolidated operating income. I'd definitely like to see more than a 2% increase, but the translation to earnings is a much better story. Excluding those gains/charges I mentioned above, net income increased 14% to $1.64 billion. Again, excluding last year's gains/charges, McDonald's reported diluted earnings growth of 19% to $2.10, beating estimates of $1.99.
The thing that the markets seem to care about most is sales growth. Total system wide sales growth increased 5% for the quarter. On a comparable sales basis, the U.S. market increased 2.4%. The company stated the increase was resultant of increases in the average "check" being paid by customers. This was a result of menu shifts and pricing. It's true. They have a simpler menu, with some $3 items on their dollar menu, as well as pricier fresh beef burgers. The international segment (including countries like the U.K. and France) had sales increases of 5.4%, with flat operating income. The high growth segment - like Italy - grew 4.6%. From a sales growth perspective, it was a successful quarter all around.
I remain concerned that eventually the imbalance between declining company owned store sales vs. increasing revenue from franchised locations will become a problem. Unless we see a shift in the revenue trend, there is limited long term potential. Even with higher comparable sales, McDonald's piece of that revenue is smaller. It becomes a question of how long they can pull more value out of declining revenue, and I don't like that equation over the long term, especially when operating income only grew 2% this quarter. Also when you consider that sales growth seems to be coming from higher spending per customer, instead of higher overall customers, I wonder whether the company is really driving new business as opposed to gaining on customer loyalty. You can only drive transaction prices so much before you need new consumers.
Whether you like McDonald's or not depends on your viewpoint of current sales/income versus what the company can do later. In terms of creating earnings, CEO Stephen Easterbrook has done impressive things. There's clearly a lot of value here that can still be translated into higher overall earnings. Estimates of $7.62 per share do seem attainable for the year, and it would keep McDonald's P/E in the 20-23 range. In this market that's not bad. Furthermore, you're looking at a 2.6% dividend that certainly seems sustainable. My question becomes: what will Easterbrook do after the re-franchising? It's quite clear that's the maneuver that's been helping the company drive earnings. They can talk about initiating tech but I'm skeptical of the impact. There isn't a lot of reasons to order McDonald's from your phone when they cook it in about three minutes.
I personally wouldn't buy this today, as I don't like chasing a 6% run in a market that's broadly declining. Let's not forget Q2 earnings when the stock fell on slower sales despite strong financials. The current market is weary, and I'm inclined to think McDonald's is not immune to bad news. A big part of the earnings this year was certainly lower overall taxes, as operating income growth is not very exciting this year. It would seem silly to buy the stock as it nears a 52-week high. Even if you're a believer in the long term, I certainly think there will be better prices to buy.