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This Powerful Brand Looks Temptingly Cheap

Andrés is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

The house of the happy meal is not as full of laughter as it once was. Shares of McDonald´s (NYSE: MCD) are in negative territory for 2012, trading below $88 after being above $100 at the beginning of the year. Growth is slowing and the company is facing some competitive challenges, but the current valuation looks like a big buying opportunity. Value investors looking for opportunities in solid stocks may want to take a look at shares of this fast food giant.

The Food War is Getting Hotter

The fast food business is very competitive, and McDonald´s seems to be feeling some pressure lately. Although sales figures matched expectations for the last quarter, profitability has been declining as the company absorbs risings costs and sticks to its value strategy. Also, management gave an uninspiring look into the next quarter during the earnings press conference last Friday.

McDonald´s is under attack from different fronts; fast casual restaurants have been stealing customers from the company, led by Chipotle Mexican Grill (NYSE: CMG), which offers burritos, bowls, tacos and salads made from higher quality ingredients than in typical quick service restaurants. Chipotle is more expensive than McDonald´s, but it does offer superior ingredients and tasty products.

Growth rates at Chipotle have been truly amazing; the company delivered an almost 40% annual growth rate in earnings per share over the last five years. The company has found an interesting position by maintaining the basic speed and experience of the fast food industry, but offering higher quality food and better ecological and sustainability standards. This is certainly a competitor – and a trend – to watch.

However, even the much-successful Chipotle is facing slowing growth over the last few months; profit margins and store traffic have been disappointing in the last two quarters. Chipotle has a strong position, and it will keep outgrowing its competitors in the middle term, but no company is immune to such a tough competitive landscape.

Yum! (NYSE: YUM) has recently launched its Cantina Bell concept, which is showing strong signs of domestic growth. Taco Bell’s same-store sales in the U.S. rose 6% in the last quarter, so Cantina Bell is off to a good start. I don´t think this will do a lot of damage to Chipotle, because Yum! doesn´t appeal as much to “health conscious” customers, but it does mean more competition for McDonald´s.

But McDonald´s has interesting growth opportunities too. The McCafé Business has been a successful initiative, increasing store profitability and providing new ways for expansion. People around the world are trying to avoid those fatty hamburgers, but coffee consumption is strong and growing, so McDonald´s has a big opportunity there.

McDonald´s is probably the biggest competitive threat to Starbucks (NASDAQ: SBUX) on a global scale, since it owns many of the most valuable store locations around the planet and one of the most recognizable brands in the world. McDonald´s is positioning McCafé as a low price alternative to Starbucks, and the Golden Arches have a larger geographical presence, particularly outside the US.

Starbucks still differentiates itself via premium coffee and a very singular image, but that doesn’t mean McDonald´s can´t successfully ride the coffee consumption boom. Just like Cantina Bell is a positive for Yum! even if it doesn’t do much damage to Chipotle, McCafé is a smart move by McDonald´s, even if it doesn´t steal a lot of market share from Starbucks.

A Profitable Business for a Low Price

McDonald´s operates nearly 80% of its business via its franchise and affiliate system, which provides rents and royalties with minimal capital expenditures during challenging economic times. The company´s size means important economies of scale, which McDonald’s translates into higher profit margins.

The company has been able to increase its dividend for 35 consecutive years, and the payout ratio is at a very sustainable 50% of earnings. The stock yields a 3.5% in dividends, and those dividend payments will continue rising in the following years. From an income investing perspective, McDonald´s does look like a buy.

Bottom Line

Competition is tough in the fast food business, and McDonald´s needs to find smart ways to adapt to healthier eating habits all over the world. But the company has a rock solid competitive position sustained by a world famous brand, an unparalleled marketing budget, and valuable locations in some of the most desirable geographies of the world.

McDonald´s is financially healthy, and the company keeps generating big cash flows to support dividend growth over the next years. At current valuations the negative news may already be reflected in the stock price, so this value meal is starting to look tasty.

 


acardenal has no positions in the stocks mentioned above. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald's, and Starbucks and has the following options: short JAN 2013 $47.00 puts on Starbucks. Motley Fool newsletter services recommend Chipotle Mexican Grill, McDonald's, Starbucks, and Yum! Brands. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.If you have questions about this post or the Fool’s blog network, click here for information.

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