McDonald's and Yum! Brands Had Bad Results But Good Returns

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

The restaurant industry actually isn’t that hard to understand. Companies in the industry focus on comparable-store sales, store openings (international primarily), and share buybacks to sustain earnings-per-share growth. Things that have impacted growth have included biohazards, regulation, and currency market fluctuations. With that backdrop, let’s review McDonald’s (NYSE: MCD) and Yum! Brands' (NYSE: YUM) earnings.

McDonald’s earnings

The company reported a 1% year-over-year gain in comparable sales. Consolidated revenue was up by 2% (the remaining 1% in consolidated sales came from the opening of more restaurants, from franchisees).

The company reported a 3% year-over-year increase in expenses, but was able to offset that with a 2% improvement in revenue (the company has a really large gross margin, so a gain on sales would be able to offset a similar percentile increase in expense). It also reported income tax increases of 0% even though the company was able to generate an additional 2% in net operating income. This resulted in the 4% gain on net income (after all, if operating income increases, but the tax rate remains the same, take-home pay gets bigger.)

So in summary, what happened in McDonald’s quarter was slight improvements in comp-sales and restaurant count, plus earnings that got padded due to better tax strategies. With a licensing strategy, I could only imagine the creativity over at McDonald’s tax accounting department.

The company reported diluted earnings per share of $1.38 for the second quarter. The company reported earnings that slightly missed the consensus forecast set at $1.40 per share. As a result, the stock declined in valuation following the earnings announcement.

Analysts on a consensus basis anticipate the company to resume higher rates of growth, with earnings growth expected to be 8.4% per-year over the next five years. The company could generate the higher rates of growth by opening more restaurants. Also, the European economy is projected to turn around by 2014. So if anything the company's earnings performance should eventually improve.

Yum! Brands' earnings

So Yum! Brands reported serious issues in its international strategy, particularly China. The company reported that same-store sales declined by 20% year-over-year in its China segment. It reported that weaknesses in the Chinese segment came from the avian flu, which is flu from birds that can mutate to spread to humans.

The weaknesses in the Chinese segment seem largely temporary. After all, fish demand eventually recovered even though nuclear radiation was dumped into the Pacific Ocean (largest body of water in the world) off the coast of Japan. So, I could only imagine that the scare over chicken will be temporary.

On a consolidated basis, the company reported an 8% year-over-year decline in total revenue for the second quarter. The decline in revenue was accompanied with a 7% year-over-year increase in expenses. Falling revenue and rising expenses are a bad combination. So, in the end the company generated a 15% year-over-year decline in net income.

The company reported diluted earnings per share of $0.61 (13% year-over-year decline). On the upside, it provided guidance that earnings per share should be able to stabilize at around mid single digits. This implies that going into the third and fourth quarters, the comp sales in China are expected to improve.

Basic outlook on the industry

It seems that restaurants, depending on locality, are exposed to food epidemics. Going forward, investors have to watch out for contamination in water supply, biohazards, and radioactivity, as they can have a significant impact on earnings going forward.

Source: YCharts

The thing that really stuck out, however, was the limited impact the avian flu had on the price of Yum! Brand’s stock. The stock eventually recovered, and its one-year performance was similar to McDonald’s. The price was impacted over the short term, but recovered because the long-term fundamentals have remained largely intact.

The restaurant sector performed fairly well based on the 34.2% gain in the value of the PowerShares Dynamic Food & Beverage (NYSEMKT: PBJ) ETF. However, what’s even more interesting is that the industry itself is expected to grow earnings by 7.8% year-over-year. So there seems to be a fairly large disconnect between the performance of these stocks and the year-over-year growth that has been estimated for restaurants as a whole.

Source: Goldman Sachs

In 2013, investors have opted to invest into riskier asset classes like fixed income and equities. The real kicker is that equities have been able to attract $74 billion in fresh capital. This has been able to push the valuation of stocks even higher.

The overriding theory is that there’s a large asset rotation taking place. Higher bond yields means falling bond coupon values, and most people in the financial sector get paid on performance. So the underlying theory is that asset managers are shifting portfolios to have a greater composition of stock rather than fixed income/money market.

Sector strategy

It couldn’t be a bad idea to own the Powershares Dynamic Food & Beverage ETF as it offers diversification and a 1.4% distribution yield (dividend). The fund’s gross expense ratio is pretty high at around 0.6%, but that is because the fund’s market capitalization is $318.3 million, which is small for an exchange traded fund. If the fund had a larger market capitalization, the fund’s base fee would most likely be lower.

On the bright side, the distribution yield offsets the management fee and the fund offers diversification that generates higher yields than the stalwarts of the industry. The exposure to smaller regional players like Denny’s and Sonic is the source of capital appreciation. The smaller restaurant franchises have more upside as they have not reached full market saturation domestically.

Conclusion

McDonald’s and Yum! Brands both missed earnings expectations this past quarter. This has sent mixed signals to analysts and may force downgrades from different analysts. McDonald’s strategy of generating better results through creative tax practices could only take the company so far.

The industry should be able to garner added capital appreciation. The lion's share of it will come from regional restaurant chains. Even though earnings growth rates are declining for the industry stalwarts, the stock performance of these giants should continue to improve based on equity inflows.

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Alexander Cho has no position in any stocks mentioned. The Motley Fool recommends McDonald's. The Motley Fool owns shares of McDonald's. 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. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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