Marshall is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
For years investors have been wondering how long McDonald's(NYSE: MCD) can continue to rise higher. The only period of weakness the company experienced was from 2000 to 2003.
In 2004, Jim Skinner was brought in as CEO after the company reported its first-ever quarterly loss. Since the low of less than $15 in 2003, the stock has been on a steady climb. Even during the financial crisis, the stock only dipped slightly as
the weakened economy sent more customers to McDonald's for its dollar menu.
The short trade in McDonald's has been a painful one, but suddenly the shorts seem to think that now's the time for McDonald's to undergo another 2000 to 2003 period. Currently, the short interest in McDonald's is 11.3 million shares.
One of the company's biggest weaknesses remains its customer service. Anyone that has been to McDonald's in different neighborhoods can attest to this fact. The customer service experience is not the same at each restaurant.
Part of company's brand is the nostalgia we had as children growing up with McDonald's. As other companies are able to offer a better customer experience, it poses risks to McDonald's and its brand.
Customer service was one of the biggest problems that McDonald's faced in 2003. New CEO Jim Skinner combated this problem by slowing new-store openings and focusing on the basics – customer service and restaurant cleanliness. If McDonald's has to go back to the basics again, it doesn't bode well for shares.
At this point, the turnaround in McDonald's should be complete and the focus needs to be on new-store openings and expanding the menu. A return to basics is what the shorts want, as the company will be less-focused on growth.
McDonald's is still having a hard time luring younger customers with its new menu items. For freshness and a healthier option, most younger customers would rather go to Subway and get a sandwich made to order. McDonald's is still looked at as a sinful treat when one gets a gluttonous craving.
Even McDonald's says that they worry most about Subway rather than other hamburger chains, such as Wendy's and Jack in the Box (NASDAQ: JACK). To compete with Subway, McDonald's just launched the McWrap as a healthier option with the hopes of luring young people into its fast-food chains instead of going to Subway.
Despite the move toward more healthier options, shares of fellow burger-joint Jack in the Box have been performing well, and are up almost 25% year-to-date. This comes after the company has beat analysts' estimates by at least 15% over the last four quarters. Analysts are also encouraged by Jack's future, where despite the company's negative 8% annualized earnings growth rate over the last five years, analysts expect EPS to grow at 12.8% annually over the next five years.
However, despite all this good news, the valuation may cause some investors to hesitate when investing in Jack. It's current P/E is upwards of 24.7, compared to McDonald's 18.6.
Although Jack is a much smaller competitor with a $1.6 billion market cap, hedge funds are getting excited about the stock. At the end of 2012, there were a total of 15 hedge funds long the stock, a 25% increase from the third quarter.
The dollar menu was at one time one of McDonald's strengths. Now its competitors have all adopted a similar pricing model and it no longer differentiates McDonald's. Jack in the Box of course has a dollar menu, but the fast-food joint also recently announced plans to offer a healthier breakfast option, oatmeal.
What McDonald's risks most with the dollar menu is actually a strengthening U.S. economy. When the economy was weak, many people resorted to the company's dollar menu as times were tough. If and when the US economy gets stronger, many won't want to go back to McDonald's since it'll be a painful reminder of how bad things were.
Worries in China
The outlook for China has gotten more negative for restaurant chains with the development of the H7N9 virus. Just recently there were 82 confirmed cases and 17 deaths. As the virus continues to spread in Asia, it could dampen the one bright spot for McDonald's growth. The more the virus spreads the more of an impact it will have on sales for McDonald's in Asia.
Speaking to the concerns and weakness in China has been the turmoil that Yum! Brands (NYSE: YUM)has been undergoing over the past few months. Its KFC China segment reported suppliers overloaded its chicken with chemicals to expedite growth, with no ideas of how long it will take to recover sales at KFC in China.
Management has previously expected weakness in China to lead a 25% fall in same-store sales for the first quarter of 2013; however, the company reported same-store sales down only 20%, part of which has driven the stock up over 5% after earnings. Yet, earnings were still down over 26% year-over-year for the first quarter, and management affirmed its downbeat 2013 guidance.
The Yum! China issues have only further brought to light the regulatory and health issues related to operating in China. These are headwinds that are in addition to a slowing Chinese economy. However, one positive for McDonald's is that it does not get a majority of sales from China, unlike Yum!, which derives some 45% of revenues from China.
Where McDonald's had notable billionaires as its top hedge fund owners, Yum! has niche-concentrated hedge fund Joho Capital as its top hedge fund owner by shares. Joho had nearly 10% of its public equity portfolio invested in the fast food company at the end of 2012.
No matter where you go in the world, there's still a line at the local McDonald's. In fact, McDonald's and Coca-Cola are probably America's greatest brand ambassadors. Children of all ages grow up knowing about these brands and wanting their products. The McDonald's brand continues to grow globally and expand.
McDonald's is constantly adding new menu items. The company's test kitchen has done an excellent job of identifying new menu items to appeal to a wider audience. Recently the company added Fish McBites, Grilled Onion Cheddar burger, and Hot 'n Spicy McChicken. New beef sandwiches and chicken entrees are expected next. McCafes continue to be rolled out into stores and are capturing the demand for coffee and coffee products. The McCafe is McDonald's effort to capture part of Starbucks' market share.
Most notable hedge fund investors include billionaires Jim Simons (RenTech), Ken Fisher (Fisher Asset Management) and Ken Griffin (Citadel Investments), all owning over 3.5 million shares at the end of 2012.
Shares of McDonalds just recently hit a new 52-week and all-time high of $103.70. However, the stock is only up about 5.9% in the past year. The stock has been trading in a sideways pattern above $100. Hence, it's low beta of 0.3. Operating margins are still high at 30.3% and return on equity comes in at 36.8%. On the balance sheet, there's $2.3 billion in cash to $13.6 billion in debt.
The current annual dividend is $3.08 per share for a yield of 3%. Of the analysts that follow the stock, five have it rated as a Strong Buy, 10 a Buy, 13 a Hold, and one an Under-Perform. Price targets on the stock range from $91 to $120 with $103.50 being the median target. The stock is trading at 18.6 times forward earnings, while Jack in the Box trades at 21.2 times and Yum! 19.3 times.
Over the long-term I'm bullish on the stock. However, the company is struggling with resistance here above $100. The H7N9 virus is a concern going forward and will impact China same-store sales. I recommend buyers wait for a dip into the $90s before buying.