Do Premium and Value Go Together?

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

It's rare to find a company that can position itself as offering both value and premium offerings. Sometimes, when a company tries to straddle the lines between high-end and cheaper options, customers can get confused and sales may suffer. Some investors might assume this is what’s happening at McDonald’s (NYSE: MCD). However, the Golden Arches has upgraded its image before, and chances are the company can do it again.

A business model built to last
There is a reason McDonald’s has been able to survive and prosper for all of these years. The company realized that by offering food at cheap prices that millions, and now billions, would frequent the chain. In addition, McDonald’s has a somewhat unique business model that only a few companies truly take advantage of.

McDonald’s uses franchisees to expand and grow its profits and cash flow. In fact, as a percentage of total revenue, McDonald’s gets 32.78% of its total from franchisees. By comparison, its competition such as Yum! Brands (NYSE: YUM) gets 14.81% of revenue from franchisees. Chipotle Mexican Grill (NYSE: CMG) is another competitor, and yet is operated almost exclusively as company-owned restaurants.

That being said, one of the company’s fastest growing franchisees, Arcos Dorados (NYSE: ARCO), is posting significant growth, and ironically re-franchises its operations as well. The company gets just 4.39% of its revenue from franchisees, so as you can see, the heavy use of franchised locations apparently isn’t a requirement for fast growth. However, what is a requirement is being able to adapt to changing tastes, and that is what McDonald’s is hoping to continue to do.

Updating and upgrading
What McDonald’s has become very adept at is updating its concept and upgrading its menu. For those who don’t believe McDonald’s can continue to change and grow with the times, consider how far the company has come already.

I worked for several years with a young lady who would never have eaten at McDonald’s when the company was a burger and fries joint. However, when McDonald’s introduced its oatmeal, she thought it sounded good, tried it, and many mornings before work she would stop at McDonald’s just for the oatmeal. 

This is a key difference between McDonald’s and its competition. McDonald’s and Arcos Dorados will benefit as the company continues to evolve. However, Yum! Brands’ main chains like Pizza Hut, KFC, and Taco Bell have stuck to their primary offerings of pizza, fried chicken, and tacos for years. While Chipotle is a much younger company, the insistence on sticking to a very narrowly-focused menu has already caused the company’s results to suffer due to input cost issues.

Strong margins and growth opportunities worldwide
McDonald’s use of franchisees and an ever-evolving menu have helped the company to class-leading margins. Based on operating margin alone, McDonald’s is significantly outperforming its peers. The company’s current quarter operating margin is 31.02%, compared to 13.43% at Yum! Brands, 17.9% at Chipotle, and just 3.81% at Arcos Dorados.

While many people know about McDonald’s great margins, some assume that a company this large is incapable of decent growth. However, those who assume McDonald’s best days are behind it might want to look at the opportunities still available.

First, Arcos Dorados will be a part of McDonald’s growth, as the company opens more and more franchised restaurants in the Latin American market. With analysts calling for 27% earnings growth, part of this growth will flow back to McDonald’s. Second, McDonald’s has a huge opportunity in China as well.

When you consider that Yum! Brands has found support for well over 5,000 restaurants and expects to continue its torrid growth in the Chinese market, McDonald’s will have plenty of time to extend its growth. McDonald’s has about 1,700 restaurants in the market, and grew this count by 14%. Clearly the Chinese market is a priority, and with thousands more restaurants possible, McDonald’s growth is far from over.

Value too?
It would be hard to call McDonald’s a value pick, but relative to peers, the stock looks attractive. Using the PEG+Y ratio, which combines the company’s yield and earnings growth to its forward P/E ratio, the stock is the second-best deal of the bunch.

Chipotle might be a fast growth stock, but at over 38 times earnings and with an expected growth rate of 20%, the company’s PEG+Y (20% divided by 38) is 0.53. Since the lower the PEG+Y ratio, the worse the value, Chipotle is hardly a pick for safety. That being said, Yum! Brands is generally seen as a strong company, but with a P/E of 24, compared to a yield of less than 2% and earnings growth of 11%, the stock’s PEG+Y is 0.54.

While Arcos Dorados seems to offer the best value with a PEG+Y of 0.94 because of its 27% expected growth rate, the company carries a heavy debt load that could derail this story. While McDonald’s isn’t a huge opportunity with a PEG+Y of 0.66, the stock’s yield of 3.14% and decent 8.5% expected growth rate means investors are getting a good mix of growth and income.

Considering the Golden Arches has been able to grow and prosper through changing tastes, there is little reason to believe the company can’t continue to grow and adapt. With growth opportunities in breakfast, beverages, and upscale offerings, this is a rare case where customers and investors can find value and premium options together in a tasty combination.

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Chad Henage owns shares of McDonald's. The Motley Fool recommends Chipotle Mexican Grill and McDonald's. The Motley Fool owns shares of Arcos Dorados, Chipotle Mexican Grill, and 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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