By: Steve Smith
This fast food giant has seen it shares enjoy a healthy climb once it embraced its roots of tasty calories at a low price point. But the stock is now very expensive on many metrics and the chart has formed a bearish head and shoulders pattern.
I was going to try some clever headline about unhappy meals or hatin’it, but I actually like McDonald’s (MCD). Maybe not the food so much but what the company has done recently to slim down the menu and basically embrace who they are; tasty calories at a great price point.
I also think the e-coli at Chipotle (CMG), along with the fact it was selling 2,500 calorie burrito bombs, has helped place whole notion of what is ‘healthy’ in the appropriate box of relativity. But I digress.
What I hate about MCD is it’s multiple; a very mature company in a saturated and competitive landscape trading at 28.5 forward earnings is unwarranted. Not when it has historically traded in the high teens and faster growing competitors such as Sonic (SONC) or Red Robin Gourmet Burger (RRGB) trade at 21x. Only Yum Brands (YUM) carries a higher multiple and that’s a function of its impending spin-off the high growth China divisions such as KFC.
The whole industry is carrying an historically rich valuation and MCD’s is the fattest relative to its expected mid-single digit growth rate. It also trades at its highest multiple on over 20 years, which includes periods of much higher growth both in the U.S. and the big surge overseas last two decades.
Indeed, the most recent earnings report on January 25 the company posted revenue of $6.55 billion, an impressive 7% increase but Net income declined to $7.15 billion from $7.95 billion. More importantly the foot traffic it had gained from the new menu and all day breakfast seems to be waning quickly as same store sales which jumped some 5% during the October through December period are now expected slow markedly.
An analyst report from RBC to lower its estimates for first-quarter same-store sales
to 2.5% from 5% noting sales were “sluggish” in January and citing the company’s recent McPick2 promotion in which the company raised the price to $5 for two items has been a disappointment. Apparently the notion of paying $5 for two $1 Dollar menu items has not sat well with customers.
In addition, MCD trades at almost 15 times its book value, and has an EV/EBITDA of 13.65. All of these numbers are not unbearably expensive, but the point is that they leave a lot of room for the valuation to be pulled back in, should the market pull back or the company not proceed with its turnaround as planned.
Despite the steady rise in EPS (last two years excluded) and share price since 2002, McDonald’s has only ever traded above a P/E of 20 a few times, and has always come back down to trade at an average of 17.6 even when EPS rose by as much as 27% in 2008. Meaning even a mere reversion to the mean and it earns the expected $5.40 in 2016 that translates into a $97 price target or a 17% decline from current $117 level.
Also, for a blue chip company McDonald’s balance sheet is less than pristine. Currently, the company has a relatively large $24 billion in debt, which is about one fourth of its market cap and about three times the amount of cash on hand that it has. With operating cash flow of $6.5 billion in the last 12 months, the debt is not an overriding concern, but it is a little bit of an eyesore in a broader market where the cost of capital is going to be rising.
Head & Shoulders
The stock’s initial move from September lows of $90s to $110 made sense given the turnaround plan and measurable increase in same store sales. But the next $12 up to $123 was been baffling especially considering it occurred while the rest of the market was faltering.
But the chart offered no reasonable entry point. Now it does. The stock put in potential top early in February and had a quick sell-off. It has now consolidated sideways beneath resistance at the $119 level and is forming a bearish head and shoulders pattern.
I don’t think McDonald’s should or will trade at discount to its peers but a decrease to a 20 p/e multiple isn’t unreasonable. This would price shares at around $106 which would fill the gap in the chart nicely.
I want to use a basic vertical put spread to establish a bearish position. This well help reduce cost and limit the impact of time decay. I will go out to the June expiration. Specifically;
-Buy to Open June $120 Puts
-Sell to Open June $105 Puts
For a $4.50 Net Debit.
This is what the risk graph looks like:
This gives us a nice risk/reward and plenty to happy about if shares drop to $105 by the June expiration.