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Why McDonald's Arches Are Golden


McDonald's definitely knows a thing or two about being bigger than life. More than 100 billion people have been served under its Golden Arches...

When the market rebounded on Friday from its losses earlier in the week, you should note that the Dow Jones Industrials Average ($INDU) made the strongest strides among all major indexes. It rose $1.2%, vs. 1% for the S&P Midcap 400 and Smallcap 600. That capped a three-month period in which the measure of market big-shots has likewise outpaced all the smaller comers.

The strength of large-cap value stocks is stumping a lot of traders since conventional wisdom suggests that small-cap growth should lead major rallies. It just goes to show that sometimes you need to throw aside what you think you know, and focus instead on what's really happening.

I've heard from some of my new readers here at Minyanville that they want to fight this tape, with one stating in e-mail that the market "has more work to do lower." Maybe, who knows? But I still see some great opportunities on the long side.

The third-best performing Dow stock on Friday was one that I like a lot right now, and have been noting in my advisory services since January 2006. It's got value, it's got momentum, and it happens to have the sweetest looking INDU chart coming out of last week's dip. So grab a pack of ketchup and a napkin, and let me explain why Big Mac is golden.

McDonald's (MCD) definitely knows a thing or two about being bigger than life. More than 100 billion people have been served under its Golden Arches -- although I must admit, the company stopped counting in 1994. It's no wonder, since keeping track of hamburger sales across 31,000 restaurants in more than 120 countries is a serious undertaking.

To keep its grills sizzling in all these restaurants, the company also runs a gigantic marketing budget of $2 billion, which for scale is roughly equal in size to the total economic output of the Central American nation of Belize. That's a whole lot of "I'm Lovin' It" on the airwaves.

This kind of advertising firepower has been driving McDonald's efforts to rebrand itself by blasting away at its Super Size Me reputation. It's not exactly going to cater a PETA luncheon anytime soon, but snazzy new décors and trendy menu items like gourmet salads, yogurt parfaits and premium coffees are the real signs of change.

These initiatives have been focused on enticing adults into visiting this restaurant chain that is already loved by kids. At a meeting with analysts last month, the company's chief marketing officer noted that MCD's beverage strategy will mimic that of its high-end chicken offerings. There, the company started by upgrading its venerable McNuggets to an all-white-meat recipe. This opened the door to follow-up offerings including its Chicken Select strips and Premium Chicken Sandwiches as the market accepted its flight of fancy in the poultry space.

Following the success of this strategy in the company's chicken offerings, the vanguard for the beverage line was the decision to start offering cups of Seattle's Best Coffee -- a division of Starbucks (SBUX) -- at its locations. Now, plans call for a continued push into coffee-based drinks as well as fruit smoothies. Also, look for a shift towards bottled "alternative" beverages such as teas, flavored waters, energy drinks and juices. Not only are they a nice alternative to carbonated drinks, but they are handier for drive-thru customers prone to spillage, and they also carry higher margins.

Again, these initiatives are mainly focused on older guests. And while the company is trying to bring in a wider range of customers, it isn't forgetting about the children who already love McDonald's Happy Meals and Playlands. To continue its success with kids and head off slowing Happy Meal sales, McDonald's is concentrating on making its children's menu more acceptable to health-conscious parents. As it stands now, the average American child consumes 2.2 Happy Meals per month. (I think the other 0.8 of a meal fell on the floor.) The stigma that McDonald's food currently carries prevents moms and dads from increasing this to, let's say, four meals per month, which would add a whole percentage-point to the company's same-store sales figures.

The super-sized marketing budget will help point out new choices for Happy Meals such as milk in lieu of soda and apples instead of fries. Another solution would be to include apples or a veggie free of charge. Nonetheless, 20% of the $2 billion marketing budget will be spent on ads touting active lifestyles, children's health and the higher quality of McDonald's meal offerings.

I believe these efforts will gain traction, as the sheer number of McDonald's locations -- with the corresponding convenience created -- will instill a powerful urge to try out these new menu items. It's this combination of familiarity, fancy newness and accessibility that helped Madonna maintain a successful career, and it is helping McDonald's regain lost prominence.

Marketing magic aside, there are some financial catalysts that should help shares move higher as well. The company's balance sheet, as it stands now, is underleveraged as it continues to increase the number of franchised locations vs. those that are company operated. McDonald's also generates tons of cash, and it had a 5% free cash flow yield in 2006, which is expected to increase to 8% this year. Conservatively, I expect the company will repurchase $1 billion worth of its own shares over the next year as it optimizes its debt burden. If this is so, the total share buyback authorization for the next two years would climb to nearly $7 billion.

Although shares are up 16% so far this year, I still think newcomers can add them to their portfolio with confidence. Earnings per share growth is likely to remain in the high single-digits over the near term, which gets me to a 2009 EPS estimate of $3.22. As its return on invested capital has been improving lately, McDonald's should see its price/earnings multiple move towards the higher reaches of its five-year range, near 20X. I like McDonald's for my 15-month target of $64 -- a nice, juicy 28% move from here.
No positions in stocks mentioned.

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