Is McDonalds a Low Price Offering?

McDonald's But Not as You Know it!

McDonald’s $MCD is a fantastic business that is firing on all cylinders. The recent results sailed ahead of estimates and the company is clearly grabbing market share from Yum Brands $YUM and other competition. However, is all of this fully priced in?

As a potential investment McDonald’s has a strong appeal due to a number of factors which I’ve listed below

• From a macro-economic perspective it offers a play on austerity in developed markets as unemployment remains high and McDonalds offers a value meal proposition
• Within Emerging Markets, McDonald’s has a ‘Western aspiration’ brand that benefits from rising disposable incomes and urbanization
• McDonald’s has successful repositioned itself away from fast food junkies and leveraged its brand into launching newer healthier alternatives
• Customers are-thus far-tolerating price increases but price pressures are increasing

Around a decade ago, McDonald’s made a master stroke in taking a strategic stake in Prêt-A-Manger (in order to ‘learn’ how to service a different market) which has partly been behind the successful re-branding. Back then, it would almost have appeared inconceivable that McDonalds would be discussing the kind of product offerings and innovations that peppered the recent conference call. For example, beverage sales were up 29% and McCafe has seen far better than expected growth in sales per store. Premium chicken sandwiches, smoothies, oatmeal breakfasts and wraps are now alongside the traditional burgers, fries and milkshakes in the product mix.

Not only has McDonald’s successfully rebranding but they have managed to diversify and tailor the product offering to differing regions. Delving deeper into the Q2 numbers for regional sales reveals how this plays out

Region	Q2 Comp Sales Increase	Q2 Op Inc Increase
Global	5.6%	11%
Europe	5.2 %	10%
USA	4.5%	6%
APMEA	5.9%	19%

Clearly, the US is the laggard in terms of both metrics, however, it is the most developed region for the company and it has been grabbing market share from Yum as its rival focuses on Emerging Market growth. Moreover, Europe is actually the biggest market for the company and these results represent strong execution.

Commodity Costs Coming

On a less positive side, commodity costs are on the increase and although customers absorbed them well, margins fell in all three regions for McDonald’s. This is an obvious concern-not least for the demographics of a typical customer- but also for future margin expansion. No one likes to be a business with challenged margins. However, I think that with slower growth, going forward, within emerging markets, we could see a moderation in things like beef prices, which could help out McDonald’s margins.

In this report, the company saw cost increases of around 4-5% generally but that figure could come down going into next year. In addition, I think that the value proposition of McDonald’s means that demand should still grow even if the Asian economies start to slow.

International expansion

Turning to expansion plans for this year, here is a break down of where new store openings will be

Region	New Restaurants for 2011
Global	1115
Europe	225
USA	150
APMEA	650
Latin America	90

APMEA is how the company bundles Asia Pacific with the Middle East. Within the APMEA numbers, new stores for China are 200 and 100 and 30 for Japan and South Korea respectively. It is a misnomer to suggest that only Yum are expanding in emerging markets!

McDonald’s Stock Evaluation

Frankly, I think it is fairly priced and would struggle to see much upside from here. I know most commentators are saying this, but that doesn’t mean I should force myself into thinking something different for the sake of novelty!  The opportunity for margin expansion does exist via lower food prices and the growth strategy looks assured but at a current price of $88.56 the stock trades on 17.3x forward estimates. This drops to 15.8x for 2012 but should investors pay this evaluation for two years out earnings, given that earnings growth ($5.6 from $5.12) is likely to be less than double digits?

I think the answer has to be negative. The yield at 2.9% is decent and it’s a decent stock to tuck away long term, but this evaluation doesn’t look cheap enough to me. I will monitor and hope for a dip.

General Mills Offers Defensive Growth Prospects

General Mills $GIS is an interesting defensive stock that appears attractive because it offers a few key plus points. I’ve listed a few of them in bullet form below

• Defensive end markets of food and yogurt
• Good exposure to lowering commodity prices
• Strong dividend yield currently around 3%

So is General Mills an attractive stock to buy?

General Mills is ubiquitous name in the US Households through its cereal brands, healthy snacks, ready-made meals (Pillsbury etc), Haagen-Dazs ice cream and Yogurt (Yoplait) offerings. The last of which is growing quicker than the other products and, accordingly, the co is busying acquiring the international business of Yoplait. Next year will be about General Mills increasing pricing in order to benefit from the retention of market share that they fought for (via promotions, discounts etc) in previous years. However, the co is predicting that media spending will track sales growth so the management are unlikely to generate any operating efficiencies there.

This type of stock will always appeal to fund managers and investors because it provides good income and helps balance risk in a long only portfolio. I like the potential for future margin expansion coming from exposure to commodity prices coupled with its defensive nature. Indeed, over the last five years General Mills has grown operating profit every year (CAGR of 7% over the period) and EPS every year (CAGR of 12% over the period).

General Mills Q4 and Full Year Results

General Mills recently gave results and they were pretty good, however the outlook was weaker than the company had previously forecast. The good news is that the market had largely priced this in because the main cause is commodity price inflation. All of which suggests that if these prices continue to moderate-in line with the tightening attempts in many emerging markets-that General Mills could see some ‘upside surprise’ to gross margins. I’ve outlined historical cost inflation and gross margins for General Mills below

General Mills Estimates(%)	2007	2008	2009	2010	2011	2012
Input Cost Inflation	4	7	9	-3	4	10 to 11
Gross Margins	35.9	35.1	36.4	39.7	39.4	Lower

It is easy to see the inverse relationship between gross margins and input cost pressures. Moreover, this year’s cost inflation push is even more pervasive because commodities are up across the board and from relatively weaker comparables. In fact, the company is predicting lower gross margins as well as a low adjusted EPS growth of only 5% for next year.

Delving deeper into the results reveals that US retail sales were down 2% but international sales (constant currency) were up 16% respectively. This should provide little succour to shareholders because US retail sales still make up over 76% of segmental operating profits but international is only 10.7%. US retail sales were down but this is largely due to less price discounting and promotions. Accordingly, overall, full year operating margins expanded from 15.1% in 2010 to 16.6% in 2011.

General Mills Evaluation

Listening to the conference call, the management are predicting a tough time in 2012 and, gross margins are seen as being lower. Similarly, the forecast adjusted EPS growth of 5% (261c from 248c) is not particularly attractive. However, I think the co could beat this guidance with lower commodity costs; however, my concerns are with the stock’s evaluation and sales growth.

At $37.26 General Mills has a market cap of $23.81bn and an EV of $30.17bn which, in my opinion, is a bit rich for a company which has generated $878m in free cash flow. In addition, the co is forecasting $670m in capital spending next year against $649m in 2011. Given that EPS is predicted to rise by 5% only, then this suggests that next year’s free cash flow generation could be similar to this year’s. A forward PE of (37.26/2.61)=14.3x and FCF/EV of around 3.2% is not particularly exciting for a company with low single digit sales and EPS growth.

In addition, the free cash flow barely covers the dividend which suggests that long term dividend growth will be tough for General Mills. I think there are better ways to play a correction in commodity prices. The bulk of General Mills products are hardly high growth so whilst it is a fine investment for investment managers looking to park cash in a defensive manner, it will not attract GARP focused investors. I took a pass.