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Is There More Upside for McDonald’s in 2019?

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Stock performance

As of Friday, McDonald’s (MCD) was trading at $211.24, which implies a rise of 19.0% since the beginning of this year. The company was trading at a premium of 37.9% from its 52-week low of $153.13 and at a discount of 0.8% from its 52-week high of $213.01.

Despite returning 19% this year, McDonald’s has underperformed the broader equity market. The S&P 500 Index and the Consumer Discretionary Select Sector SPDR ETF (XLY) have returned 19.3% and 22.9%. XLY has invested 7.7% of its holdings in restaurant and travel companies. During the same period, Starbucks (SBUX), Wendy’s (WEN), and Jack in the Box (JACK) have returned 36.3%, 26.9%, and 4.8%, respectively.

McDonald’s stock was driven by its strong performance in the fourth quarter of 2018 and the first quarter. The lower unemployment rate, wage inflation, and increased consumer confidence led customers to spend more at restaurants. The improved consumer sentiment has also contributed to a rise in restaurants’ stock price. McDonald’s reported its first-quarter earnings on April 30. During the first quarter, the company reported an adjusted EPS of $1.78, which beat analysts’ estimate by 1.7%. McDonald’s revenues were higher than analysts’ expectation of $4.93 billion at $4.96 billion. McDonald’s SSSG (same-store sales growth) was 5.4%, which beat analysts’ estimate of 3.4%. The company’s management credited the conversion of its old restaurants to “Experience of the Future” and its promotional offering for strong sales in the US. To learn more, read McDonald’s: Key Takeaways from Its Q1 Earnings.

Revenue growth prospects

For 2019, analysts expect McDonald’s revenue growth to remain flat at $21.03 billion. McDonald’s management is focusing on increasing the restaurants operated by franchisees to 95% to optimize its operations. By the end of the first quarter, 92.9% of McDonald’s restaurants were franchised. So, refranchising and unfavorable currency translations will likely lower the company’s revenues this year. However, the positive SSSG and opening new franchised restaurants are expected to offset the effects of refranchising and unfavorable currency translation. The company is expected to maintain its revenues at the levels in 2018.

McDonald’s management is focusing on converting a higher number of old restaurants to “Experience of the Future,” expanding the delivery service to more restaurants, enhancing customers’ experience through implementing digital advancements, and menu innovations to drive its sales.

By the end of the first quarter, McDonald’s had deployed “Experience of the Future” in 8,000 restaurants. The company plans to convert 2,000 restaurants to “Experience of the Future” this year—400 were covered in the first quarter. McDonald’s delivery sales, which include sales from company-owned and franchised restaurants, were $3 billion. McDonald’s plans to expand the service to more restaurants. There were 20,000 restaurants with the service across 75 countries at the end of the first quarter. McDonald’s acquired Dynamic Yield in March. The acquisition will likely help the company deliver more personalized offerings to its customers.

EPS growth prospects

For 2019, analysts expect McDonald’s EPS to grow 1.5% to $8.02. The expanded EBIT margin and lower number of shares outstanding due to share repurchases will likely drive the company’s EPS this year. However, higher interest expenses and the effective tax rate are expected to offset some of the expansion in McDonald’s EPS.

Analysts expect the company’s EBIT margin to improve from 43.1% to 43.9%. Increased revenues from the higher margin franchisee business due to refranchising, the net addition of new restaurants, and sales leverage from positive SSSG are expected to drive the company’s EBIT margin. However, some of the growth in the EBIT margins will likely be offset by labor inflation, investments in growth initiatives, and the new accounting standard.

In the first quarter, McDonald’s repurchased ~5.4 million shares for ~$963.6 million. By the end of the first quarter, the company had the authorization to repurchase shares worth $6.05 billion. For 2019, analysts expect McDonald’s effective tax rate to rise from 24.2% in 2018 to 24.8%.

Dividend yield

On May 23, McDonald’s board declared quarterly dividends of $1.16 per share at an annualized payout of $4.64 per share. As of Friday, the company’s dividend yield was 2.2%. The company’s stock price was trading at $211.24. On the same day, Starbucks (SBUX), Wendy’s (WEN), and Jack in the Box’s (JACK) dividend yields were 1.64%, 2.02%, and 1.97%, respectively.

Valuation multiple

McDonald’s stock price has increased 19% since the beginning of this year. The company has also raised its valuation multiple. As of Friday, McDonald’s was trading at a forward PE ratio of 25.2x—compared to 21.6x at the beginning of this year. Despite the strong performance in the last two quarters, the company is trading at a discount compared to its peers. Starbucks and Wendy’s are trading at forward PE ratios of 29.1x and 28.5x, respectively.

On Friday, McDonald’s was trading at 26.3x analysts’ 2019 EPS estimate of $8.02 and at 24.2x analysts’ 2020 EPS estimate of $8.71. The company’s EPS is expected to rise 1.5% in 2019 and 8.6% in 2020.

Analysts’ recommendations

The optimism surrounding McDonald’s implementing digital advancements and expanding its delivery service and its strong first-quarter performance compelled analysts to raise their target prices. Since McDonald’s reported its first-quarter earnings, Jefferies, J.P. Morgan, Stifel, UBS, SunTrust Robinson, BMO, Cowen and Company, Mizuho, BTIG, and Piper Jaffray have all raised their target prices. On June 25, Credit Suisse started its coverage on McDonald’s with an “outperform” rating and a target price of $230.

Overall, analysts are favoring a “buy” rating for McDonald’s stock. Among the 32 analysts, 78.1% recommended a “buy,” while 21.9% recommended a “hold.” On average, analysts have given a 12-month target price of $$218.0, which implies a return potential of 3.2% from its stock price of $211.24 as of Friday.

Wendy’s stock has been rising since the company reported its first-quarter earnings on May 8. Read Does Wendy’s Valuation Multiple Still Look Attractive? to learn more.

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