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Why McDonald’s Is a ‘Buy’ before Its Q1 Earnings

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Apr. 27 2020, Updated 8:33 a.m. ET

Amid the global sell-off due to COVID-19, McDonald’s (NYSE:MCD) stock declined to a low of $124.23 on March 18. Since then, the company has made a significant recovery. As of April 24, the company was trading at $184.02, which represents a rise of 48.1% from the lows on March 18. Investors’ excitement about the passage of $2 trillion stimulus package and the expectation of the pandemic already peaking led to a rise in the company’s stock price.

McDonald’s will likely report its earnings before the market opens on Wednesday. So, should you buy the stock before the company’s first-quarter earnings? First, we’ll discuss analysts’ expectations for the quarter.

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Analysts expect McDonald’s revenue to fall

Analysts expect McDonald’s to report revenue of $4.66 billion during the first quarter, which represents a fall of 6% from $4.96 billion in the same quarter of the previous year. The negative SSSG (same-store sales growth) and a decline in company-owned restaurants could lead to a fall in the company’s revenue. However, the increase in the number of franchised restaurants could offset some of the declines.

Earlier this month, McDonald’s management provided an update on its first-quarter performance. The company’s management stated that McDonald’s has reported a 3.4% decline in its overall SSSG during the quarter due to COVID-19. For the first two months, the company reported an SSSG of 7.2%. However, the SSSG declined by 22.2% in March.

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US fared better than other segments

Looking at the segment-wise performance, the US segment fared better than other segments. The US segment reported a positive SSSG of 0.1%. In the first two months, the US segment reported an SSSG of 8.1%, which was driven by an increased average check size and guest count. Also, one extra day of operation in February due to the leap year contributed to the SSSG. However, as COVID-19 intensified in March, the segment’s SSSG declined by 13.4%. With social distancing guidelines in place, the company only operated its drive-thru, delivery, and takeout services in the US. Meanwhile, the International Operated Markets, International Developmental Licensed, and Markets & Corporate segments reported a decline in their SSSG of 6.9%, 4.3%, and 3.4%, for the first quarter, respectively.

McDonald’s net added 781 new franchised restaurants in the last three quarters of 2019. The new restaurants and restaurants opened in the first quarter could offset some of the declines. However, due to refranchising, the company operated 57 fewer company-owned restaurants at the end of 2019 compared to the first quarter of 2019.

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McDonald’s EPS to fall by double digits

Analysts expect McDonald’s to report an adjusted EPS of $1.57 in the first quarter of 2020, which represents a fall of 11.9% from $1.78 in the same quarter of the previous year. The lower revenue, lower EBIT margin, and higher interest expenses could impact the company’s EPS. However, the decline in the number of shares outstanding due to share repurchases could offset some of the declines.

For the quarter, McDonald’s EBIT margin could fall from 42.3% from 39.9%. The sales deleverage from negative SSSG, increased SG&A expenses, and higher D&A expenses could bring the company’s EBIT margin down. The company’s interest expenses could rise from $274.1 million to $305.4 million during the quarter.

Valuation multiple

The recent surge in McDonald’s stock price has led to an increase in its valuation multiple. As of April 24, McDonald’s was trading at a forward PE ratio of 27.0x compared to 23.3x at the beginning of the year. Despite the increase, the company is still trading at a discount compared to Starbucks (NASDAQ:SBUX) and Wendy’s (NASDAQ:WEN). On the same day, Starbucks and Wendy’s were trading at forward PE ratios of 31.3x and 37.2x, respectively. Meanwhile, Jack in the Box was trading at 11.6x.

As of April 24, McDonald’s traded at 30.1x analysts’ 2020 EPS estimate of $6.11 and at 22.6x analysts’ 2021 EPS estimate of $8.13. These EPS estimates represent YoY a fall of 22.1% in 2020 and a growth of 33.2% in 2021.

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Analysts’ recommendations

Since the beginning of this month, many analysts have cut their target prices. BMO, Telsey Advisory Group, Credit Suisse, UBS, Guggenheim, Cowen, BTIG, Piper Sandler, and JPMorgan Chase have all cut their target prices. As of April 24, analysts’ consensus target price was $198.46, which represents a rise of 7.9% from its current levels.

Despite the price cuts, Wall Street is bullish on the stock. Among the 35 analysts that follow McDonald’s, 71.4% recommend a “buy,” while 28.6% recommend a “hold.” None of the analysts recommend a “sell.”

My take on McDonald’s

So far this year, McDonald’s has lost 6.9% of its stock value. The company has outperformed the broader equity markets and its peers. During the same period, the S&P 500 Index has declined by 12.2%. Meanwhile, Starbucks, Jack in the Box, and Wendy’s have fallen by 14.0%, 28.4%, and 14.9%, respectively. Investors’ optimism about the company’s initiatives, like expanding its delivery service and implementing digital advancements and drive-thrus, led to an increase in its stock price. Also, the company operates 93% of its restaurants as a franchise. Lower sales will have less of an impact on the company’s margins. So, I think that McDonald’s will continue to outperform its peers this year. Investors should buy the stock ahead of its first-quarter earnings.

Meanwhile, Starbucks will report its second-quarter earnings tomorrow. To learn more, read Why Starbucks Is a ‘Hold’ before Its Q2 Earnings.

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