Earlier this week, I was doing my homework for the "Fast Money Halftime Report" and was asked if I had an opinion on the restaurant stocks following the strong earnings from El Pollo Loco (LOCO) .
Earlier that day, Yum! Brands (YUM) announced that the latest chicken supply issues in China had taken a toll on its same-store sales and said that it would be reporting a 13% decline in this region following this latest issue. Being that this wasn't the first chicken supply scare announcement from the company, I thought for sure YUM's stock would get crushed as investors are totally losing confidence in the China growth story at the company. It fell 4% before hours but, surprisingly, by the end of the day it actually finished higher. And shares gradually drifted higher for the remainder of the week.
Some of it is the fact that consumer discretionary stocks have turned out to be the leaders of the market in the past few weeks. Lower oil prices (down 12% from highs) and other commodity costs, a less-than-feared consumer retail reporting season, strong auto sales (a 17.5 million North American SAAR was way higher than people thought) and an improving U.S. economy (although we all would have liked to see a better jobs report on Friday).
But one thing I've learned over the years is to pay attention to how a stock trades on good and bad news. If it doesn't go down on bad news, that's an important inflection point and more often than not means most, if not all, the bad news is priced into the shares. The same goes for when there is good news and the stock doesn't rally. A -13% comp is pretty bad news following much of 2012/2013 where YUM's comps in China fell consistently at a double-digit rate. So the action in YUM's shares were pretty telling to me.
Jim Cramer and I have been involved in the YUM story in the past for Action Alerts PLUS, but to be completely honest, every time it was a tough battle. We wound up making money in the name more times than not, but I wasn't up for the challenge yet again. Still, it did bring my attention to its largest rival.
McDonald's (MCD) seems to have bottomed in the low $90s. It didn't go down much following its disappointing July same-store sales and didn't fall in sympathy with the YUM news as I had initially expected. As I did more analysis on the name, I found it pretty interesting and I like it in the low $90s.
Here's a stock that is down 10% from its highs and off 8.1% in the past three months on concerns about U.S. competition in the restaurant space (U.S. is 30% of total sales), possible weakness in Europe (40% of sales) and, of course, the China chicken supply issues (23% of total sales). I suspect that the August same-store sales on Sept. 9 will be pretty underwhelming as well. But the company has a new head of North America and a fresh set of eyes on this business. The balance sheet is under-leveraged and the company, at its analyst meeting, said that it was exploring ways to return more cash to shareholders.
I think there is a good chance the company raises its dividend on Sept. 25 and that the 3.5% dividend yield is secure and attractive compared with what you get from the bond market these days. I also think some of the recent problems at the company have been self-inflicted with poor product choices and weak marketing messaging. This is a company that from 2004-2011 was able to produce not only an average of 5.9% same-store sales, but 1500 bps worth of operating margin expansion to 31.6%, as compared with the high-teens margins for the industry as a whole.
I get the macro environment is tough. But I do think there are enough internal product moves this company can make -- along with customization and pricing tiers and store expansion (especially in emerging countries) -- that should be enough to stabilize the market share and, along with lower commodity pressures and further refranchising the 1500 stores it expects in APMEA and Europe), help on the margin front. Operating margin opportunities also exist in APMEA, where this segment posts below-corporate-average margins of 23.1% as compared with 42.8% in the U.S. and 29.6% in Europe. Also, general and administrative expenses (G&A) will now be more geared towards the digital capabilities (online ordering, payment, loyalty programs), which should drive higher engagement.
In the end, the quick serve restaurant business is a $900 billion market, so while competitive, there is still opportunity for the company to get back to its longer-term goals of 3-5% system sales growth, 6-7% operating income growth and returns on incremental invested capital in the high teens.
So, back to the leadership change in North America. The 41-year vet Jeff Stratton announced his retirement in running the North American business. Admittedly, this should have happened a year ago because MCD has seen very disappointing sales in this region in the face of a lot more competition. In 2013, full-year same-store sales fell 0.2% and year to date they are running down 1.9%, with June and July both off 3%. Insert Mike Andres, who had worked at the company and then left to be CEO of Logan's Roadhouse. His tenure goes back to 1984 at MCD and his family has a long stretch of MCD franchises. Andres starts next month and we expect a new game plan from him: products, new high-density kitchen prep and service changes. This will not lead to significant improvement in the near term, but I like being ahead of the expected strategy changes.
While it tries to fix North America and its other issues, there is a plan to return cash to shareholders that was initially announced in May. The plan targets returning $18 billion to $20 billion in dividends and buybacks between 2014 and 2016. This is a 10-20% increase in its cash outlay vs. 2013 and without knowing the incremental leverage they are using, there could be more behind it.
Clearly it's worth watching the challenges in Russia and China. Trade sanction issues have created some retaliatory actions against U.S. companies. But Russia is about 4-5% of MCD's total operating income and manageable. China, again, is bigger exposure to the company on total sales, but just 4% of total operating income and much of the bad news seems to be understood at this point.
So, the top-line trends will remain challenging for a while, but the cash return story and stock action make it an interesting value play. Plus, with the analyst community not in favor of the name -- 9 Buys, 21 Holds and 1 Sell -- it won't take much for the company to turn once the visibility improves.