Until recently, among the shares most loved by investors Value (Including Warren Buffet) there was Tesco, the largest supermarket chain in the UK. Thanks to his image, when profits began to fall and the sustainability of the business to creak, investors continued to look at historical results, trusting in a quick and imminent turnaround, which actually never happened.
To date, McDonald's seems to be in the same situation of uncertainty. The stock continues to be popular with value investors despite recent earnings disappointments. As happened with Tesco, many investors look at past returns and "hope" for a rapid turnaround.
Is McDonald's in the same location as Tesco?
The numbers seem to be on Mc Donald's side. Looking at the results, it seems anything but a company in crisis, and in fact its share is traded on the New York Stock Exchange around all-time highs: the price performance mirrors the evolution of the fundamentals.
The problem, however, is that fewer and fewer people eat in his restaurants: the number of customers decreased in 2013 and 2014 by 1,6% and 4,1% in the USA and by 1,5% and 2,2% in Europe . The average turnover per restaurant has also decreased by 2% over the past three years. But this trend is not generalized in the sector of fast food, because other chains have instead increased both their turnover and the number of customers.
Over the past five years, the company has generated cumulative earnings of $26,3 billion, done buyback for $12 billion and distributed dividends of $14,3 billion. In other words, it returned all profits to the shareholders. With the total number of restaurants growing at just 2% annually, McDonald's isn't currently growing profits by expanding its global footprint or reinvesting cash flows. But, thanks above all to the international expansion in franchise, however, it managed to improve the net margin bringing it up to around 18%-20%.
This means that the prices of its products have increased more than the costs (labour, raw materials, rents): an undoubtedly positive figure, but for how long can this formula work? Few companies manage to maintain net profits at 20% for long periods of time, and McDonald's could fall back towards the historical average of 12%-15%. Maintaining the double-digit growth in earnings and dividends to which the company has accustomed shareholders requires a double-digit increase in the prices of hamburgers and Happy Meals, because the number of restaurants is not increasing at a sufficient rate and neither is the is the turnover per restaurant.
I have many doubts that the company can achieve these increases, given the shift of consumers to other chains: if McDonald's simplifies the menu and focuses on what it has always offered, it risks losing customers who prefer healthier solutions; if instead it continues to expand into other areas, I fear that the customer experience will continue to deteriorate.
Mc Donald's similarities with Tesco
Reading the analyzes of the last 2-3 years, there are many similarities between the two companies in support of a bullish thesis. The ambitious campaign of international expansion has caused Tesco to lose its focus on customers: “As Tesco has focused so much on growth initiatives, some of the top managers and resources have been moved out of the UK”. Similarly for McDonald's “customer growth in the period 2013-2014 was negative due to strategic errors and operational inefficiencies (for example, the proliferation of menus, with over 100 items added in the last 10 years).”
Unfortunately, many investors suffer from the syndrome of the past: these companies are excellent and the current problems are only a temporary deviation from phenomenal long-term results. Again according to analysts two years ago: “Tesco is one of the best retailers in the world", “with a long history of growth and superior returns”. Likewise,"Mc Donald's is a high quality company with a unique brand”, as well as “a market leader in a growing yet defensive sector, with significant competitive advantages and a stable business model".
Their conclusions? “(In 2011) we believe an investment in Tesco offers an excellent risk/reward ratio for those with a 3-5 year horizon.” “(In 2015) I think Mc Donald's is a compelling investment opportunity for the next 3-5 years.” I admit that this analysis is very superficial: the two companies are very different in terms of the sector they belong to, business model, etc…
I don't know if McDonald's will have the same problems that Tesco had: what I have noticed is that the theses brought forward in favor of Tesco (wrong, with hindsight it turned out to be quite a value trap) are the same courses for McDonald's in its attempt to reinvent itself. But this cannot ignore whether its customers still love McMenu or not, while management seems to prefer financial engineering.
There is also a more important difference: before its collapse Tesco traded at a P/E of 10x-12x, while McDonald's traded at a P/E of 21x. If labor costs become more burdensome (particularly in emerging countries), margins could actually shrink, which will cause a de-rating of multiples. McDonald's has all the makings of potential undervalued turnaround, with the small detail that it is not undervalued.
