4 Reasons McDonald’s is Losing its Groove

When it comes to fast-food stocks, one is head-and-shoulders above the rest. Certainly, nobody can touch it in terms of revenue, which, at $27.4 billion a year, is more than twice that of the closest competitor. The company’s net profit margin of 20% is almost twice the industry average of 11%.

I’m referring to McDonald’s Corp. (NYSE: MCD), of course, which I’m sure is no surprise. What may throw you for a loop, though, is that I think the stock can no longer deliver anything close to the 14%-a-year it posted during the past half-decade. So if you’re looking for stocks with the potential to really trounce the market, then you might want to look elsewhere.

#-ad_banner-#Considering how popular McDonald’s is among individual and institutional investors, I understand my statements may come as something of a shock. However, there are several reasons I think McDonald’s is about to fade.

1. Rapid deceleration in growth. Although sales have risen 8% annually during the past five years, and analysts see them continuing to expand at that pace in coming years, the bottom line is unlikely to cooperate as before. Indeed, analysts project earnings growth will decelerate to about 8.5% a year for the next three to five years — a far cry from the 17.5% growth rate of the prior five years.

This sort of pullback often befalls large companies that have matured and are set to enter a much slower growth phase. After all, McDonald’s already has 33,500 restaurants in 119 countries, including some pretty remote locations like Samoa, Venezuela and the Republic of Macedonia. At this point in the company’s history, rapid growth is increasingly unlikely.

2. Fierce competition. McDonald’s faces this in abundance from direct rivals like Yum Brands Inc. (NYSE: YUM) — which owns Taco Bell, Pizza Hut and other brands — Wendy’s Co. (Nasdaq: WEN), Burger King Corp. and Jack in the Box Inc. (Nasdaq: JACK). While none of these four enterprises is a match for McDonald’s individually, they have combined sales of about $20 billion a year.

There’s also a threat from fast-food alternatives like Panera Bread Co. Inc. (Nasdaq: PNRA), a mid-cap firm with annual revenue of $1.9 billion and, in my opinion, far more growth potential than McDonald’s. These so-called “fast casual” restaurants are rapidly expanding, despite somewhat more expensive menus, because of a reputation for having a wider array of healthier, more wholesome food choices.

In the case of Panera, those choices include sandwiches on whole grain bread and a variety of fresh soups and salads. The company capitalizes on growing demand for things like high-quality organic and all-natural ingredients and free-range chicken, and by making its menu accessible to those who don’t use meat or dairy products. 

The large-cap fast-casual chain Chipotle Mexican Grill Inc. (NYSE: CMG), which generates annual revenue of $2.4 billion, takes a similar approach. McDonald’s and the rest of the fast-food industry are far behind on these trends and probably too late to take ownership of them, setting the stage for potentially big losses in market share to the fast casual industry in coming years.

3. Commodity cost inflation. Rising energy prices and spiking costs for key product ingredients will certainly squeeze the margins and bottom lines of McDonald’s and its competitors. In the past couple years alone, for example, the price of beef has climbed 33% and wheat has gone up 69%. Energy prices have soared, too, even with the recent pullback. As a group, oil, natural gas and coal are up nearly 50% in price during the past two years.

4. The bull‘s-eye on its back. Because McDonald’s is the world’s leader in fast food, it takes most of the blame for the link between fast food and obesity and for other types of bad publicity that affect the industry, even though competitors have similar products. This added burden places the stock at higher risk.

One of the latest examples of this is the “pink slime” controversy earlier this year. After starting 2012 at about $100 a share, McDonald’s stock began to slide as the media regularly ran reports about hamburgers and other beef products containing a mixture of low-quality beef cuts (dubbed pink slime) that were banned for human consumption in the U.K. Between Jan. 1 and March 23, the stock fell nearly 5%, even though McDonald’s announced on Feb. 1 it would no longer allow pink slime in its beef products. The stock has continued to trend lower and now sits at about $88 a share, or 12% below where it began the year.

Meanwhile, main rival Yum Brands, which generates annual revenue of $12.9 billion and sells many beef-containing products, is up almost 14% in 2012, having started the year at $59 a share and climbing to about $67. Shares of Jack in the Box are up 19% year-to-date. Current economic woes have affected all of these stocks, but I think it’s possible McDonald’s has suffered worse, at least partly because it was the company most often associated with pink slime in the media.

Risks to consider: Investors who have come to expect major outperformance from McDonald’s could be greatly disappointed if I’m right about it becoming a slower-growth stock.

Action to Take –> Don’t expect McDonald’s to deliver 14% a year anymore. For the reasons I’ve given, I think the stock may only be capable of a bit more than half that going forward.

Look at it this way, if earnings meet analyst projections for 8.5% annual growth in the future, they’ll rise from $5.27 a share in 2011 to about $7.90 a share in 2016. Assuming investors continued to pay 16 times earnings for the stock, at that point the price would be about $126 a share (16 x $7.90 = $126.40). From the current share price of $88, this represents an annualized rate of return of 7.4%.

That’s not too bad, but it’s certainly nothing near what McDonald’s has delivered in the past — and it might not even be enough to pace the overall market. Investors looking for market-beating growth potential in this space might want to consider Panera Bread and/or Chipotle instead.