McDonald's: Growing Challenges Signal Trouble For This Stock (NYSE:MCD) (2024)

Over the past few decades, McDonald's (NYSE:MCD) has become the staple of global food culture. The company is a symbol of modern man's desire for quick and affordable food. McDonald's is so popular that studies have found that more three-year-olds can identity golden arches symbol than know their name. Of course, that famous study came from the 2000s era, and it is fair to say that times have changed drastically since then.

One can only understand McDonald's by taking a long-term perspective on the company. Most notably, its extreme rise in popularity in the more-developed nations up to the 1990s, its subsequent rise in developing countries, and its general decline since the 2010s in the U.S. The company has seen the number of U.S locations decline since 2014, with comparable traffic sifting in a negative direction in 2013. Unsurprisingly, this trend began as most millennials came of age, many of whom saw Super Size Me as children and had a greater desire for healthier foods.

The company's focus has shifted over the past decade as it has upgraded stores to cater to the changing world. However, it seems that we are now living in a world that is shifting at an accelerating pace. This is seen by changes in consumer desires, labor shortages, technology, and profit margins. Indeed, it is not entirely clear that McDonald's can keep up with today's changing world as it loses dominance to the likes of Chick-fil-A, Domino's (DPZ), Five Guys, and Starbucks (SBUX) (based on the American Consumer Satisfaction Index).

Despite these trends, McDonald's stock has gone nowhere but higher. This is due to tactical financial management, which has allowed profit margins to strengthen despite weak sales.

Discontent Within McDonald's Organization

While the company's same-store sales and sales have declined, its stock value has risen drastically. This is because the company shields itself from store profitability since it generates most of its income from franchise fees. The company has also made immense efforts and improving efficiency through technologization, which has reduced employee counts at stores. This has seemingly made McDonald's into yet another artificial intelligence company that is almost solely focused on replacing its human workforce with machine drive-thru attendants, cooks, and even managers. Indeed, it seems the company is not far from creating a full-fledged fast-food vending machine such as from the movie Idiocracy.

The robotization of McDonald's is a serious matter for investors to consider. In my view, the company is a proving ground for whether or not an almost entirely machine-based restaurant is feasible. While these efforts have undoubtedly boosted McDonald's profit margins, it has coincided with a decline in customer satisfaction and rising employee turnover over the past decade. This can be compared to alternative approaches such as Chick-fil-A's, which has seen extreme growth over the past decade, has 50% higher per-unit sales than McDonald's, and notoriously happier employees. There are also legal ramifications of technology use as seen by the recent lawsuit in Illinois, claiming the company has been illegally collecting biometric voice data.

Of course, last year's events may have ushered in a new era for the company. As smaller mom-and-pop restaurants have been forced to close doors, McDonald's and its peers are now seeing their market share grow. Still, the company faces a severe labor shortage, with many concerned with low wages and poor working conditions. They recently raised their minimum wage to $15/hr at corporate-owned stores (which make up a small portion of its total stores).

Franchise costs are rising on other fronts, which cannot be fixed through further mechanization. Agricultural commodity prices have increased by over 50% since 2019 as supply-chain constraints and weather issues have created a global food shortage. This issue is not acute in most developed countries; however, it leads to higher costs for fast food restaurants - particularly on meat products. As such, McDonald's menu costs have risen to recoup costs, but this may eventually exacerbate declines in demand. While statistics are difficult to come by, input-cost margin pressures are likely higher in developing countries that have been harder hit by the global food crisis.

As franchise sales decline and margins come under pressure, McDonald's has not seen its income decline materially. This has created growing disputes between franchisees and the corporation. As McDonald's pursues immense technological advancement, it demanded an assessment of $70M in fees from franchisees. This triggered a widespread revolt and lawsuit, which recently caused McDonald's to reduce the figure drastically. The company has also been sued for alleged racial discrimination against black employees and a separate lawsuit regarding discrimination from black franchisees. While the latter suit was dismissed, it is clear that discontent within the entire McDonald's organization appears to be growing.

McDonald's Earnings Per Share To Decline

McDonald's is in an odd position both operationally and financially. The company's stock value has gone nowhere but up while it has seen growing operational difficulties. As I mentioned earlier, these issues are obfuscated because most of McDonald's income comes from franchise fees and not operating stores. Surveys show that most McDonald's franchisees are increasingly feeling cash-strapped, with 90% stating unsatisfaction with cash flow in 2019. During the same period, McDonald's has seen its income remain generally flat.

The past decade has also seen McDonald's drastically increase its leverage. While its profit margins have risen, more significant amounts of those profits are going to interest costs. See below:

The buildup in McDonald's debt, its growing franchisee disputes, and its brand's decline in market share all go hand in hand. The company's operating income would be in decline with its revenue if it were not for aggressive margin-boosting measures - which may be exacerbating tensions with franchisees.

Additionally, McDonald's has used debt financing to make significant share repurchases, keeping its earnings-per-share trending higher while its earnings have stagnated and sales have declined. This can be seen quite clearly below:

Since the company's revenue went into decline in 2014, its income has stagnated, though its earnings-per-share has risen as the company has borrowed money to reduce shares outstanding. A leveraged buyback is normally pursued as a means of maintaining a positive trend in EPS without organic growth. According to a recent BIS study, this increasingly common practice may be creating systemic risks in the market. While it is possible that McDonald's is repurchasing shares in the view they are cheap or other reasons, I do not believe these buybacks will contribute to the company's long-term success due to the debt it has created.

McDonald's credit rating is now at BBB+, which puts it right on the cusp of losing investment-grade status. As such, the company is unlikely to continue to borrow money to repurchase shares and artificially boost its per-share financial metrics. Additionally, growing franchisee and employee disputes will likely continue to create negative pressure against McDonald's high fees as many locations may not remain profitable.

At the end of the day, McDonald's may not make most of its money from food sales, but it is still in the food business. I believe it is clear that, in the future, issues with its brand and food business will negatively impact its bottom line as many stores close as they cannot meet leasing and fee costs. Accordingly, I expect the company's EPS to reverse into a negative direction over the coming years. This differs from the consensus view of a positive trend in McDonald's EPS outlook; however, it seems the consensus may not see the "forest for the trees" regarding McDonald's systemic operational and financial difficulties. One must look no further than its rising leverage ratio and near-zero working capital:

McDonald's has negative book value due to its immense leverage buildup. For now, the company generates a strong enough EBITDA to meet its financial obligations; however, it almost certainly cannot continue to create new debt, which has been the only factor causing its per-share metrics to rise.

Even if store closures decline and franchisees' troubles continue to mount, we could see a rapid and drastic reduction in McDonald's operating margins. This metric is historically high at 41% and implies franchisees' complaints regarding unreasonable fees are very well-founded. As the company's franchise revolts grow, I believe there is a high probability that McDonald's will be forced to cut costs. If not, its U.S store count will continue to decline at an accelerating pace.

The Bottom Line

In my opinion, it is a bit strange that MCD has risen in value despite clear indications of fundamental deterioration. That said, investors may not be seeing this issue clearly due to the share-buybacks and franchise fee increases. Even still, we can see below that MCD has never had as an expensive valuation as it does today:

For McDonald's EV to EBITDA ratio to return to normal levels of around 12X, its market capitalization would need to be about $82B, equating to a price of about $110. Obviously, this would be a substantial decline of over 50%, but such is the case when debt is high.

It may be sometime before the broader financial market realizes how overvalued MCD is today, so the stock may not decline to $110 soon. Of course, I expect its EBITDA will decrease over the coming years, so an even lower price target is possible. However, the belief that MCD is a post-pandemic winner due to the bankruptcy of its mom-and-pop competitors is not sufficient to justify its valuation today. This is particularly true when considering the financial decline of its franchisees and high leverage.

Overall, I am bearish on MCD and believe the stock is a short opportunity. Declines may be catalyzed by the earnings report later this month which I believe may disappoint due to higher input costs during the quarter. More importantly, I see little bullish impetus left at its current record valuation and the stock's difficulties breaking above its resistance level of ~$240.

There are risks to consider when short-selling a stock like MCD. Not many short-sell the stock, and its borrowing cost is near-zero, so it does not have short-squeeze risk. I also believe MCD's meager dividend yield of 2.2% is a small carry cost to pay, considering its significant overvaluation. Of course, investor sentiment surrounding MCD has been bullish as many view it as a post-pandemic investment. While I do not see this thesis as strong, emotions arguably have more sway than fundamentals in the current investing environment, so it is possible that MCD sees a breakout. This risk is slightly amplified with Q2 earnings arriving at the end of the month. Accordingly, tight stop losses are critical. Fortunately, MCD generally does not have significant upside volatility so a tight stop loss at $245-$255 may be sufficient.

Harrison is a financial analyst who has been writing on Seeking Alpha since 2018 and has closely followed the market for over a decade. He has professional experience in the private equity, real estate, and economic research industry. Harrison also has an academic background in financial econometrics, economic forecasting, and global monetary economics.