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Our 28 Favorite Stocks: July Performance Review & Outlook

In this week’s Blue Harbinger Weekly, we provide a brief performance review and outlook for each of the 28 holdings across our Blue Harbinger strategies. We also provide access to a members-only report on our “Top 3 Covered Call Stocks.” Lastly, you’ll notice we’ve updated performance though the end of July, and all three Blue Harbinger strategies continue to significantly outperform.

McDonald’s: Weighing the Risks Ahead

McDonald’s has outperformed the S&P 500 (SPY) by 37% over the last year.  However, the company faces a variety of risks moving forward. In the week’s Weekly, we weigh the risks ahead for McDonald’s, and provide our view on why it might be time to reduce your exposure to this blue chip stalwart.

McDonald's (MCD) - Thesis

McDonalds (MCD)
Rating: Hold
Current Price: $117.60
Price Target: $128.57


Thesis:

We believe McDonald’s stock is approaching its fair value as it has increased significantly over the last year, and we see less-dramatic growth opportunities going forward.  We believe the stock continues to offer shareholders an attractive dividend yield and lower volatility than most stocks.
 

Weighing the Risks Ahead:

McDonald’s has outperformed an S&P 500 ETF (SPY) by 37% over the last year.  However, the company faces a variety of risks moving forward.  In the week’s Blue Harbinger Weekly we weigh the risks ahead for McDonald’s, and provide our view on why it might be time to reduce your exposure to this blue chip behemoth.  We also provide an update on the one Blue Harbinger stock that announced earnings last week (it beat estimates by a very wide margin, and it continues to look great going forward!).
 

For starters, McDonald’s has undertaken a variety of initiatives over the last year that have improved the strength of the company and improved its stock price significantly.  However, these initiatives are now baked into the stock price, and it is unlikely for McDonald’s to generate the same level of big gains over the next year.  We have described these initiatives below.

  • Chinese supplier issues:  Part of the reason McDonald’s has been able to generate outsize returns over the last year is because the stock was starting from a very low level.  McDonald’s stock was still in the dog house (pun intended) due to Chinese supplier issues that caused customers in the region to lose faith in the company.  Since then China has been able to rebuild trust from its customers, and this has contributed to stock price gains.  And while McDonald’s hopes to maintain the traction they’ve built in China, it is unlikely they’ll experience the same types of gains considering they are starting from a much higher price now (more on valuation later). 
  • New CEO:  Steve Eastbrook became CEO in March 2015, and the stock immediately gained 6% on the news.  We believe the stock price will continue to demand a premium with Steve as CEO, but it’s not likely to experience a similar 6% pop in 2016 because there isn’t likely to be another new CEO that is perceived to be even better.

For added color, shareholders were unhappy with the old CEO and welcomed Steve’s previous experience as the Chief Brand Officer of McDonald’s.  Not unlike other large global employers, McDonald’s constantly faces brand challenges (for example quality of food perceptions), and thus far Steve has done an excellent job addressing the challenge.  For example, he changed some recipes to improve the quality of ingredients (e.g. using real butter in egg McMuffins).

  • All Day breakfast:  McDonald’s made breakfast items available all day and this had a positive impact on sales.  We believe this will continue to be a positive impact going forward, but it’s already baked into the price (more on valuation later).
  • Turnaround Plan Completion:  McDonald’s has been in a multi-year turnaround plan whereby capital expenditures have been heighted.  Turnaround initiatives included significant expenses around reimaging a variety of restaurants.  These turnaround plans are largely competed, and as a result capital expenditures are expected to be significantly lower going forward.  McDonald’s has been transparent with the progress of the turnaround plans, and the gains from lower future expected capex is largely baked into the price already.

Valuation:

We are raising our McDonald’s price target to $128 per share compared to our previous target of $122.69.  To arrive at this valuation we used a discounted cash flow model.  Our model assumes approximately $5.1 billion of free cash flow in 2016, a 5.82% weighted average cost of capital and a conservative 1.5% growth rate.  Our price target is approximately 9% higher than McDonald’s current market price, and this is not unattractive, especially considering its 3% dividend yield and lower volatility versus the rest of the market.  However, this is a lower expected return compared to many other stocks, and McDonald’s faces a variety of risks.

Risk Factors:

  • Already Near Fair Value:  For starters, we believe McDonald’s is not nearly as undervalued as it was in our last valuation report on July 27, 2015.  At that time the price was $97 per share, and we believed the stock had over 26% upside due mainly to the initiatives we described above.  Now that McDonald’s has executed on many of those initiatives, we believe the stock has less upside going forward.  Our valuation (above) assumed only a 1.5% growth rate for McDonald’s, but if that growth rate falls to only 1% then our price target would fall to only $115 per share, which is $2 lower than its current market price.  For reference, McDonald’s global comparable sales grew by 1.5% in 2015 (source: fourth quarter earnings announcement).
  • Unattractive Growth Prospects:  With many major initiatives now in the past, McDonald’s future growth prospects seem far less attractive.
  1. Value Menu Initiatives: One potential source of growth is the company’s expansion of “value initiatives.”  For example, McDonald’s recent “Two for Two” menu offers may drive traffic in the near term, but eventually the effects of the promotion may wear off, traffic may decrease, and McDonald’s may be left with reduced traffic spending at lower price points.
  2. REIT Spinoff: Another potential source of growth is the possibility of a REIT spinoff.  There has been some talk among McDonald’s board as to unlocking shareholder value by spinning off the company’s real estate into a real estate investment trust (REIT).  We believe this could unlock a one-time valuation increase for shareholders, but this seems unlikely based on recent news as we have written about here.  Further, we don’t believe it offers as much stock price appreciation potential as the company has achieved over the last year.
  • Changing Consumer Preferences:  There is a constant and evolving risk that consumer preferences could shift away from McDonald’s and more towards, smaller, healthier, more socially responsible restaurants.  We believe there is some truth and some falseness to this perception.  It is true that consumer preferences change, and may shift away from McDonald’s.  However, McDonald’s has very significant socially responsible initiatives underway to address customer concerns.  More information is available on the Sustainability section of the company’s website.  In our view, McDonald’s often receives a disproportionately large amount of negative media attention simply because it is so large that it has become an easy target for a variety of activists and causes.
  • Currency Risks: The impacts of foreign currency exchange rates are largely out of McDonald’s control, and they have had a significantly negative impact on the company’s recent earnings.  For example, McDonald’s consolidated revenues decreased 7% in 2015, but would have actually increased 3% if it were not for the strong US dollar.  We believe any strong currency moves in the opposite directions could cause a jump in McDonald’s earnings.  However, this is not a long-term strategy, and we don’t expect it to significantly improve earnings on a sustainable basis.  And in fact, it could continue to move against McDonald’s in the future.

Conclusion:

We rate McDonald’s a hold with a price target of $128.57.  We are not yet selling our MCD holdings, but we are not adding to our position either.  We are currently reinvesting all McDonald’s dividend payments into other stocks.  We still believe McDonald’s stock has price appreciation potential, but simply not as much as it had a year ago due to its recent strong rally.  We recognize the stock offers an attractive dividend yield (over 3%) and lower volatility.  We believe the stock is still attractive to income investors (we own it in our Income Equity portfolio), and we continue to hold it in our Disciplined Growth strategy as well because it offers some price appreciation potential and it adds important diversification to the strategy. 

Upcoming Earnings Announcements: Plenty of Upside Ahead

In this week’s Weekly, we review the Blue Harbinger stocks that announced earnings last week (they completely knocked it out of the ball park), and we explain why we believe they’ll continue to deliver very big gains going forward.  We also review the Blue Harbinger stocks that will be announcing earnings over the next two weeks, and why we believe they too will deliver terrific results.  Also worth noting, this weekend Barron’s announced it is “Time to Buy Bank Stocks.” We highlight our favorite bank stock in particular.

Are You Diversified? Appropriately?

Long-term investors should not forget the risk-reward tradeoff.  For example, if you were diversified into investment-grade bonds over the last year then your account balance probably hasn’t suffered as much as if you’d invested entirely in stocks.  However, over the long-term, we expect stocks to significantly outperform less-risky bonds.  This week’s Weekly highlights some extremely attractive stock-specific opportunities that have been created by 2016’s recent market volatility.

Year-End Rebalancing and Great Opportunities

Time to sell your winners and buy the losers? Some contrarians might think so.  With 2016 right around the corner, it can be helpful to see what has and has not been working, and why.  For example, Caterpillar has been a persistent loser (as we wrote about here), and Nike and McDonald’s have been big winners this year.  This week we review the Dow Jones stocks we do own (and why), and our view on when it’s prudent to rebalance.

Market Cycles and Investor Blindness

This week’s Blue Harbinger Weekly focuses on broad market cycles, and how quickly investors forget about them and become blind to their dangers and opportunities.  We consider the staggered market cycles of the US versus international economies, and the impacts on specific industries such as railroad companies and heavy machinery manufacturers.

2016 Outlook: Own Selective Small Cap and High Dividend Stocks

There is a long history of mean reversion in the stock market.  And considering the soon-to-be dueling monetary policies of the hawkish US Fed and the dovish ECB, combined with 2015 year-to-date performance, small-cap value stocks with high dividend yields look very attractive heading into 2016.

Ben Graham’s Margin of Safety and Current Market Opportunities

When Coca-Cola replaced their classic formula with “New Coke” in 1985 the stock tanked, and when they brought back “Coca-Cola Classic” less than three months later the stock rebounded significantly.  Similarly, when McDonald’s had trouble with Chinese meat suppliers in 2014 the stock tanked, and since rebuilding customer confidence the stock has come roaring back.  Chipotle Mexican Grill's (CMG) recent setbacks may be providing enough margin of safety for brave long-term investors to do something very smart.

McDonald's (MCD) Update - Earnings Home Run

McDonald’s (a Blue Harbinger 15 stock) is a great example of how it pays to be a contrarian investor.  Despite a recent outpouring of negativity about the company in the media, McDonald’s gained over 8% yesterday after announcing its earnings beat Wall Street expectations on stronger than expected sales.  Over the last year we’ve heard the pundits crying things like “McDonald’s is too big,” “McDonald’s can’t compete with healthier alternatives,” “McDonald’s brand is dead.”  And despite the negativity, McDonald’s has outperformed the overall market (MCD is up 23% in the last year versus a gain of only 6% for the S&P 500).

We continue to believe in McDonald’s going forward as the company moves past some historical missteps, and it continues to be a cash generation machine with lots of growth opportunities.  Regarding missteps, McDonald’s had some supplier issues in China last year that caused a large drop in sales, but this has been corrected and the company continues to gain traction in China.  Additionally, new CEO Steve Easterbrook has made changes to simplify the menu and improve some ingredients which should also help profitability going forward.  Also, MCD’s introduction of all-day-breakfast in the US is expected to have a positive impact on the company’s future earnings announcements.

You can read our previous McDonald’s updates here, and our complete McDonald’s thesis and research report here.

McDonald’s (MCD) Update - Possible Real Estate Spinoff

According to the Wall Street Journal, McDonald’s board member Miles D. White said on Thursday that the company may soon make a decision on what to do with its vast real estate holdings.  There has been continued murmurings that the company should spinoff its real estate holdings into a REIT (Real Estate Investment Trust) vehicle because it could potentially unlock value for shareholders.  REITs often pay little or no taxes on earnings as long as they distribute most profits through dividends, and they typically receive a higher valuation multiple than retail companies like McDonald’s.  Some investors, such as Larry Robbins of Glenview Capital Management, believe a real estate spinoff could unlock $20 billion in shareholder value.  However, Morgan Stanley analyst John Glass says the possibility of forming a REIT is remote and doing so would not create as much value as one might think.

McDonald’s stock has underperformed the S&P 500 over the last 2 and 1/2 years, but has been outperforming so far this year as management works hard to end the slump.  Regardless the 2 and 1/2 year slump, McDonald’s remains hugely profitable, and we believe has the potential to outperform the market in the coming years.  You can read our complete McDonald’s research report here, and you can view our previous McDonald’s updates here.

McDonald's (MCD) All Day Breakfast

McDonald's (MCD) announced yesterday that they'll begin serving all-day-breakfast on October 6th.  Breakfast has been McDonald's best selling daypart, and this is, of course, an effort to increase profitability for the fast-food giant.  The market likes the news so far, as the stock is up over 2% this morning (the market is only up ~1%).

Remember, even though MCD's earnings missed estimates and declined in 2014, Q1-15 and Q2-15, the firm still generates enormous cash flow, and we believe the stock is worth considerably more than its current market price suggests.  You can read our full McDonald's thesis here.

McDonald's (MCD) - Thesis

McDonalds (MCD)
Rating: BUY
Current Price: $97.10
Price Target: $122.69

 

Thesis: 

McDonald’s earnings have declined recently due in large part to supplier issues in China, an unfavorable lower court ruling that resulted in a large increase to foreign tax reserves, the strong US dollar’s negative impact on non-US operations, and a brand that seems to be in decline.  However, the company continues to deliver enormous amounts of free cash flow, new management is pursuing significant top and bottom line improvements, and the stock’s recent declines are overdone.  Using a discounted cash flow valuation model, we believe MCD is worth $122.69 per share, giving it more than 26% upside versus its current market price.  We rate MCD a “Buy.”


Current Situation:

Things seem bad at MCD.  The company has delivered a negative earnings surprise (versus the consensus estimate) in all but the most recent of the last six quarters (they beat by $0.02 in calendar Q2).  Net income (2014) declined considerably versus previous years, and Q1-15 and Q2-15 EPS was well below Q1-14 and Q2-14.  The CEO was replaced in 2015, and public perception seems to be negative.  Additionally, it seems a daunting task for MCD to deliver significant growth considering it’s already very large, and consumers’ tastes seem to have shifted to prefer higher quality, higher-service competitors.

 

Free Cash Flow:

Despite negative public perceptions and declining earnings, MCD continues to generate an enormous amount of free cash flow.  Cash flow from operations minus capital expenditures continues to exceed $4 billion per year, and will likely increase in the future due to managements plans to limit capex to $2 billion (it’s been $2.5 to $3.0 billion in recent years), and to achieve $300 million of net annual savings in SG&A expenses by the end of 2017.  This will put free cash flow around $5.3 billion per year, leaving plenty of room for the company’s roughly $3.2 billion of annual dividend payments.

However, the free cash flow becomes somewhat concerning considering MCD is in the middle of a 3-year plan (2014-2016) to return $18-$20 billion of cash to shareholders.  It’s concerning because they’re only generating roughly $14 billion of free cash flow during this period.  The shortfall is made up through debt issuances and cash generated by refranchising of restaurants.  It doesn’t seem entirely unreasonable to finance dividends and share repurchases with debt (to an extent) if management believes the stock is undervalued especially considering they’re paying a 3.5% dividend yield on the equity and MCD’s cost of debt is in roughly that same neighborhood.  Further, MCD has plans to refranchise 3,500 restaurants by 2018 which will add to cash inflows.  However, there are only so many restaurants they can refranchise, and there is a limit to the amount of debt they can issue.  Something will need to change for MCD in the long-term because the current operating status quo will not allow this much cash to be returned every year beyond the next few years.

During the most recent post earnings conference call, MCD CFO, Kevin Ozan, announced they’ll be delaying their next dividend payment announcement two months until November which suggests there may be big changes coming with regards to how MCD uses its extra cash.  MCD may be announcing expensive restructuring, expensive growth initiatives, a big acquisition, a reduction in share repurchases, changes to the dividend policy, or some combination of the above.


Valuation:

We value MCD at $122.69 per share using a discounted cash flow model.  Our model assumes approximately $5.3 billion of free cash flow in 2016, a 6% required rate of return and a conservative 1.5% growth rate.  A 1.5% growth rate is very small, and could easily be eclipsed over the next two years simply if foreign currency exchange rates stop working against MCD (for example, MCD’s Q2 investor relations earnings report notes foreign currency translation had a negative impact of $0.13 and $0.23 on diluted earnings per share for Q2-15 and year-to-date, respectively.  And MCD lost 2% of net income to currency in 2014).  If MCD grows at 3% into perpetuity its worth $184.03, and if it grows at 0% it is worth $92.02.  And there is room for growth considering MCD’s 2013 (most recently available data) system-wide restaurant business accounted for only 0.4% of the outlets and 7.5% of total sales within the “Informal Eating Out” segment of the market (2014 MCD Annual Report).

 

Turnaround Plans:

MCD is engaged in a variety of initiatives to stem the company’s slumping sales growth and declining profits.  One major initiative is improving the brand image.  The newly appointed CEO was formerly in charge of branding at MCD, and he will bring expertise in this area to the highest level of the organization.  There is a strong focus on enhancing the appeal of core products and addressing food perceptions; MCD is focused on improving and highlighting the quality of ingredients.  Another initiative is expanding breakfast, which is the company’s strongest day-part.  Market testing around all day breakfast availability continues.  Previously mentioned cost reductions are also an important initiative.  The company plans to reduce capital expenditures to around $2 billion and decrease annual SG&A expenses by around $300 million.  If successful, these reductions will improve free cash flow and profitability.

 

Conclusion:

We’re giving new management time to execute on its turnaround plans; especially considering the company is already worth significantly more than its current stock price suggests (we value MCD at $122.69 per share based on discounted cash flows); and because we are comfortable taking the contrarian stance on a stock that we believe has been overly beat up by public perception.  We own shares of MCD, and we rate the stock a “Buy.”

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