Why We're Staying Clear Of McDonalds Shares

McDonalds (NYSE:MCD) shares have certainly had a tough past three years, failing to advance with the rest of the surging equity markets. Given that McDonalds is one of the most valuable brand names in the world, boasts a 3.6% dividend yield, and is expanding throughout the developing world, we initially thought that this could be an opportunity to generate significant alpha. However, when we dug deeper, we quickly realized that the days of McDonalds outperforming the market are long over. We believe that investors who invest in the company today will likely generate subpar investment returns for the foreseeable future.

At Main Street Wins, we pay significant attention to long term trends, especially those which are investable. One of the trends that is currently gaining significant traction is an increasing importance to healthy living. Shares of companies like Under Armor (NYSE:UA) and Nike (NYSE:NKE), which specialize in active wear, continue to hit new highs seemingly weekly. Apple (NASDAQ:AAPL) has released its revolutionary health device, the Apple Watch, which we think will further drive consumer interest in health monitoring. Consumers are frequently flocking to their nearest Whole Foods Market (NASDAQ:WFM) or Trader Joe's, stocking up on health foods like Quinoa and Greek yogurt. Unfortunately, McDonalds is increasingly associated with low quality fried food and obesity. A poor reputation, in our view, is a difficult thing to shake. While McDonalds has taken some steps to appease health oriented customers, it still lags significantly beyond its competitors. According to Fox business, salads only make up 2 to 3 percent of sales at McDonalds. We know why. Salads at competitors such as Panera Bread (NASDAQ:PNRA) can includes exotic ingredients such as Gorgonzola cheese, apple chips, pecans (found in the Fuji Apple Chicken Salad) or Thai cashews, edamame, red peppers, and cilantro (found in the Thai Chicken Salad). Salads at McDonalds are essentially all romaine lettuce, chicken, cheddar cheese, and one or two grape tomatoes. In order to improve salad ingredient variety, McDonalds would have to raise prices.

The issue is that McDonalds does not have the ability to charge 6 or 7 dollars for a premium menu items. Rather than paying a high price for a quality sandwich at McDonalds, customers would much rather pony up an extra two dollars and eat at Panera or Chipotle (NYSE:CMG), where they can dine at a place that isn't associated with a dollar menu or an obesity epidemic. We think McDonalds is in an impossible predicament: consumers are seeking healthier alternatives, yet the core McDonalds customer is extremely price sensitive and cannot afford to pay more for these options. In the past, McDonalds has tried to implement higher quality items. For the most part its efforts have been unsuccessful for the reason we outlined: the majority of customers McDonalds is currently targeting cannot afford such steep prices even if they were interested in the items. Fox Business reported that McDonalds introduced premium Angus burgers and Fruit and Walnut salads, but it had to pull these menu items for the above reasons.

McDonalds is clearly undergoing a rough period. But has the market discounted these problems into the stock price? We don't think so. As of September 23, 2014, the stock still trades for 16.98 times trailing earnings. We think this is quite expensive for a company that is becoming increasingly linked to obesity in America through documentaries such as Super Size Me. Indeed other financial metrics can be used to support our bearish thesis on McDonalds. As one can see from the chart below from the Chicago Tribune, same store sales at McDonalds are currently abysmal.(click to enlarge)In our view, there is no reason why an investor should initiate a position in a company that trades at near a market multiple but has -4% growth in same store sales worldwide. We think McDonalds should trade closer to 14 times earnings or roughly 77 dollars a share. Given the significant dividend yield, we don't think shares will ever fall that low though. However, we would warn potential longs that they may be in for a few years of underperformance as McDonalds works out its structural issues.

We hope we have provided unique and accurate insight into why we're staying away from McDonalds shares. To be clear, we're not suggesting the shares will collapse or the stock will never reach new highs again. We just think boosting comparative store sales, improving perception of the brand, and revamping the menu are significant challenges. At Main Street Wins, we would rather stay on the sidelines until we see some of these changes being implemented or the stock trading at a decent discount to the broader markets.