Finding shelter under the 'Golden Arches'
McDonald's stock has soared as investors play defense in a volatile market. Should shares be a tasty addition to your portfolio?
NEW YORK (CNNMoney.com) -- Say what you want about their French fries, McDonald's, the world's largest fast-food chain, is one appetizing investment.
So far this year, McDonald's has been the second best performing stock on the Dow Jones industrial average. Shares are up 32 percent this year.
With its huge presence in the fast-food industry and its status as one of the world's most recognizable brands, McDonald's (Charts, Fortune 500) has developed a reputation as a defensive stock, one that can reliably withstand volatility in the market.
Now, with the threat of a recession looming large, McDonald's could be a good buy for investors looking for stability.
In a recent research note, Andrew Barish, an analyst at Bank of America, called McDonald's stock, "a safe place to ride out the storm." Barish rates the stock a "buy" and recently raised his earnings per share estimate for 2008 by 9 percent.
But Barish did point out that rising commodity prices could be a concern. And that's not the only challenge McDonald's will have to deal with next year.
Steven Kron, an analyst at Goldman Sachs, lists "a slowing consumer weighing on domestic sales," as one of McDonald's key risks.
Of course, the stock has seen its ups and downs in the more than fifty years since Ray Kroc founded the company. But despite the current signs of an economic slowdown, McDonald's appears well positioned to continue its current run, analysts said.
Rising commodity prices could be a drag
There is no escaping the fact that it probably will cost McDonald's more money to buy all the items that go into making Big Macs and Chicken McNuggets.
McDonald's said it expects the cost of chicken to go up 4 to 5 percent in the United States next year while beef prices are expected to rise 2 percent. In Europe, the price of cheese is expected to climb 20 percent.
However, some analysts are optimistic about McDonald's ability to withstand the increased cost of ingredients.
"McDonald's has the size and scale to be able to manage costs as well as or better than their peers," said Jeffery Bernstein, an analyst at Lehman Brothers.
In other words, when it comes to negotiating prices with their suppliers, McDonald's has more leverage simply because its contracts are so big.
Another way McDonald's could offset higher ingredient costs is by raising the price of some menu items, Bernstein said.
Clearly, a modest price increase is not likely to drive away many of McDonald's customers, since the cost of a "value meal" is already very low.
But McDonald's has built a successful strategy based largely on convenience and affordability.
What will happen if the creator of the "dollar-menu" decides to pass on some of its higher costs to consumers?
Weak dollar helping sales
Citigroup analyst Glen Petragila said higher prices won't be a problem. Even if consumers pull back, McDonald's is not likely to see a huge hit to its sales.
To that end, even though McDonald's raised prices by 3.5 percent this year, it still saw same-store sales growth of nearly 5 percent in the U.S. through October.
Same-store sales measure the performance of stores open at least one year and is commonly used by analysts as the best yardstick of growth for restaurants and retailers.
Part of the reason why McDonald's can weather adverse economic conditions so well, according to Petragila, is that they do most of their business at breakfast and lunch.
When consumers feel the need to cut back on spending, he said, they are more likely to stop eating out at dinner time, which won't impact McDonald's as much as it will traditional family restaurants.
In fact, Petragila thinks McDonald's may see an increase in traffic at dinner time as consumers "trade down from casual dining to fast food."
What's more, McDonald's does 50 percent of its business outside of the U.S., which works to the company's advantage in several ways.
It means McDonald's has less exposure to economic turmoil in this country. There's also the fact that international markets are growing more rapidly than the U.S. since the fast food business abroad is not mature as it is here.
McDonald's chief rival, Burger King, does only about 30 percent of its business abroad, so it is significantly more exposed to softness in the United States. Wendy's does less than 20 percent of its business outside of the United States.
And with the dollar as weak as it is, sales of Big Macs bought in foreign markets will translate into higher sales for McDonald's when translated back to dollars.
For example, McDonald's reported that total sales in Europe so far this year are up 17.5 percent this year. Much of this increase was due to the strong euro. Sales would have been up just 8.3 percent in Europe if exchange rates were at year-ago levels.
Would you like dividends with that?
Despite being perceived as a defensive investment, McDonald's still has the potential for healthy earnings growth.
Analysts surveyed by Thomson First Call are expecting the company to report revenue of nearly $23 billion for the year, up 6.2 percent from last year. Earnings per share are projected to increase 17 percent to $2.86 for the year.
Over the next few years, McDonald's earnings are projected to grow 9 percent, compared to annual earnings growth forecasts of 15 percent for Burger King (Charts), which went public last year, and 12 percent for Wendy's (Charts).
Yet, McDonald's stock trades at roughly the same valuation as its two main competitors. They all trade at about 19 times calendar 2008 earnings estimates.
So what makes McDonald's a better investment? Doug Christopher, an analyst at Crowell, Weedon & Co., thinks that comparing McDonald's stock to Wendy's and Burger King is not neccesaraly the best way to evaluate the company.
"McDonald's is a blue chip, bellwether kind of stock" he said, "I don't look at it in the context of a Wendy's or Burger King."
Instead, Christopher says that McDonald's valuation is justified when you compare it to other consumer-oriented conglomerates such as Procter and Gamble (Charts, Fortune 500) and Colgate-Palmolive (Charts, Fortune 500). Both companies are expected to report annual earnings increases of about 10 percent a year and trade at more than 20 times calendar 2008 earnings estimates.
Also, McDonald's generates a healthy amount of free cash flow, which it is using to reward shareholders. In September, McDonald's raised its annual dividend by 50 percent. The company has also been an aggressive buyer of its own stock.
Finally, McDonald's plans to go after Starbucks (Charts, Fortune 500) by launching a new line of specialty coffee drinks, due out by the end of next year. This could boost sales by more than $1 billion a year once it is fully implemented, according to McDonald's estimates.
Add all that up and the stock looks to be a sound investment in an unpredictable market.