DJIA - McDonald's: Mixed Q2 Results But Still A Safe Haven Against Recession

• This is a follow-up of my pair trade thesis to go long MCD and short TXRH as we enter into a recession.
• MCD's Q2 results posted increased comparable sales, but margins shrank.
• MCD is in any case a healthy business that offers stability and protection when the market sells off.

Introduction

As strange as it may be, we have first gotten used to seeing one red week after another in the market, in fears of a recession. Now that we know that GDP in the U.S. decreased for two consecutive quarters , the markets seem to be shrugging fear off. Now, in consideration of a possible upcoming recession, at the beginning of this month, I participated in the Seeking Alpha's Top Pair Trade Thesis . My suggestion, which can be read here , was to go long McDonald's Corporation ( MCD ) and short Texas Roadhouse, Inc. ( TXRH ).

These were, in summary, the reasons backing the thesis up.

1. The two stocks, although belonging to the same industry, have a low correlation.
2. MCD's business model is based on franchised restaurants (93% of total) while TXRH runs directly more than half of its restaurants. This difference makes MCD more resilient during a recession as it offers stable and predictable revenue that MCD is able to convert into free cash flow.
3. With high commodity prices, MCD has a better bargain power due to its size and its control over the supply chain. Moreover, beef price is increasing dramatically, damaging more TXRH than MCD.
4. MCD's average ticket is estimated to be less than half TXRH's. In case of a recession, we can expect customers to move down the restaurants pipeline towards low-cost solutions.
5. MCD's financials show a mature company that, while keeping its top line stable, has been able to increase its margins to great extent (at the end of 2021 net margins were at 33%, a result that we usually find in the luxury industry). Though MCD's debt is far bigger than TXRH's, 95% of MCD's long-term debt is fixed-rated at an average annual interest of 3.2%, way lower than today's inflation. Thus, while TXRH is still focused on growth and expanding its business, MCD has all the characteristics to be a safe haven during times of volatility and economic downturns.

At the end of my article, I also suggested that this pair trade was particularly effective as we enter into a recession. However, it could also be reversed as the first signs of a recovery appear, which, historically, have been periods where TXRH has outperformed MCD.

MCD Q2 Earnings: mixed results

Now, I paid close attention to MCD's Q2 earnings release, because I wanted to see how my thesis is playing out.

In this article, I would like to briefly discuss the positive and the negative of this report as it confirmed some of my hypothesis while disattending other expectations I had.

Let's dive into the release to see how MCD performed.

1. Global comparable sales grew by 9.7% YoY. However, the domestic market saw an increase of only 3.7%, while international operated markets grew by 13% with strong performance in France and Germany
2. Consolidated revenues decreased by 3%
3. Consolidated operating income decreased 36%
4. EPS of$1.60, a 46% decrease

At first, this doesn't look very good. What happened?

In the report, we find that the main driver of comparable sales growth in the U.S. was menu price increases and value offerings across both our everyday menu and digital offerings.

As Kevin Ozan, MCD's CFO, explained during the earnings call :

Our Q2 comp of a little under 4, was driven completely by higher average check. Our guest counts were relatively flat. So, it really was check driven. And that average check was driven obviously, mainly by price increases.

This means that MCD wasn't able to attract more customers (in the earnings call, Mr. Ozan actually mentioned "a decline in units per transaction"), but was still able to pass on to customers a partial chunk of inflation. As I explained in my previous article, MCD has a long history of outpacing inflation with its strong pricing power. This time, it seems that MCD is still absorbing part of the inflation in order to be attractive to customers through its value proposition of being the best restaurant for cheap and tasty fast food.

Consolidated revenues decreased by 3% mainly due to FX. This is hitting most of the American companies that have a part of their revenue outside of the U.S. In constant currencies, MCD would have registered a 3% increase.

But why did the operating income and the EPS decrease, respectively, by 36% and 46%?

The answer is simple: Russia. MCD sold its Russian operations, and this resulted in a charge of $1.2 billion and a gain of only $271 million. Had the company not done this operation, consolidated income would have been flat (+7% in constant currencies). To this, the EPS was hurt also by an extra $0.05 decrease related to the settlement of a tax audit in France. Otherwise, the EPS would have been $2.55, an increase of 8% YoY (14% in constant currencies).

I think it is pretty straightforward to say that MCD is not in trouble and that it is just going through the unexpected consequences of events nobody can foresee nor control. However, the rest of the business is healthy, and it is actually profitable.

Let's get to operating margins and net margins. MCD posted these results for the quarter:

We can easily calculate that in 2021 the operating margin was 45.7%, while in 2022 it dropped to 29.9%. Net income was 37.7% last year, while this quarter it came in at 20.8%.

While these numbers are in any case good, MCD has not gotten investors used to such low margins. How did the company explain this?

Mr. Ozan said that:

company-operated margins were hampered by significant commodity and wage inflation as well as rising energy costs. [However] we had strategic wage rate increases in our company-operated restaurants kind of mid last year. So, we won't start lapping those until the second half of the year. So more of that inflation was hit in the first half of the year than the second.

So, since MCD raised wages in the second half of last year in order to keep employees, this first half is seeing very tough comparables from a margin point of view. As we move on toward the end of the year, and we lap last year's wage increases, we should see margins go up once again.

One of the drivers that may be helping MCD once again push up its margins is something I noticed in my previous article and that now was actually mentioned by MCD's management: inflation is weighing more on food at home versus food away from home. Chris Kempczinski, MCD's CEO, said that MCD was looking at this trend and is expecting to benefit from it:

we track as many of you do as well, food at home versus food away from home. And right now, we're seeing a significant gap. In fact, we think, by our measure, it's the largest gap we've ever seen and -- well, is seen in 50 years between food at home and food away from home, meaning that food at home has increased pricing significantly faster than what food away from home, McDonald's and others in our industry have done. I don't know what the impact of that is. But certainly, we expect that there is some benefit that we're seeing as part of that.

Families may thus be encouraged to eat away from home, seeing that food away from home has not seen prices surge as food at home has.

Conclusion

Investors will have to watch how MCD's margins move in the next two quarters. For this quarter, I think it was a correct move not to pass on the whole weight of inflation to customers, in order to stand out as a really valuable place to go. However, if MCD accepts to have shrunk margins for a longer time, the stock price will need to be corrected in order to reflect new multiples. For the time being, I think the stock deserves to trade at a premium given the resilience and the quality of the company, alongside with its long track of dividends and share buybacks that do reward shareholders.

The discounted cash flow model I used in my previous article is still good for me, and it gave me a target price of $254. However, at the time, I stated that this model didn't take into account a premium that should be paid to companies so reliable as MCD. I think a 15-20% premium is adequate for such a stock. Now, the stock has climbed up a little bit and is trading in the low $260s. There might not be enough upside for investors to jump in, but over the long-term MCD is a safe haven few investors have not benefited from.

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