#$bite

Two of the roughest, most failure-prone sectors in the stock market have always been—and probably always will be—restaurants and retail. Competition is brutal in both spaces, margins are usually slender, and bankruptcy always seems to be one poor management decision away.

I’ve written about the slow-motion train wreck of the traditional retail sector fairly regularly over the last couple of years, and with several large operators like Nordstrom’s and Kohl’s posting surprisingly decent earnings lately, I thought it might be a good time to check back again. Could brick-and-mortar retail be on the brink a comeback?

Probably not.

Last week, job placement firm Challenger, Gray & Christmas reported that 43,600 retail jobs have been eliminated since January. One iconic chain after another, including Sears, Penney’s, and Macy’s have announced store closings. Teen retailers Pacific Sportswear and Aeropostale filed for bankruptcy in April and May, respectively, while Sports Authority went under in March and closed all of its 460 stores by June. This creative destruction is likely to continue.  According to Mark Cohen, the director of retail studies at Columbia University, “the traditional retail industry in some respects is facing Armageddon.”

The one/two punch of ecommerce and Amazon has left most brick-and-mortar retailers reeling. Amazon reported 2015 revenues of $107 billion, and is expected to grow to $137 billion in 2016. Amazon’s stock is up 13 percent year-to-date, 2446 percent over the last ten years, and a stunning 50000 percent since its 1996 IPO. The only retailers left relatively unscathed in its wake are deep discount concepts TJ Maxx, Ross Stores, and Dollar General. These chains offer ‘treasure hunt’ bargains that Amazon does not/cannot offer. (Some specialty firms like Louisiana-based Pool Corp, which I mentioned a few months ago, are also faring well.) Even with these few bright spots, for John Q Public, buying retail stocks, however inexpensive they appear, is an extremely risky and probably ill-advised strategy.

Restaurants could be a different story, however. There is no Amazon equivalent devouring the sector. Also, restaurants are benefiting from a favorable secular tailwind as well-managed chain operators continue to expand their marketshare. Many folks might feel a nostalgic fondness for mom-and-pop diners and other locally-based eateries, but chains hire better people, train them better, buy food at lower prices and understand that good, consistent menu offerings are the key to financial success. While my fund does not own any restaurant stocks today, my reluctance is due to excessive valuations, not long-term viability. Shake Shack, The Habit, Wingstop, Buffalo Wild Wings and the still private Five Guys are all great concepts with great growth potential. I am less excited about Cheesecake Factory (they are great operators, but the food is mediocre), Noodles, Pot Belly, and Del Frisco.

Personally, I am fascinated by restaurants. Maybe it’s because performing due diligence on them is a lot more enjoyable than analyzing an obscure software or biotech company. I own 50 percent of a successful nine-year-old Cajun restaurant in Berkeley, California. I have also invested in other restaurants (with my own money) over the last two decades. Some have done quite well. Some have crashed and burned. Investing in restaurants can be fun, but nerve-racking, because it doesn’t take a Chipotle-level scandal to bring on a sudden reversal. Consumers often simply tire of a concept. In recent weeks the 48-unit Fox & Hound, 23-unit Champs, and larger chain Logan’s Roadhouse have all filed for bankruptcy. Houston-based Ignite restaurant group, which owns Joe’s Crab Shack and Brick House Bar and Grill, is teetering on the edge of bankruptcy, as well.

This isn’t the first time you’ve heard us question sustainable growth related to McDonald’s turnaround plan. Slowing comparable store sales expansion and restaurant industry weakness have now gotten investors on board. Will things get worse?

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By Kris Rosemann

McDonald’s (MCD) shares took a hit after the burger giant reported second quarter results July 26, and we can’t say we are the least bit surprised. In fact, if we did, we would be flat out lying; we’ve been skeptical of its turnaround plan since it was released in May 2015, “Turnaround Plan at McDonald's Does Not Fly With Franchisees.”

It seems as though we’re beginning to see what we had been expecting, and what bullish McDonald’s investors had been hoping they wouldn’t so soon; that is a slowdown in comparable-store sales growth, particularly in the US. Global comparable store sales growth came in at 3.1%, not a bad number in itself, but short of consensus expectations of 3.6%. Meanwhile, US comparable store sales growth left even more to be desired at 1.8%, compared to expectations of 3.2%. Similarly unimpressive was the 1.6% comparable store sales growth in the firm’s ‘High Growth’ segment, hardly high growth at all.

However, the issues in McDonald’s US growth may not be firm-specific. Same-store traffic across the entire restaurant industry in the US in the second quarter of 2015 fell 3% on a year-over-year basis. With traffic falling, promotions and other marketing gimmicks are likely to increase, which will likely impact menu pricing strength (and franchisee satistfaction) moving forward. Generally speaking, we think McDonald’s brand power should give it a leg up in this area, but we continue to warn of the firm’s need to sustain impressive bottom-line growth for at least the next few years to grow into its current valuation, if ever. Shares, for example, are trading at more than 20 times fiscal 2017 earnings, which implies significant expansion over 2016 numbers (on the basis of consensus forecasts). The market is way ahead of itself, in our view.

Though we've downplayed it a bit, it may now be worth noting that Brexit has the potential to be meaningfully harmful to McDonald’s bottom-line results as well. Coming to light is that the firm has the highest exposure to the UK and Europe of any US-based restaurant with 37% and 9% of revenue coming from Europe and the UK, respectively. Not only does consumer confidence rest in the balance with the looming economic uncertainty in the region, but outsize currency headwinds could provide a material drag on reported results as well. McDonald's may now be fighting an uphill battle.

Still, "Mickey D's" continued to work to boost operating margins via refranchising efforts in the second quarter of 2016, but operating income growth slowed materially from recent quarters and was up only 3% in constant currency--we were expecting a lot more and so was the market! Operating income growth on a constant-currency, year-over-year basis came in at 28% and 16% in the two prior quarters, respectively. Diluted earnings per share fell 1% from the year-ago period on an as-reported basis, though a number of one-time charges were largely responsible for the disappointment.

McDonald’s poor quarterly results play directly into our thesis on the firm, and the outside pressure from weakness in the US restaurant industry only adds to investor concern around the fast-food giant. Our opinion on the company remains the same as it was following its first quarter earnings report, “Restaurant Roundup; Valuations Overcooked.”

“If McDonald’s is to grow into its current share-price trajectory and valuation, it will need to continue to put up impressive comps growth and execute flawlessly to continue its bottom line strength. The ongoing refranchising will certainly help expand margins, but will the improvement be enough? We don’t have enough confidence to make that call at the moment. The sustainability of the fundamental drivers behind McDonald’s performance over the past year is not likely replicable over the long haul, and eventually investors will realize the biggest draw to the firm remains its brand name, not the “growth potential” behind egg sandwiches now being available all day.”

The biggest difference between our reaction to McDonald’s first-quarter 2016 report and now the second quarter report is that what were once merely concerns a few months ago now appear to be becoming a reality for the fast-food giant. The company may very well catch another "comp growth" updraft in the future thanks to its impressive brand strength (and easier lapping of weak quarters), but even so, its valuation is making our nose bleed. Surely McDonald's is a fantastic company with a very nice dividend yield, but its stock may be just starting to slip. Caution. Our fair value estimate remains unchanged at this time.

Interested in our fair value estimate and fair value range of McDonald’s? Download its report by becoming a member to Valuentum here.

Related tickers: ARCO, BITE

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