Please respond to Sivy on Stocks SIVY ON STOCKS from money.com
May 16, 2001

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Face-off on McDonald's

Is the world's number-one fast-food chain really poised for a comeback --
or is the stock depressed for good reason.

By Michael Sivy

MONEY editor-at-large Ken Kurson and Michael Sivy go head-to-head over this
column's recommendation of McDonald's (see Supersize this Stock!
[ http://www.money.com/money/depts/investing/sivy/archive/010514.html ]).
On Monday, Sivy argued that the stock is a good buy even though it appears
beset with problems -- the economic slowdown in the U.S.; fears about
mad-cow disease and hoof-and-mouth disease that have depressed beef
consumption in Europe; and the chronically weak euro, which reduces the
value of McDonald's European profits. Sivy believes that these problems
will soon pass, profit growth will pick up again, and the stock's valuation
-- well below historical levels -- will climb back toward normal. Kurson
doesn't buy it. Their debate follows:

Kurson
This time you've gone too far! How can you possibly like anything about
McDonald's -- either the business OR the stock? (I'm assuming you at LEAST
detest the food.) Yes, the valuations are cheap next to its own historical
averages, but NOT against competitors. The PEG ratio is by far highest in
the group: McDonald's PEG is 1.39 versus 1.01 for Brinker [EAT], 0.99 for
CBRL Group [CBRL], 1.06 for Darden [DRI] and a lowly 0.95 for Tricon [YUM]
(despite those endless delicious stuffed crust innovations at Pizza Hut).
And McDonald's price/sales ratio is more than TWICE any of its competitors.

And for what? A proven ability in the PAST to build faster and a net profit
margin that's the envy of the sector. But as your column points out,
overseas is where the opportunity is and also where the problems are. You
say the problems will pass, but I totally disagree. Mad-cow disease and
hoof-and-mouth disease MAY be temporary, faddish, fashionable concerns. I
happen to think they're not so easily dismissed, but even conceding that
point, it doesn't get at the root of MCD's failure to replicate overseas
the disgusting (and disgustingly profitable) empire it has erected here.
Evidence? Japan, where MCD is planning a piddling 220 new stores in 2001
(versus 360 in 2000). That's the company's second biggest market (bigger
than Europe) and there are concerns about profit margins there, as well.

You rightly point out the company relied too heavily on promotional
gimmicks. But then you give MCD points for totally ridiculous stuff like
high-end coffee at their McCafes. Yeah, right. I'm sure Starbucks is
quaking in its boots. Just like Pizza Hut was terrified by McPizza.

Sivy
The short response to the points you raise is that I don't really believe
in securities analysis.

Here's the longer version: I don't believe that projections of a company's
business trends are more reliable than the stock's actual track record and
natural statistical tendencies, such as regression to the mean. If analysts
couldn't anticipate the effect of telecom infrastructure overbuilding on
Cisco's business, they can't anticipate anything.

Fact is, McDonald's has proved remarkably resilient over time, despite its
mediocre products. The same arguments you make now have been made before.
And yet McDonald's has retained its dominant position relative to Tricon
and Wendy's and other smaller chains.

When globalization was a hot concept right after the Berlin Wall fell,
companies with global franchises enjoyed excellent growth. Now "globaloney"
is out of fashion and no one is willing to pay up for such franchises (that
goes for U.S. packaged food companies too).

At the moment, everything is going against McDonald's stock. But most of
the these trends are cyclical, in one way or another. The U.S. economy will
turn. And the McDonald's marketing machine will improve its success rate.
And sooner or later, the stock's multiple will improve. I'm not looking for
the next Dell Computer, but I do think that from this price the return on
McDonald's will beat a 12 percent hurdle rate.

As to the current backlash against beef, I regard it as a temporary -- and
rather ridiculous -- expression of deviant psychology. Basically, the same
sorts of people who supported North Vietnam in the '60s have redirected
their self-hatred from the national to the personal level. This leads to
body-piercing, food phobias, and incompetent riots at international
free-trade meetings. This too shall pass -- or at least be redirected again
to rescuing mink, or something.

Kurson
I, too, place no faith in securities *analysts*, and thus share your
suspicion about growth-rate projections. But I certainly believe in
securities *analysis*, and you do, too, because that's what it is to
recommend MCD based upon its history, the cyclical nature of the economy,
the foolhardiness of those who oppose beef. These all fit comfortably under
the heading of traditional analysis, and I don't see any percentage in
throwing out all the tools just because a couple of them display the greasy
fingerprints of sell-side analysts.

As for your point about past record being more compelling, yeah, I give a
company credit for a track record. But only when there's a forward-looking
justification for why that success (and higher valuation) will continue. I
mean, if a stock costs more than the stock of its peers because the company
is doing things differently and is hard to imitate, I'm willing to afford
it some juice. But if a stock costs more simply because it always has, I'm
skeptical. Especially when things have changed to make previous advantages
less impressive -- as I believe has happened to McDonald's. That's why I
cited the sharp fall-off of store openings in Japan.

Any drop in beef consumption may very well be temporary: There's clearly no
limit to how fat Americans are willing to become and like a lot of trends,
we're way out in front and I expect the rest of the world to follow suit in
time. However, I DON'T think McDonald's will continue to show the dominance
in fulfilling that demand, or at least continue to do so way better than
competitors.

Sivy
Where I differ with you is that I have a far greater skepticism toward all
trend projections, even though I acknowledge that we have to use them to
value stocks.

Just as economists have predicted 19 of the past seven recessions,
securities analysts tend to over-predict changes in earnings trends. What
really changes, though, is the level of valuations. A decade ago, everyone
loved companies with global brand names. Now they ignore those stocks. I
tend to think that the fashion has changed far more than the underlying
fundamentals. Statistically, it's most successful to bet on companies with
strong track records when they're off their game and valuations are low --
that's true even if you can't predict where their next success will come from.

###

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http://www.money.com/depts/investing/sivy/index.html

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