MCD Sizzles, But FX to Take a Bite

MCD: May Sales Sizzle but FX to Take Bite Out of Earnings

Currency headwinds temper growth but MCD shares remain a good value in a dangerous market

McDonald's Corporation (MCD - Analyst Report) continues to report strong worldwide same-store sales but, as expected, foreign currency translation remains a drag on earnings.

Much of the foreign exchange [FX] drag -- expected to be $0.20 for 2009 -- was already factored into estimates or offset by anticipated declines in commodity costs in 2H09. In turn, we are trimming our 2009 EPS estimates by just $0.04 to $3.78 and maintaining our Buy rating on what we consider a defensive safe haven in a dangerous market.

McDonald's announced today that global same-restaurant sales jumped 5.1% in May, with overseas operations remaining strong and those in the U.S. moderating. Comps in in the U.S. grew 2.8% in May -- respectable given the powerful 7.7% rise in May 2008, though slower than the 6.1% reported in April. In Europe, comps surged 7.6%, and in Asia/Pacific, Middle East and Africa they grew 6.4%.

Although McDonald's quick service competitors -- including Burger King Holdings Inc (BKC - Analyst Report), Wendy's/Arby's Group (WEN - Analyst Report), Jack in the Box Inc. (JACK - Snapshot Report) and CKE Restaurants Inc. (CKR - Snapshot Report) -- haven't announced May sales yet, recent results suggested they were losing share, with comps in some cases lower than price increases.

McDonald's U.S. sales were fueled by its successful recent rollout of McCafe coffees. The new premium coffee line has an appealing ad campaign and is likely to draw value-conscious customers away from the $4 lattes at Starbucks (SBUX - Snapshot Report).

Europe benefited as restaurants added breakfast and extended their late night hours. Notably, Germany -- a very weak area for Burger King -- continued to post positive comps.

Strong sales in Australia and Japan juiced strong Asia/Pacific comps. McDonald's has successfully tailored its menu offerings to local tastes.

China, where McDonald's represents a more expensive meal, remains one area of weakness. China's contraction, however, should have a much bigger effect on Yum! Brands Inc (YUM - Analyst Report), which derives 28% of its revenue there.

The U.S. dollar's recent surge remains the major headwind facing the company. Same-store sales are logged in local currency. Revenues on the income statement are not. When overseas revenues are translated to dollars for reporting purposes, the strengthening U.S. dollar continues to temper results. System-wide sales grew 7.0% in constant currencies, but actually declined 0.4% after translation.

As we have noted in the past, however, currency shifts have little impact on McDonald's fundamentals. The company effectively operates its overseas operations as separate businesses, sourcing, selling, funding and building new units in local currency.

Offsetting much of the negative impact of FX translation will likely be declining commodity costs in the second half of the year and strict containment of other operating costs. In April, management indicated that commodity costs, which had risen sharply over the last year, have reversed and that much of the relief should be felt in the second half of the year.

Shares of McDonald's are 13% off their 52-week high, on fears that the drag from currency translation and tough 2008 comparisons will stall growth in 2009. While currency remains a substantial headwind, commodity deflation may temper the strong dollar's effects on margins, and same-store sales show no signs of marked deterioration as menu innovations entice cash-strapped consumers to the Golden Arches' value proposition.

At current prices, MCD shares are trading at 15.3x our 2009 EPS estimate, which we think is justified by the company's strong balance sheet, consistent earnings, healthy cash flow, high ROE (30%), generous, safe dividend (currently yielding 3.3%) and stock buybacks. In turn, we think the shares provide relative safety and moderate growth in a turbulent environment and exposure to faster-growing international markets.