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McDonald’s Corp. $42 – New York symbol MCD

MCDONALD’S CORP. $42 (New York symbol MCD; Conservative Growth Portfolio, Consumer sector; WSSF Rating: Above average) operates over 30,000 fast-food restaurants in over 120 countries, which sell mainly hamburgers, chicken, french fries and soft drinks. Foreign operations account for two-thirds of its sales and one-third of its profit.

The company’s revenue grew steadily, from $14.9 billion in 2001 to $20.5 billion in 2005. Profits fell from $1.36 a share (total $1.8 billion) in 2001 to $1.32 a share ($1.7 billion) in 2002, but rose to $1.97 a share ($2.5 billion) in 2005.

Much of McDonald’s recent success stems from its plan to improve the quality of its food and service. It replaced its low-priced meals, which sparked a price war with competitors, with better quality food that generates higher profits for the company. It also added healthier foods, like salads and fruits.

Like all fast-food companies, McDonald’s is under constant pressure from health advocates to improve the nutritional quality of its foods.

A good example is trans-fats, which increase the risk of heart disease. McDonald’s wants to replace its cooking oil with a trans-fat free version. However, it has had a hard time lining up reliable suppliers.

Selling outlets frees up cash

Right now, McDonald’s owns about 25% of its restaurants. But it plans to sell more of its companyowned outlets to franchisees, particularly overseas. It recently sold 24 stores in the UK, and aims to sell 50 more by the end of 2006.

Over the next three years, the company also plans to transfer 1,500 outlets in up to 20 countries to franchisees under developmental licenses

Under this system, a local franchisee will own the restaurant, as well as the underlying real estate. McDonald’s will continue to collect a royalty based on sales, but will not pay for upkeep or capital expansion.

Developmental licenses will make it easier for McDonald’s to expand in overseas markets. That’s because local owners have a much better understanding of local tastes and customs than McDonald’s managers. It also frees up more cash for stock repurchases and dividends.

In the first nine months of 2006, McDonald’s repurchased $1.8 billion worth of its stock. It also recently raised its annual dividend by 49.3%, from $0.67 a share to $1.00. The new rate yields 2.4%. McDonald’s has earmarked $10 billion for share repurchases and dividends between 2006 and 2008.

Spin-offs unlock value

The company is also taking advantage of investor interest in restaurant stocks to sell some of its non-core operations.

Earlier this year, wholly-owned CHIPOTLE MEXICAN GRILL INC. (New York symbols CMG $61 and CMG.B $58; Aggressive Growth Portfolio, Consumer sector; WSSF Rating: Speculative) sold shares to the public.

McDonald’s sold some of its Chipotle shares for $329.1 million. In October, it handed out its remaining stock to its own investors through a special exchange offer. We see Chipotle as a buy, but only for highly aggressive investors.

McDonald’s could unlock more of its value by spinning off or selling some of its other businesses, such as Boston Market (630 casual dining restaurants) and its 33% stake in Pret A Manger (a UK sandwich retailer).

The company has re-modeled over 5,000 of its stores in the past five years, which has helped encourage repeat visits.

It has also added more 24-hour drive-through outlets, and installed credit/debit card readers. Initiatives like these have helped cut customer wait times and satisfaction.

Balance sheet improving

McDonald’s improving earnings have helped it cut long-term debt, from 0.9 times equity in 2001 to a more reasonable 0.55 times at September 30, 2006. Longterm debt will likely fall to 0.5 times equity in 2007.

The company also has $4.3 billion ($3.46 a share) in cash, which gives it plenty of flexibility to develop new menu items and expand.

When McDonald’s hit $12 in 2003, it was trading for less than 10 times earnings. Since then it has nearly quadrupled. Earnings have not quite doubled but the stock still trades at an attractive price to earnings ratio.

Cheap for a global leader

McDonald’s will probably earn $2.39 a share in 2006, and the stock trades at 17.6 times that estimate. Earnings should reach $2.57 in 2007, which implies a p/e of 16.3. It also trades at 2.4 times its revenue of $17.30 a share. That’s cheap for a company like Mc- Donald’s, which dominates a huge, growing industry like fast food.

McDonald’s is a buy.

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