Lock in gains on this fast-food stock and buy its rival

After a year and a nearly 60% gain, it's time to exchange shares of one restaurant chain giant for another.

By StreetAuthority Aug 26, 2013 5:16PM
File photo of a McDonald's restaurant in Suffolk, England (© Geography Photos/Universal Images Group via Getty Images)By James Brumley

It's unusual to hear someone in the financial media suggest selling a stock -- particularly one they previously recommended.

But knowing when to close a position at the right time is just as important as getting into the right trade at the right time. That's why I'd prefer not to leave this loose end open.

If you stepped into a Wendy's (WEN) position about a year ago on my recommendation, I think it's time to lock in your 40% gain and use those proceeds to invest in McDonald's (MCD).
 
A little more than a year ago, I concluded that, "based on the company's plausible growth forecast, shares could be worth somewhere around $7 by the end of 2013 or mid-2014 -- about 60% higher than current levels." The stock actually hit $7 in late July and has since reached a high of $8.05.

But it's time to lock in the gain.

Don't misunderstand my intention. It's not a pessimistic judgment of the company, and yes, the stock could move higher. But with a little more than a 60% gain to protect, any further upside potential just doesn't justify the inherent pullback risk built into a 12-month 60% rally.

Perhaps the biggest concern is the valuation. The stock's now priced at a frothy 33.8 times trailing earnings. That's not considerably more expensive than how Wendy's shares were valued a year ago -- but a year ago, valuation wasn't the concern. The turnaround effort was poised to be the driving force behind the stock. The turnaround is a done deal, however, and with earnings growth projected to slow to 13% in 2014, it's tough to imagine the market willing to pump up the premium beyond its already lofty levels.

While Wendy's has been red-hot this year, McDonald's has been less than impressive. Shares are up for the year, but down 8% from April's peak and still falling at a decent clip.

The recent news hasn't been particularly encouraging, either. The world's largest fast-food chain has missed earnings estimates in four of its past five quarters. To make matters worse, Subway recently announced it was aiming to open as many as 1,000 to restaurants in Europe next year, where McDonald's is already struggling.

Given all  that, why would an investor want to jump into an apparent laggard? For the same reason that now's the time to shed Wendy's -- nothing lasts forever. Both stocks can (and have) stopped and turned on a dime, and McDonald's is due for a rebound for a handful of reasons.

One reason is simply that traders have unduly punished the stock. Earnings misses or not, the restaurateur is still on pace to boost earnings 4.4% this year and projected to increase the bottom line 8.6% next year. That's in line with the growth rate the company has logged for years now. Point being, despite recent criticisms driven by unmet expectations, the company is still doing fine.

Another reason McDonald's shares are poised to start climbing again is the company's new push to keep as many units as possible open 24/7, and to serve breakfast after midnight. Investors weren't particularly impressed when the plan was unveiled. But hungry consumers have responded favorably to the new hours of service and expanded menu. Less than half of McDonald's 33,000 restaurants are open around the clock, but that figure should reach about 60% by 2016.

Finally -- though perhaps a little unfairly -- the company is really starting to take advantage of its franchise model by leveraging the clout of its name in a couple of ways.

Much like Wendy's, McDonald's is looking to get out of the company-owned restaurant business by converting as many locations as possible to franchises. Though doing so lowers revenue, franchise fees are much higher-margin revenue. As part of those deals, the company usually keeps the underlying rights to the real estate, and carries that property at cost on the books. Translation: McDonald's will effectively own a bunch of undervalued real estate.

But at the same time, McDonald's move has ruffled some franchisees' feathers. McDonald's franchise fees have increased to a hefty average of 12% of store sales. That equates to an average of $300,000 per year being forked over from franchisees to the corporation, up from $212,000 (8.5% of sales) just five years ago. Franchisees are grumbling, but they have little choice in the matter.

Putting it all together, McDonald's has more going for it now than the market's giving it credit for.

Risks to consider: Though unlikely to actually change the status quo, the recent movement to increase minimum wage rates at fast-food restaurants will cast at least a modest shadow of doubt on the company's viability.

Action to take:
It's admittedly tough to jump off what seems like a rocket stock, but veteran investors know nothing lasts forever. Wendy's is a fine company, and the stock should do well in the future. But for the time being, shares are overbought and ripe for a pullback. It's better to be out too early than too late. On the flip side, McDonald's have been suppressed for a little too long and are due for better days.

The only consideration to make before booting Wendy's is just how close this idea is to incurring a long-term taxable gain as opposed to a short-term taxable gain. The original suggestion was made on Aug. 16, 2012, so you've been in for nearly a year. It may be worth holding a tad longer if you're on the short-term/long-term taxable gain bubble.

James Brumley does not personally hold positions in any securities mentioned in this article.
StreetAuthority LLC does not hold positions in any securities mentioned in this article.

More from StreetAuthority
8Comments
Aug 27, 2013 1:27PM
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You gotta admit...Wendy's red head is a lot hotter than McDonald's.
Aug 27, 2013 12:40PM
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Although I like Wendy's way more than McDonald's, I very rarely go there any more.  The price of the meals are very high.  I just can't justify spending $10 for a fast food meal x 8 for my family.  I will just go to the store and buy groceries and cook at home and get more than 1 meal out of it.
Aug 27, 2013 11:02AM
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Another MSN story about WENDY'S, good God people there must be something else to write about other than Wendy's?  Oh wait, you do have three stories a week about Sears being in trouble.
Aug 27, 2013 1:43AM
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Don't bother, it will turn around, and then they will be saying dump Wendy's and buy McD,s
Aug 27, 2013 11:10AM
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TRUE STORY! my wife and I went thru a burger king drive thru at 6pm this past sunday. We ordered two whoppers. The attendant responded "I'm sorry sir but we are out of whoppers". Yes folks! out of whoppers at 6pm on a sunday eve. clearly a whopper is made off premise as they had other burgers. pretty sad and scarey!
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