On this Market Foolery podcast, host Chris Hill and Supernova and Rule Breakers' David Kretzmann check in with the wild reason McDonald's (NYSE: MCD) shares jumped to a new high Tuesday, and they reveal why similar-sounding results for Domino's (NYSE: DPZ) left its shares in the red on the day. Meanwhile, Alphabet (NASDAQ: GOOG) (NASDAQ: GOOGL) looked good overall on revenue, but detail-oriented investors saw some items of concern in how it's acquiring that revenue.
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This video was recorded on July 25, 2017.
Chris Hill: It's Tuesday July 25. Welcome to Market Foolery. I'm Chris Hill. Joining me in studio today, from Rule Breakers and Supernova, David Kretzmann. Thanks for being here.
David Kretzmann: Good day, Chris!
Hill: It is a good day, and it's one of those days where, if this was an hourlong show, we would have no trouble filling the time with all of the earnings news. There are more companies reporting earnings this week in the S&P 500 than any other week.
Kretzmann: It's a packed week.
Hill: It is packed, and we're not going to get to all of them. We are going to get to Alphabet, and we're going to get to Domino's. We're going to start with McDonald's, which is hitting a new all-time high on their second-quarter results. Any time you're looking at restaurants, same-store sales is, if not the most important metric, it's certainly in the top three or so. Global same-store sales for McDonald's up 6.5%. That's insane!
Kretzmann: Not what many people would have expected.
Hill: This is McDonald's!
Kretzmann: They're supposed to be dead in the water, right?
Hill: Well, not necessarily dead in the water, but in the same way that people look at the return on bonds and that kind of thing, it's 1% or 2% -- that's sort of how I've thought about McDonald's global comps for so long. Yeah, they'll be up 1%-2%, that sort of thing. Any restaurant would love to have this.
Kretzmann: Yeah, we are in the so-called "restaurant recession" right now. We've had a couple years of declining restaurant traffic, at least here in the U.S. McDonald's has done a lot to revamp those sales. Obviously, they came out with all-day breakfast back in fall of 2015. That attracted some people back into the stores. They're doing some more to revamp their core menu. They're transitioning from frozen beef to fresh beef in some of their sandwiches. So, doing a lot of different things. Then, on the operational front, they're also transitioning more and more to the franchise model. Right now, about 80% or so of their total restaurants are franchised, and they're looking to get that to 90% by the end of 2018. They're not only just doing that transition to franchising overall, but they're also trying to get the weaker franchises to sell to the stronger franchise operators. Say, let's consolidate to our best operators. And so far, that seems to be going really well for them, refocusing on what matters.
Man, it's paying off. This is a company that's still producing free cash flow of over $4 billion. The dividend has been rising steadily since the Great Recession, so it's over a 2% yield. On top of that, the stock has doubled in the past six years or so, so shareholders who have been patient and stuck with the company, even though there were a few slow years there since the recession, those patient shareholders are being rewarded today.
Hill: We talked recently on Motley Fool Money about Microsoft and the performance of that stock since Satya Nadella became CEO. Steve Easterbrook became CEO of McDonald's in the spring of 2015. Since then, just a little over two years, the stock is up 60%. And that was absolutely a situation where you could say he had a little bit of an easy act to follow with Don Thompson not doing a great job. Not only did he not do a great job and the stock didn't do well, but you also heard a lot of grumbling from the franchisees, and it really seems like Easterbrook, right out of the gate, made a lot of overtures to the franchisees, wanted to understand what their pain points were, how he could help, all that sort of thing. I don't think anyone expected this. Even the most optimistic bull when it came to all-day breakfast, I don't think they were expecting this.
Kretzmann: Sixty percent in a couple of years, for a company that's already the size of McDonald's, you're not expecting this level same-store sales growth. So yeah, I would say Easterbrook gets an A+ so far. And those results are even more impressive when you consider how restaurants across the board are struggling right now. If restaurants were in a great time altogether, then these results are good but maybe not great. But these results are phenomenal, considering the restaurant environment.
Hill: Delivery -- do you have any insight into where they are with delivery? I think they're partnering with Uber Eats. The sense I get is, they're in the earliest stages of delivery. When you think about Panera and what Panera has done, not just with the 2.0 concept in some of their locations, but also delivery, the idea that McDonald's could put up even better numbers if they get delivery right, I don't know. I'm dumbfounded, clearly.
Kretzmann: Yeah, that could be another growth driver. They didn't mention anything in the press release for this quarter. I haven't had a chance to look at the conference call yet. But something that they are rolling out with their franchisees, they've reached an agreement with the majority of their franchisees that McDonald's the company will put up 55% of the cost of certain restaurant upgrades if the franchisees agree to fund an advertising campaign for a national value menu. As I said, the majority of the franchisees approved that arrangement with the company. Those innovations include new dessert counters and self-order kiosks. So they're looking for different ways to improve that ordering process. Those in-store kiosks, you're seeing more restaurants do that, including Panera. Delivery might be something we keep hearing about more in the next few years, who knows?
Hill: Let's move over to Alphabet. Second-quarter revenue grew 21%, also an astonishing number when you consider just how big Alphabet is, and how much money that company makes. But the share's down a little bit today. Some of the key metrics are going in the wrong direction, and top of that list is cost per click.
Kretzmann: Yeah, cost per click is down 26%. That is sort of made up with the volume of clicks. Paid clicks overall are up 52%. So you're seeing the number of clicks going up, but the cost per click is going down. So you're seeing some pressure on margins there, but that has been an ongoing trend. So that isn't necessarily anything new. If you look at just the Google segment, that's the core advertising segment for the company, it makes up about 90% of total revenue -- that segment's revenue was up 21%, but the traffic acquisition costs, essentially the cost to get that revenue, grew 28%. So you're seeing that pressure on margins, but like I said, I don't think this is anything necessarily new to worry about. If this becomes an ongoing trend where you're seeing the costs rise and revenue continue to decelerate, then that might be something you need to take a step back and look at.
But at this point, for one quarter's results, I think there's still a lot to like with this company. I still have Alphabet at the top of my list for the company to hit the trillion-dollar mark first. I think a lot of people look at Apple, Amazon, and Alphabet as the strongest three contenders, or certainly of the top five contenders to hit that trillion-dollar mark. But I look at Alphabet, and they're growing their top line at about the same pace as Amazon, around 22%. That's been pretty consistent over the past five years. The companies are neck-and-neck in terms of revenue growth. In terms of valuation, Alphabet's valuation is a lot more reasonable. They're producing twice the operating cash flow and free cash flow of Amazon.
So this is still an incredibly powerful business. You obviously have some regulatory headwinds with the EU's decision to stick Google with a $2.7 billion fine. The company has plenty of cash, over $90 billion in net cash, so they can afford that. But there is that regulatory risk with Alphabet, and potentially increasingly with Amazon as well. So that'll be something to watch.
Hill: The EU fine that they paid, the $2.7 billion, am I correct that all of that was accounted for in this quarter?
Kretzmann: Yeah. If you just take an apples-to-apples comparison from this quarter and last quarter, it'll show their net income and operating income basically getting sliced a good amount and dropping. Hopefully that's a one-time event. It should be a one-time event. So when you back that out, it's still a very solid quarter in terms of free cash flow and earnings. Things are still by and large great for the company. One area that I see a lot of promise and continue to see a lot of promise in is with YouTube, which now has 1.5 billion monthly viewers. People spend an average of 60 minutes a day on their phones and tablets watching content on YouTube. They mentioned that the fastest-growing place to watch YouTube content is actually in the living room on a TV through a streaming device like Roku. So people are increasingly engaging with YouTube, so I think that property alone is incredibly valuable. Then you have Google Photos, Google Maps, you have these properties that, I think they've done an incredible job from a user-experience perspective. You're seeing that engagement continue to increase across the board.
Hill: One item that has been resurrected is Google Glass, making a comeback for businesses, essentially.
Kretzmann: The enterprise, yeah. I think it was a Wired article from a week or two ago. There's a manufacturing facility in Minnesota where the workers are using this to help them with measurements and dimensions of whatever they're working on. It's a quick way to pull up that info. There's certainly still a future for augmented reality. I think Google was several years early on the consumer side, but there's still potential there. And they're also working on something called Google Lens, which I think, over the next few years, this could become a huge driver for the company. I think we'll hear more and more about it. It's essentially an augmented-reality photo search. Imagine that you have your phone, you hold it up to a flower, and it'll tell you what kind of flower that is. Or you hold it up to a restaurant, and it'll immediately on the screen pull up the reviews, something like that. It's essentially using the camera as a search device and as that filter. So they have this Google Lens product where, they're testing it, and they're still very early, as far as that product development goes. But I think that's something we'll see more and more of in the next few years.
Hill: Going back to YouTube for a second, I would happily send the people the people at Groupon $20, I would kick in $20 if they would just stop running their YouTube ads. It has this annoying singsong thing. They're really the worst.
Kretzmann: I've heard that one, yeah. It's not good.
Hill: Yeah, you know the one. Anyone who's been on YouTube and has encountered a pre-roll Groupon ad knows exactly what I'm talking about. I was thinking about this this morning.
Kretzmann: But you remembered it, so maybe it worked.
Hill: I remembered it, but I've also taken time to figure out the name of the ad firm and email them and be like, "Please stop. Please just stop."
Kretzmann: Wow, good for you.
Hill: But I was thinking, if you're doing the spectrum of video advertisements, whether it's YouTube or just what we think of in terms of traditional television advertising, at one end of the spectrum, I think you have Nike. Whoever does Nike's commercials, that to me is the gold standard. They are phenomenal. At the other end of the spectrum is Groupon.
Kretzmann: That's a spectrum there.
Hill: Yeah, instead of a scale from 1 to 10, it's, how good is this ad on a scale from Groupon to Nike?
Kretzmann: With the Nike ads or some of those old Apple ads, you'll actually search for them on YouTube to watch them. That's the gold standard. What's interesting about that is, YouTube no longer runs 30-second ads. They found those ads do not perform well. No one wants to sit for a 30-second ad before watching a two-minute video on YouTube. But they are seeing more and more success with, they're calling it six-second bumper ads. It's a quick-hitting ad right before the video. More brands are testing that out. I think, as they test out more ad formats like that, you will see the value, the cost per click, for YouTube, go up. I think there's a lot of value in that platform, because when you have such an engaged audience, you can test different formats for those ads, and I think those ad spaces will become more valuable over time. But you'll have to go through some quarters like this where they're still figuring it out. But the platform itself is growing, and for patient shareholders, that's what counts.
Hill: Domino's Pizza getting hit despite the fact that second-quarter same-store sales in the United States were up more than 11%. Those are phenomenal numbers. But unlike McDonald's, where we saw this great number globally, big disparity with Domino's Pizza. Looking great in the U.S., but internationally, significantly lower.
Kretzmann: Yeah, international comps were up 2.6%, which isn't bad, and that's actually 94 straight quarters of positive comps internationally. So I don't know. There's a lot to worry about here, Chris. I don't know if they really cracked the code yet internationally. We'll have to watch closely. But it seemed like the slowdown from what management mentioned was generally driven by Europe, especially the U.K. They mentioned that there's weaker consumer confidence. They weren't using that as an excuse. They said, "We need to do better, we need to find ways to reach customers where they're at." So this isn't something I would be overly concerned about. Management has stated that their long-term goal over the next three to five years is to grow international comps between 3% and 6%. So when you miss that hurdle pretty soon after mentioning those long-term projections, I think it's understandable for the market to be a little skeptical, especially when the valuation is lofty. The stock is still trading around 40 times trailing earnings. The expectations are high.
I think Domino's is still clearly the best of class in the restaurant space, so I would treat this more as an opportunity to potentially start a position if you don't already have one, or maybe look to add a little bit to your position if you have that long-term time horizon. But when you have such a lofty valuation multiple, it's hard to put out perfect results each quarter, which is really what it requires. But looking longer-term, I think Domino's is still in a great position to snap up market share. They're the clear innovator when it comes to online ordering, digital ordering, delivery, all of that stuff. And the leadership under Patrick Doyle has just been incredible over the past several years. So I think there's still a lot to like here. EPS grew 35% this quarter. Domestic same-store sales up almost 10% for the quarter, which is just unheard of in this restaurant environment. So yeah, the international comps will be something to watch, but 23 and a half straight years of positive global comps, I think Domino's has cracked that code. I think they know what they're doing, and they can probably turn that around pretty quickly.
Hill: Yeah, I was probably being a little tough on them. But that is the noteworthy number comparison when you look at this quarter. The U.S. same-store sales are so great, and to see them drop off to that degree, I think that's why it's noteworthy. But as you said, this is a stock even with the drop today -- it's down about 8% this morning -- even with that drop, it's still up 33% over the past year. And you mentioned Patrick Doyle, another great example of a CEO who, when he takes over, comes in and really shines a light on the challenges that the company is facing. In the case of Domino's, Patrick Doyle was the one who really pushed the idea, "You know what people say about our pizza? It's not very good. How about we focus on making the pizza better?" And not only did they do that, but they did the whole ad campaign around that. And not only is the pizza better -- is it the best pizza in the world? No, but it doesn't have to be. They made it better, and they made sure that they communicated to people, "We hear what you've been saying, and we're trying to make it better."
Kretzmann: Yeah, a lot of things are going well for Domino's. Another thing that they really perfected is that digital ordering system.
Hill: I was going to say, the mobile.
Kretzmann: Yeah. It's such a sticky process for the consumers. Once you have that app downloaded and you have your account created with Domino's, it's easy to just go back and repeat that order every week, every month, or whatever the case may be. So you're seeing more and more of those orders continue over time with repeat customers. They've also done something with, I think by this point, they finished it up, or they're close to finishing it up, the whole re-imaging process of their stores. Domino's is another company where they're almost entirely a franchise operator. But most of their franchisees in the U.S. have completed a re-imaging of their stores where, if you walk into a Domino's today, it actually looks a little bit more like a fast-casual restaurant, where you can see the pizza being made, you can see the ingredients, and it's just a better customer experience. Obviously, the majority of their business is still takeout and delivery. But when you do walk into the stores, it's a better experience. They've noticed a sales lift from the stores once they transition to that re-imaging.
I think the market is something to think about as investors, if we eventually do see a deceleration in domestic same-store sales, which will happen at some point, even though the last couple years have been incredible for Domino's, which is really impressive considering the restaurant environment, right now the expectations are still very high for the company. So when you see that deceleration in same-store sales, it wouldn't be a surprise to see the stock get hit. We know it can happen internationally. The same quarter last year, international same-store sales were up 7% or so, now growing under 3%. Maybe analysts are a little bit worried about what happens domestically over the next year.
Hill: You mentioned the mobile. I think it's easy to look at mobile ordering just in terms of the technology. And that makes sense, particularly if you've ever used any app to order anything. The user experience matters a great deal. But I think what's important to recognize in the case of Domino's is, it's not just that they created this great mobile ordering platform, but that they realized, "If this works, this is going to mean more business, this is going to mean greater throughput, and this means we have to be able to handle it in the kitchen." So it's not just a matter of getting the mobile app experience right; it's a matter of making sure that you're prepared on the back end to fulfill an increase in orders. That's something -- not to pick on them -- that Starbucks hasn't quite figured out yet. And they've called that out themselves in the last couple of quarters, that they're getting more and more mobile orders, and it's leading to a little bit of a mosh pit when people go to pick up their stuff.
Kretzmann: Right. It's a great problem to have, but it's still an issue.
Hill: It's still a problem.
Kretzmann: Still a problem, yeah. And it's something to figure out. But looking at Domino's and McDonald's, I think it reinforces the importance, as an investor, to be patient with these companies. I can think of a couple restaurants right now that are going through tough times of their own. But when you have a proven operator, generally strong leadership, or the potential for new leadership to step in, it doesn't actually take all that long for a concept to turn around. Think of Panera in 2014. Not a whole lot of fans of Panera in the investing community a few years ago. Within three years, when they took a step back and recognized, "There's a lot of stuff we can improve here," including that digital and online order experience, it only took two or three years for the company to become a darling in the restaurant space and turn it around. With restaurants in particular, when you have a company with a proven brand, a proven record and leadership that's either willing to change or the potential for new leadership to step in, in the case of McDonald's and Domino's, I think, as an investor, it really pays to be patient with those kinds of companies. You don't want to give up when they're still trying to figure things out.
Hill: When you're ordering pizza, is there anything that you add on your own? Regardless of what the topping is, is there any kind of, whatever I order, I'm going to add a little Parmesan cheese, or a little fresh basil, or anything like that on top?
Kretzmann: I'll sometimes add extra cheese when I'm feeling that need for more calcium, Chris. It's all about the calcium. What about you?
Hill: I go a little crushed red pepper, just to add a little bit of heat on there. But yeah, more cheese is always a good thing.
Kretzmann: Yeah, it's hard to go wrong with that.
Hill: Thanks for being here!
Kretzmann: Thanks for having me!
Hill: As always, people on the program may have interest in the stocks they talk about, and The Motley Fool may have formal recommendations for or against, so don't buy or sell stocks based solely on what you hear. That's going to do it for this edition of Market Foolery. The show is mixed by Dan Boyd. I'm Chris Hill. Thanks for listening. We'll see you tomorrow!
Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool's board of directors. Teresa Kersten is an employee of LinkedIn and is a member of The Motley Fool's board of directors. LinkedIn is owned by Microsoft. Chris Hill owns shares of Amazon and Starbucks. David Kretzmann owns shares of Alphabet (C shares), Amazon, Domino's Pizza, Nike, and Starbucks. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Apple, Nike, and Starbucks. The Motley Fool has a disclosure policy.