When McDonald’s Corp. (NYSE: MCD) reported earnings last week, it missed terribly by almost every metric possible.
Yet traders are taking the stock higher, leading many investors to conclude that they should be along for the ride.
Unless you like Vegas-style odds, that’s not a bet I’d recommend you make. Here’s why…
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McDonald’s is a turnaround situation, and this rally is powered by optimism that is anything but proven.
That means any dollar you invest in the company at this point in time is disproportionately risky.
Today, we’ll discuss what analysts aren’t telling you about McDonald’s and why, even before this short-sighted rally, the company’s stock still had a long way to fall.
Here’s what you need to know if you’re thinking of investing in McDonald’s – or any fast-food player for that matter.
Traders pushed up MCD’s stock price past 4% gains in trading last week before the gains leveled out to 2.3% by midday on Wednesday. The stock fell slightly more since then. Judging by trading behavior, you’d think that McDonald’s is on the cusp of an amazing turnaround and that there’s compelling evidence it’s already hit rock bottom and the path of least resistance is up.
Analysts are enchanted with Steve Easterbrook’s vow for a “turnaround plan” on May 4, with one opining that the rally around it could make MCD’s success a self-fulfilling prophecy, as an influx of capital from hopeful investors makes the turnaround successful.
It’s wishful thinking. No amount of conjecture can put these results, or McDonald’s overall position in its sector, in a good light.
Here’s what’s really going on.
Only One Analyst Seems to Get McDonald’s
According to the quarterly earnings report, MCD’s global comparable sales at its restaurants that have been open for at least 13 months fell by 2.3%. Revenue fell to $5.96 billion, down 11% from the $6.7 billion reported a year ago.
Earnings per share (EPS) are also suffering, with MCD reporting adjusted earnings of $1.01/share, down from the $1.21/share McDonald’s achieved in the year-earlier quarter. That’s a 16.53% decline.
Nobody in their right mind would invest in a company with that kind of performance except as the purest form of speculation.
Yet plenty of traders and analysts are either cheerful or blasé about McDonald’s chances of turning things around.
The bet that traders are making here is based on nothing more than a completely unknown turnaround plan that has yet to be announced.
There was only one analyst I saw who assessed the situation perfectly. R.J. Hottovy, a senior restaurant analyst at Morningstar, threw a bucket of reality-flavored ice water on the unjustified optimism. “The results show it’s not going to be an overnight turnaround story,” he said of McDonald’s earnings. “There are a lot of moving parts. There’s a lot of significant investment that needs to be made.”
Easterbrook Has His Work Cut Out for Him
None of my current bearishness on McDonald’s should be taken as a dismissal of CEO Easterbrook’s skills and leadership. He’s a resourceful and feisty advocate of the McDonald’s brand, and he clearly understands that restoring his company’s battered image is paramount. Most importantly, he’s already got a record of success, being credited with presiding as chief global brand officer over a period of sales growth in Europe that outshone growth in the United States despite the fact that Europe’s recession lasted longer.
I can see what CEO Easterbrook is going to have to do. He’s going to have to get back to branding, get back to value, and more importantly, he’ll have to simplify his menu with products that the market actually wants. McRibs, crab sandwiches, and barbecue experiments are just a few of the diversions they’ve had in the last few years that have alienated their consumers and created an opening for new rivals like Chipotle and Shake Shack to exploit.
Tainted meat allegations in China and pink slime rumors here in the United States haven’t done much to improve their image, either. As much as I love MCD personally, even I’ve thought twice about what I’m putting in my mouth as a result of this.
I don’t think that there’s a new taste standard developing that accounts for the rise of other burger chains. I think MCD got away from its core values, and they allowed the markets to discover new tastes. It’s very significant to me that consumers are willing to pay 60%, even 70% more for burgers at Shake Shack or Five Guys, when at the end of the day they’re splurging on what is still just a slab of meat between two buns. To think that the product differentiation is so significant at this point means MCD not only failed its consumers, but they failed their employees and their investors because they completely lost touch with their target market.
McDonald’s has made no bones about having product brandings via MCD University and in fact has placed an emphasis on this over the years. I have no idea what they’ve been teaching, but it sure doesn’t match the marketplace. Their product is fast, the service is good, but their product research has been out in left field. I sure hope they don’t have tenured professors.
Of course, McDonald’s longtime investors can still revel in the last string of uninterrupted good news for its shareholders, a streak that’s stayed alive since 1977. But even that may not remain intact…
Another Bad Earnings Report Could Dethrone This Dividend Royalty
McDonald’s has raised its dividend every year since 1977, enough to put it on my list of “Dividend Royalty.” But I have serious concerns about whether the very attractive yield they pay is sustainable given their performance.
To understand why I think one of the most reliable upsides to investing in McDonald’s is now in trouble, look to this nugget from their earnings report: the company’s net income fell by 32.6% year over year in Q1/2015, tumbling from $1.2 billion to $811.5 million.
To put that number in perspective, McDonald’s returned $3.2 billion to shareholders in dividends in 2014. That means that if McDonald’s arrests the downward trajectory of its sales – which would be an achievement in and of itself – the company is still on track to see its payout ratio (the percentage of earnings per share it returns to shareholders) soar from an already historically high 63% in 2014 to top 90% this year!
And bear in mind, that’s the scenario assuming McDonald’s breaks with its 37-year tradition and doesn’t raise its dividend payout in 2015. If the company keeps performing at these numbers, it’s just very hard to see it maintaining – let alone raising – its dividend.
I find it far more likely that McDonald’s will slash its dividend payout to return its payout ratio to the range it was achieving in the last gasps of its most recent undisputed glory days, the years leading up to 2012. It averaged a payout ratio of 47% back then.
Revenue in Q1/2015 fell to $5.96 billion, which translates to an EPS of $0.84 per share, or $3.36 annually. Assuming a new payout ratio of 47%, this would amount to a return of $1.57/share to shareholders this year. With today’s stock price hovering at $97.20/share, this equates to a yield of 1.60% – quite a steep cut from the 3.50% McDonald’s offers today.
Obviously this is hypothetical. But as Steve Easterbrook faces the task of devoting desperately needed capital towards investments to restore MCD’s growth potential, McDonald’s dividend payout will be one of the first places he looks. Though it’s painful for shareholders in the short term, it would be a greater disservice to them to let MCD stay the course.
Looking ahead, there’s no rush to invest in MCD stock. Despite the fact that we’re talking about a company that is presently failing, and that I’ve kicked off my buy list, eventually they’ll get their act together.
And you’ll know when that happens not because of a breathlessly heralded new menu or experiments with all-day breakfast… but because earnings will actually be good.
My bet is that the food will, too.
Source: Money Morning