Something Wicked This Way Comes: McDonalds – A Bear In A Bull Costume

Authored by 720Global's Michael Lebowitz via RealInvestmentAdvice.com,

As Halloween nears, kids are choosing costumes to transform themselves into witches, baseball players and anything else they can imagine. In the spirit of Halloween, we thought it might be an appropriate time to describe the most popular costume on Wall Street, one which many companies have been donning and fooling investors with terrific success.

Having gained over 65% in the last two years, the stock of McDonald’s Corporation (MCD) recently caught our attention. Given the sharp price increase for what is thought of as a low growth company, we assumed their new line of healthier menu items, mobile app ordering, and restaurant modernization must be having a positive effect on sales. Upon a deeper analysis of MCD’s financial data, we were quite stunned to learn that has not been the case. Utility-like in its economic growth, MCD is relying on stock buybacks and the popularity of passive investment styles to provide temporary costume as a high-flying growth company.

Stock Buybacks

We have written six articles on stock buybacks to date. While each discussed different themes including valuations, executive motivations, and corporate governance, they all arrived at the same conclusion; buybacks may boost the stock price in the short run but in the majority of cases they harm shareholder value in the long run. Data on MCD provides support for our conclusion.

Since 2012, MCD’s revenue has declined by nearly 12% while its earnings per share (EPS) rose 17%. This discrepancy might lead one to conclude that MCD’s management has greatly improved operating efficiency and introduced massive cost-cutting measures. Not so. Similar to revenue, GAAP net income has declined almost 8% over the same period, which rules out the possibilities mentioned above.

To understand how earnings-per-share (EPS) can increase at a double-digit rate, while revenue and net income similarly decline and profit margins remain relatively flat, one must consider the effect of share buybacks. Currently, MCD has about 20% fewer shares outstanding than they did five years ago. The reduction in shares accounts for the warped EPS. As noted earlier, EPS is up 17% since 2012. When adjusted for the decline in shares, EPS declined 7%. Given the 12% decline in revenue and 8% drop in net income, this adjusted 7% decline in EPS makes more sense. MCD currently trades at a trailing twelve-month price to earnings ratio (P/E) of 25. If we use the adjusted EPS figure instead of the stated EPS, the P/E rises to 30, which is simply breathtaking for a company that is shrinking. It must also be noted that, since 2012, shareholder equity, or the difference between assets and liabilities, has gone from positive $15.2 billion to negative $2 billion. A summary of key financial data is shown later in this article.

In addition to adjusting MCD’s earnings for buybacks, investors should also consider that to accomplish this financial wizardry, MCD relied on a 112% increase in their debt. Since 2012, MCD spent an estimated $23 billion on share buybacks. During the same period, debt increased by approximately $16 billion. Instead of repurchasing shares, MCD could have used debt and cash flow to expand into new markets, increase productivity and efficiency of its restaurants or purchase higher growth competitors. MCD executives instead manipulated EPS and ultimately the stock price. To their good fortune (quite literally), the Board of Directors and shareholders appear well-deceived by the costume of a healthy and profitable company. Over the last three years, as shown below, compensation for the top three executives has soared.

Source: MCD 2017 proxy statement (LINK)

The following table compares MCD’s fundamental data and buyback adjusted data from 2012 to their last reported earnings statement.

Data Source: Bloomberg and MCD Investor Relations

The graph below compares the sharp increase in the price of MCD to the decline in revenue over the last five years.

Data Courtesy: Bloomberg

Passive Influence

The share price of MCD has also benefited from the substantial increase in the use of passive investment strategies.

Active managers carefully evaluate fundamental trends and growth prospects of potential investments. They typically sell those investments which appear rich and overvalued while buying assets which they deem cheap or undervalued. When there is a proper balance among investing styles in a market, active investors act as a policeman of sorts, providing checks and balances on valuations and price discovery. Would an active investor buy into a fast food company with minimal growth prospects and rapidly rising debt, at a valuation well above that of the general market and long-term averages? Likely no, unless they knew of a greater fool willing to buy it at a higher price.

On the other hand, passive managers focus almost entirely on indexes and are typically less informed about the underlying stocks they are indirectly buying. They are indiscriminate in the deployment of capital allocating to match their index usually on the basis of market capitalization. Such a myopic style rewards those indexes exhibiting strong momentum. When investors buy indexes, the stocks comprising the index, good and bad, rise in unison. Would a passive investor buy into a fast food company with minimal growth prospects and rapidly rising debt at a valuation well above that of the general market and long-term averages? Yes, they have no choice because they manage to an index that includes that company.

When the marginal investors in a market are largely passive in nature, active managers are not able to effectively police valuations, and their influence is diminished. During such periods, indexes and their underlying stocks rise, regardless of the economic and earnings environment.  As the saying goes “a rising tide lifts all boats,” even those that are less seaworthy, such as MCD.

Summary

We warn investors that, when the day after Halloween occurs for MCD and other stocks trading well above fair value, investors might find a rotten apple in their portfolio and not the chocolatey goodness they imagined.

Buybacks will continue to occur as long as executives reap the short-term benefits, stock prices rise, money is cheap, and investors remain clueless about the long-term harm buybacks inflict on value. We suspect passive strategies will also garner a larger than normal percentage of investment dollars as long as these blind momentum strategies work. That said, valuations will reach a tipping point and the masking of fundamental weakness will be exposed.

Building wealth on faulty underpinnings is a strategy ultimately destined for failure. We urge investors to understand what they are buying and not be mesmerized by past gains or what the “market” is doing. Simply, when a stock rises above fair valuations, future returns are sacrificed.

Comments

NoDebt Wed, 10/18/2017 - 15:40 Permalink

I think this guy did an article on NetFlix yesterday.  I sort of like how he writes.  Just simple, down-to-earth analysis.  You can tell he's a fundamentals-type investor.  And humble enough to admit you'll go broke following his advice right up until the day it actually matters (whenever that is).It doesn't FEEL like a ZH doom article, which I think is a good thing to have around every now and then. 

besnook Wed, 10/18/2017 - 15:41 Permalink

mcd was my first exploratory short in this market. i followed mcd for more than a year before i bought some puts and got burned when mcd borrowed 2bil rated at bbb to buy back shares and make them look brilliant because the sale of company stores and the closure of hundreds more made same store sales bounce even though the structural decline in sales has not abated. mcd is worse than the fangs because mcd's valuation is fraudulently hidden in plain sight under the guise of accounting management while the fangs' valuations are based upon investors defrauding themselves.

JustPastPeacefield Wed, 10/18/2017 - 15:42 Permalink

Ever go to a McD in Manhattan? I get the urge to flee, and then be de-fleaed. Quickly.(and since it's open-season of middle-aged White guys, i just assume they're adding a little special sauce to my meal. no thanks.)

SunTzu2U Wed, 10/18/2017 - 15:43 Permalink

"Simply, when a stock rises above fair valuations, future returns are sacrificed."What about when all assets are above fair valuations. If you hold to historical measures of value, there really is almost nothing to buy.

Don Pancho Wed, 10/18/2017 - 15:59 Permalink

those numbers are played with all the time that you'll never know whats actually going up and whats going down. got to look past the numbers and start thinking about how will the company impact the market in the next 5 - 10 years. example's like Video streaming Netflix wrecked BlockBuster or how  Apple's/ Iphones Stock Bubble is gong to pop in the next 10 year's. And it will! lol screw the Stock market plan with your head but Follow your gut....

Doctor Faustus Wed, 10/18/2017 - 16:02 Permalink

OT. "By the pricking of my thumbs, something wicked this way comes." Macbeth, Act 4, William ShakespeareRay Bradbury's tale of the same title is one of my favorite stories and I read it every October. Much better than the movie that came out in the 1970s.

Gods Wed, 10/18/2017 - 16:19 Permalink

Ahh the peasant class food not even fit for my dog. Keep eating shit we need a body count as to free up some space on this rock.

Eddielaidler Wed, 10/18/2017 - 16:27 Permalink

I'm on the inside at Mcdonalds. I can verify that the modernization has zero effect on sales. Mobile ordering is zero in non urban areas. Kiosks are not being used and have zero net effect at this time. Remodels translate into temporary increased but negligable guest count. Small operators are being attritioned (spent) out of the business. The new fresh meat Hot off the Grill initiative will provide negligible ROI. There is no ROI for the operator......just mountains of debt. I expect that 5 years from now there will be fire sales of larger blocks of franchises to larger operating corporations much like Burger king as cashflow dries up for the operators.

FreeNewEnergy Herodotus Wed, 10/18/2017 - 18:49 Permalink

In mob parlance, it's called a bust-out. Wise guys will just sell everything and pocket the profits, stiff the suppliers until they're on a cash-only basis, then, yeah, light a match.McD's situation is just a little bit more imaginative and on a larger scale. Poison people, cash checks if you're in the C-suite, stiff employees and, hell, you own the supply chain.I wanted to short this bitch when it hit 100. Glad I didn't have any money to throw away because it just kept going up, up, and away.McD's and their share price and their commercials and their customers are all about what passes as normal in America.It's not normal. It's a shit sandwich with the shit on the outside. Sadly, everybody's fuckin' lovn' it.Jeebus, I wish Janet Yellen would eat there more often.Fuck.

In reply to by Herodotus

Herdee Wed, 10/18/2017 - 16:40 Permalink

Central Banks are still printing at record levels. Sure they'll be a small pullback soon but because of the excessive levels of money printing and huge government debts where they have to have more deficits, the market is saying that after all this money printing they've done, the central banks aren't ging to let it fall, they're probably just getting started now on hyperinflation plan. You haven't seen any printing yet, you just wait, you'll see it at unimaginable scales sooner then later. Why you say? Look at the indicators, the federal government's spending is out of control, States and Cities, Pension Funds all going bust. They have to print big to make deficits small and allow Pension Funds to start making money. Either that or she all goes tits-up. Expect free government direct cheques to everyone to spend, and then, even more. Believe me, it'll even get to the point of the government even sending you out money for all the income tax that you ever paid. That's what it will take to get it going.

Bai Suzhen Wed, 10/18/2017 - 18:00 Permalink

I'm out running errands, and someone asked me whether I'd bring them a burger and order of fries?  Sure.  How hard can that be?  The only place I see on the way back is Mickey Dees.  I pull into the drive-thru and can literally feel the grease hanging in the air.  It's 10:27.  Shaniqua asks if she can take my order?  I tell her over the speaker what I want.  She replies that she can't take my order because they don't start selling hamburgers until 10:30.  I tell her that that's 3 minutes.  Can't she just take the order and I'll wait in the car for 3 minutes, drive around and pick it up?  I'm the only person in the drive thru.  She again states that she can't take the order until 10:30.  By then it's 10:29.  I ask myself, "What the hell am I doing, here?" and drive away, sans burger.  I swear I'll never go to another McDees as long as I live.      

helloimjohnnycat Wed, 10/18/2017 - 18:09 Permalink

My personal McTruth :I've never eaten a McDonalds slime burger.Damn, grab an apple, or a carrot.Burning Grease is for Diesels.Fried makes you tired.If that shit-ass company EVER expects to get real White people ( fuck you whiggers ) back in numbers, first, they'll have to start shooting every other nigger darkening the golden arched doorways.If Americans would stop electing joos to Congress, we could end the Fed and take control of our monetary system.Before long, the dollar would not be so worthless and any damned coon stealing a stack of Washingtons would not be tolerated. The niggers would stop with the gangsta' acts cuz we ain't playin, bro.All that mammy-shineree dat Travarious dinnindonuffins would be quashed like a ghetto roach.If Travarious & Shitavious stoled 15 onesies, well, Game on !  Justice will be dealt like Dirty Harry. Dinnin I jest say, " We ain't playin' wiff you, nigga' boy. " ?lmao