EC Something Wicked This Way Comes: McDonald's – A Bear In A Bull Costume

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.

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Michael Molman 9 months ago Contributor's comment

#McDonalds definitely does not deserve to be up 65% in two years and the idea of stock buybacks and passive investing being responsible for most of the gains is interesting. I am curious how far the stock will fall when the current bull market ends. $MCD

Moon Kil Woong 9 months ago Contributor's comment

McDonalds isn't the only company taking on debt to buyback shares and pay dividends. A huge amount are doing it and one can't blame them. This is what pays in the Federal Reserve's money game. Not investing in capital projects, hiring, or even growing. Debt and financial wizardry rules because capitalism has been distorted.

McDonalds is actually spending money improving their stores as of recent. For that I commend them. The author is right, all is not all roses under the hood, but McDonalds is far from the worst smelling zombie in the market.

Caitlin Snow 9 months ago Member's comment

$MCD has a long way to go, but their healthier menus is a step in the right direction.