John Heinzl is the dividend investor for Globe Investor's Strategy Lab. Follow his contributions here. You can see his model portfolio here.
Next to buying a stock and watching it fall, the thing that hurts most as an investor is selling a stock and watching it rise.
I speak from experience.
Last December, I punted struggling fast-food giant McDonald's Corp. from my Strategy Lab model dividend portfolio . I also sold the shares personally. It was a tough decision, because McDonald's had served up some juicy capital gains over the years, with a generous side of dividend increases.
But the future was looking bleak for the world's biggest burger joint. Facing an onslaught of competition and shifting consumer tastes, the chain's same-store sales – a key measure of a retailer's health – had turned negative after years of uninterrupted gains.
What began as a few lousy months here and there turned into a complete sales rout. As of June, 2015, McDonald's had registered 13 consecutive monthly declines in global same-store sales and, during that time, just two months of (barely) positive sales growth in the key U.S. market, which generates 40 per cent of its operating profit.
Perhaps not coincidentally, McDonald's stopped reporting monthly same-store sales after the June report and said it would henceforth release sales quarterly.
Selling my shares seemed to be the right call.
But by this fall, expectations had been beaten down to such an extreme that any whiff of good news was bound to spark a rally in the stock. And that's precisely what happened when McDonald's announced better-than-expected third-quarter results on Oct. 22, including a same-store sales increase of 4 per cent globally and 0.9 per cent in the United States – its first quarterly U.S. comparable sales gain in two years.
Does one positive quarter mean that McDonald's is suddenly fixed? Of course not. But the market is behaving as if the Golden Arches' glory days are back: The day the quarterly results were released, the shares soared 8.1 per cent – their biggest one-day increase in seven years – to a record high. McDonald's ended Tuesday at $111.64 (U.S.), down 54 cents. (I sold my shares at $90.97.) Maybe the market knows something I don't know. Or maybe it's just wrong.
I can already hear the chants of "sour grapes," so let's look at some numbers.
After the run-up in the share price, the stock is now trading at a trailing price-to-earnings multiple of about 24 – well above its five-year average of 18.2. For a company that has been essentially standing still for years – it's expected to earn $5.27 a share in 2016, the same as it earned in 2011 – such a rich multiple seems unwarranted.
Many investors buy McDonald's for the rising dividend, but that is also a source of uncertainty. Based on the current dividend of $3.40 annually, the company is now paying out about 70 per cent of earnings, up from less than 50 per cent a few years ago. The higher payout ratio gives McDonald's less wiggle room financially and suggests future dividend increases will continue to be muted. The past two annual hikes were just 5 per cent each, down from increases averaging nearly 12 per cent over the previous three years.
The timing of the next dividend announcement also raises questions. For more than a decade, McDonald's raised its dividend like clockwork every September. But this year, citing the need to evaluate "capital allocation decisions" in light of its turnaround efforts, the company delayed the dividend announcement until its investor meeting on Nov. 10.
As for operational performance, investors might want to check their enthusiasm regarding the company's U.S. restaurants. While same-store growth of 0.9 per cent is a step in the right direction, when taking inflation and rising labour costs into account, it still falls well short of what McDonald's needs in order to increase its U.S. operating profit, which fell by 1 per cent in the quarter.
"We have said in a normal inflationary environment, we generally need a 2-per-cent to 3-per-cent comp [comparable sales growth] in the U.S. to maintain margins," Kevin Ozan, McDonald's chief financial officer, said on the third-quarter conference call. "With these additional labour costs, certainly the comp needed to maintain margins in the near-term would be higher than that."
Under new chief executive officer Steve Easterbrook, McDonald's does appear to be making some progress. New menu items such as the Buttermilk Crispy Chicken Sandwich had a positive impact in the third quarter and the recent launch of all-day breakfast in U.S. stores is also off to a promising start, the company says.
The jury is still out on other initiatives, however. To compete against higher-end burger chains, McDonald's is rolling out Create Your Taste kiosks where customers can order premium hamburgers with an array of toppings, but the meals cost more – and take significantly longer to prepare – than regular McDonald's fare. For a fast-food chain that has always stressed value, convenience and speed, it represents a major – and so far unproven – departure.
For the current fourth quarter, Mr. Easterbrook predicted that same-store sales will again be positive "in all segments" of the business. But even he conceded that the turnaround is "still in the early stages." That's a message investors should heed before they take a bite of the company's premium-priced stock.
John Heinzl