Why the McDonald’s stock ‘recovery’ is a mirage

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John Heinzl is the dividend investor for Globe Investor's Strategy Lab. Follow his contributions here. You can see his model portfolio here.

I'll admit it: After I punted McDonald's Corp. from my Strategy Lab model dividend portfolio, there were times I thought I'd made a big mistake.

My rationale for getting out was simple: Facing intense competition and shifting consumer tastes, Mickey D's had posted a string of negative same-store sales results that suggested the burger chain's best days were behind it.

Well, I still believe that, but the stock apparently saw things differently: When I sold in December, 2014, McDonald's traded at about $91 (U.S.). Last May – 17 months later – it hit a record high of $131.96 for a gain of 45 per cent (excluding dividends).

Why were investors suddenly lovin' McDonald's again? All-day breakfast.

In the fourth quarter of 2015 when the fast-food giant launched all-day breakfast in the U.S. market, its domestic same-store sales jumped by a healthy 5.7 per cent. The momentum carried into the first quarter of 2016 when U.S. same-store sales rose 5.4 per cent.

In addition to serving up Egg McMuffins 24/7, McDonald's rolled out a new value offering – McPick 2 – that lets customers choose two items for $5. Together, these initiatives were sufficient to reverse two years of quarterly U.S. same-store sales declines and – to my chagrin – put the sizzle back in McDonald's stock price.

But any regrets I had about selling have since faded, because the boost to McDonald's sales and share price both turned out to be temporary.

As the novelty of all-day breakfast was wearing off, U.S. same-store sales growth cooled to just 1.8 per cent in the second quarter and slipped to 1.3 per cent in the recently reported third quarter. Given the tough upcoming comparisons, U.S. same-store sales growth could well turn negative again in the fourth quarter of 2016 and first quarter of 2017, analysts say.

The result: Investors are once again losing their appetite for the shares, which closed on Tuesday at $112.72 – down about 15 per cent from their May high. Andy Barish, an analyst with Jefferies, sees little reason for the shares to move higher in the near term.

The "stock has strong dividend and cash return to shareholders, but we believe this is reflected in valuation at current levels with limited incremental drivers at this point," said Mr. Barish, who rates McDonald's a "hold" with a price target of $115.

Even as menu innovations have given its sales a short-term lift, McDonald's is grappling with a deeper problem: Its customer traffic isn't growing. Through the first nine months of 2016, the chain's "comparable guest counts" – that is, the number of transactions at restaurants open for at least 13 months – fell 0.1 per cent globally.

To keep its same-store sales growing, McDonald's must therefore try to squeeze more money out of each customer – no easy feat for a company that relies heavily on value-priced items to drive sales and whose brand is seen as uncool – or even toxic – in the eyes of many young consumers.

According to a recent Wall Street Journal report, just one in five millennials – those aged 18 to 34 – has ever tried a Big Mac. And no wonder: They're too busy spending their money at Subway, Chipotle, Panera, Tim Hortons, Taco Bell, Starbucks or one of the myriad gourmet burger chains that do what McDonald's does – only better.

Just as all-day breakfast was a temporary fix, McDonald's has been pulling some financial levers in an effort to make its stock more appealing to investors. In recent years the company has dramatically increased its debt – which soared 62 per cent to $24.1-billion in the year ended Dec. 31, 2015 – to fund stock buybacks and dividend increases.

Through the first nine months of 2016, buybacks more than doubled to $9.8-billion. Buybacks give earnings per share a boost by reducing the number of shares outstanding, but "most of this was financed with additional debt," said Carol Levenson, director of research at Gimme Credit, an independent corporate bond research firm.

Rising debt comes with a cost. Last year, the major debt monitoring agencies cut McDonald's credit rating. As Fitch Ratings wrote when it notched McDonald's down to BBB-plus from A: "The downgrade reflects Fitch's view that McDonald's has become more aggressive with its financial strategy and also concerns about continued sales declines, market share losses, and brand strength going-forward."

As it levers up its balance sheet, McDonald's is also raising cash – and cutting expenses – by franchising corporate stores. While the strategy has merit, it can't go on forever. At some point, McDonald's will have to address its core problem and get traffic growing again by attracting a generation of consumers who have little love for the Golden Arches.

Until that happens – and there are no guarantees it will – I suspect McDonald's will continue to rely on fleeting menu fixes and financial engineering schemes to disguise the fact that its business has hit the wall. I wish McDonald's luck, but I'm happy to watch from the sidelines.