- Although sales will improve due to the launch of the all day breakfast and meal customization initiatives, speed of service may slow down.
- The company will borrow an additional $10 billion for buybacks, increasing leverage.
- Risks of a sharp decline in equities is still very much on the table. Now is a time to be cautious and not overly optimistic on US equities.
McDonald's stock has now rallied 20% plus since the 25th of August (see chart below) and recent announcements such as a 5% hike in the dividend and an additional $10 billion in share re-purchases next year will definitely keep the perma bulls locked in for the long haul. After very impressive third quarter results last month (which were really as a result of the new turnaround plan initiated in May), McDonalds (NYSE:MCD) seems to have some serious momentum behind it, especially when you consider management's believe that earnings will be even stronger in the 4th quarter.
Following its investor's event last week, many analysts have substantially raised their price targets for Macdonald's stock, with Credit Suisse (NYSE:CS) looking for $128 a share and RBC capital re-issuing its "outperform" rating. These new updates are good news for shareholders as positive sentiment and price targets usually mean the respective stock will move north from here. Nevertheless there are a few things that investors need to be mindful of when a stock "is expected" to continue rallying.
Even though same store sales grew by 0.9% in the third quarter (first positive number in seven quarters in the US), one good quarter doesn't mean tat the turnaround is complete. The US is by far the most important market for the company so sustained growth here should definitely move the bottom line substantially but there are still inherent risks in the way management wants to grow the business.
Firstly, the all day breakfast and customized burgers undoubtedly should attract more millennials in the US. But all this also means more investment in technology and staff which will make life far more difficult for restaurant franchisees. Franchisees are attracted to this business model because of the perceived "certainty" it gives them. The more frequently the menu is changed, the more "uncertainty" it brings to the restaurant owners. This is why this year in the US, the company will close more units than it will open, which is a first in 40 years.
Management has decided that under-performing restaurants will be sold in order to raise cash and invest elsewhere. What's the take-away here? Well the more the company tries to appeal to customers taste (which is a never-ending battle), the more it will have to deviate from the proven system that built it. Furthermore many customers eat at McDonald's because of the speedy service. One would think that speed will definitely decline if the CEO Steve Easterbrook continues to try and attract more affluent customers through more expensive offerings.
Secondly, the company announced at its investor event that it will be taking on $10 billion in debt to fund additional share repurchases and dividends in 2016. Whereas many investors may believe that now is a good time to borrow (given present prevailing low interest rates), some credit rating agencies such as Standard & Poor have cut the company's credit rating to BBB+ which demonstrates no company is infallible despite the huge cash flow it spins off. The company now has a debt to equity ratio of 2.16 (see chart) which will increase when the new debt is taken on over time.
Recently investors called for the company to unlock its huge real estate holdings by setting up a REIT but management has decided to take the debt route. Its a calculated risk but one which the company probably had to take as its a dividend aristocrat that has to answer to its shareholders every year through buybacks and increasing dividends. The potential risk from taking on more debt is from rising interest rates combined with lower profits. This would really put a strain on the company. And its entirely a possibility that McDonald's stock could come back below $100 a share especially when you look at a recent chart of the spiders (see below).
The index hasn't hit its 200 day moving average since 2011 (on a weekly setting) but first time since 2011, its 50 day moving average has been heavily pierced through. I have always stated that equity markets in the US have suffered a lot of technical damage in August, that I don't think has fully played out yet. This is why I am always very mindful of world events (Like what happened in Paris at the weekend) that could end up being a catalysts for markets moving lower.
Therefore I believe at this juncture and especially if you are an income investor, it would be prudent in my opinion to start lightning up on your McDonald's holdings. The higher it goes, the more you should lighten up. There are far more interesting options at the moment in terms of other dividend aristocrats having lower p/e and p/s ratios and higher dividend yields.
To sum up , I still think McDonald's will continue to be a growth story over the long term. However McDonald's stock has had a nice run-up which will definitely mean some profit taking if its rally continues. Furthermore, apart from higher risk from company taking on more debt, it is still facing some near term headwinds in terms slower service times and competition among the fast-casual chain. Lightening up here would be prudent in my view.