McDonald’s shares continue to plow ahead as if nothing is wrong. Consolidated sales fell, net earnings dropped, US comps faltered, and all of the company’s EPS performance during the fourth quarter, results released January 23, was buyback driven. The company is trading at 22 times trailing earnings and holds a sizable net debt position.

By Brian Nelson, CFA

The Golden Arches introduced its all-day breakfast initiative in the US in October 2015, and we had been skeptical of its sustainable incremental contribution. We believed the efforts would only amount to a one-time shot in the arm to performance, if they were successful at all. For years, McDonald’s (MCD) had argued that serving breakfast all day would be a catastrophe when it came to kitchen set-up and incremental complexity, and we bought it. Through much of 2016, it had seemed that McDonald’s biggest blunder was that it had not rolled out all-day breakfast sooner, especially as US same-store sales improved considerably after implementation. Our skepticism in seeing the logic of management’s prior concerns about all-day breakfast had put us in an overly cautious position on the stock, and the continuous complaints from franchisors prior to the roll out only seemed to have corroborated our ongoing skepticism of the initiative’s success--but shares of McDonald’s, along with the frothy market, continued to trek higher.

On January 23, in conjunction with the release of McDonald’s fourth-quarter report, we received confirmation that we were correct in our thesis that all-day breakfast initiatives would amount to merely a one-time, year-over-year step-change in sales performance--not a sustainable one paving the way for continuous year-over-year growth. During the fourth quarter, consolidated revenue at McDonald’s fell 5% (3% in constant currencies), while comparable sales and operating income in the US dropped 1.3% and 11%, respectively--effectively validating our long-held concerns that all-day breakfast initiatives would be a short-term shot in the arm, not a cure for McDonald’s long-term problems. Even so, global comparable sales leapt 2.7% in the period, and consolidated operating income increased 5%, helping to drive diluted earnings per share 10% higher, to $1.44. Hidden perhaps, reported net income declined 1%, so nearly all, if not all of the improvement in the bottom line, was driven by share buybacks.

As sometimes is the case, or at least in this case, one can get a thesis correct, but shares can still be pulled higher with the broader trends of the market. That’s okay because a lot of members may own McDonald’s, and we’re not fretting our decision to warn about the weakening fundamental backdrop. As we look to 2017, we continue to be excited about McDonald’s refranchising initiatives that are working wonders on margins, and while we expect same-store sales declines in the US to continune, the company is holding its own in the ultra-competitive quick-service restaurant space. What keeps us up at night, however, is that most of the McDonald’s bottom-line improvement is buyback-driven, and performance in the US may weaken aggressively through the course of 2017 in light of an increasingly-promotional environment. Management certainly has its work cut out for it, both in managing investor and franchisor expectations.

At the time of this writing, shares of McDonald's are trading at 22 times trailing 2016 earnings of $5.44 per share. Long-term debt stands at ~26 billion, while cash on the books is ~$2.3 billion, according to the latest quarterly filing.  

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