When shares of McDonald's (NYSE:MCD) started their bull run last September, it made little sense to me. I don't see the McDonald's brand as being well-positioned at all, either in the U.S. - where concepts like "locally sourced", "fresh", and "healthy" seem to be the buzzwords - or overseas. The company announced a series of initiatives - such as moving to "cage free" eggs - to combat those concerns, but that augured a potentially significant increase in food costs, which combined with state-level minimum wage increases promised to impact margins. Sales did look good over the winter, with the much-touted "All Day Breakfast" providing a driver; but lost in the media frenzy over that menu switch was the company comparing against ridiculously poor quarters a year ago. As I pointed out in January, CNN titled its coverage of McDonald's Q4 report, "McDonald's sales are soaring," ignoring the fact that the year-prior quarter had been so bad that former CEO Don Thompson quit just days later.
I shorted the stock about halfway up its run, but bailed soon after at a modest loss - fortunately so, given that MCD would touch $130, a stunning ~37% gain in just six months. Since then, I've been trying to understand, essentially, what I have been missing about the bullishness behind MCD. Certainly, the dividend (now yielding just under 3%) and the perception of McDonald's as a defensive and possibly even counter-cyclical stock have helped; dividend-paying consumer staples across the board have climbed a wall of worry over the past year-plus. (I'm not so sure MCD quite counts as a 'staple', but some bulls might argue otherwise.) But that doesn't seem likely to explain what is a huge run for such a large, well-covered, widely-owned stock.
In retrospect, the key issue I believe I missed is that for McDonald's Corporation, many of the potential headwinds, particularly on the margin side, may not even matter. As the company continues to refranchise in Asia - where it is selling off rights in Malaysia, Singapore, China and Hong Kong - and the U.S., it is moving toward a target of owning just 5% of its stores, and moving closer to the oft-cited argument from founder Ray Kroc that McDonald's is a real estate company, not a hamburger company. A lean, mean, MCD corporate that simply takes its royalties and can slash overhead looks highly attractive in the long run.
That said, my concerns about the McDonald's business model persist, even if McDonald's plan to push those concerns onto its franchisees. And the long-term success of this financial engineering is dependent on those franchisees taking sub-optimal deals; from that long-term standpoint, the refranchising deals taking place across the globe are for the most part zero-sum games. I suppose betting on McDonald's to win those negotiations makes some sense; but even with shares down ~4.5% after its Q2 earnings release Tuesday, there's a lot of winning priced in.
Business Is Not Good
The narrative around McDonald's - that CEO Steve Easterbrook has planted the seeds of an amazing turnaround with bold choices like the all-day breakfast rollout - is so skewed as to be nearly false. Yes, comp numbers in particular have looked better since Easterbrook took over on March 1 - but McDonald's didn't post a single month of positive comps in all of 2014, and business didn't improve much in the beginning of 2015, either. Both Q4 and Q1 benefited from easy comparisons, and Q2 did as well.
However one chooses to look at the Q2 2016 report, it wasn't impressive, at all. Line-by-line, region by region - most of the news wasn't particularly good:
The headline miss from McDonald's Q2 was on U.S. comps, which came in at just 1.8% against consensus of 3.2%. Sub-2% growth, given recent history, should be considered extremely concerning. U.S. same-restaurant sales fell 2% last year - which means McDonald's two-year stack is negative. They declined 1.5% in Q2 2014 and increased 1% in Q2 2013. In other words, the average McDonald's in the United States generated less revenue in Q2 2016 than it did in the same period four years earlier. (Bear in mind that comp figures include all McDonald's, both company- and franchisee-owned.)
That's with the impact of All Day Breakfast, of course, which was projected to drive a ~250 bps benefit to comps; yet McDonald's led its space by just 140 bps. There were also significant initiatives already rolled out in drive-thru operations and signage and inside the restaurant, cited by Easterbrook and MCD bulls as driving a turnaround. But there isn't another All Day Breakfast boost coming after Q3, and the quarter raises the question I've asked for some time: what happens when McDonald's has to lap the decent results it's posted under Easterbrook, instead of the abysmal quarters near the end of former CEO Don Thompson's reign?
International Lead Markets
Performance here was pretty solid, admittedly; McDonald's drove a 2.6% comp off a 3.8% figure the year-prior. Operating income increased 7% on a constant-currency basis. The UK, Canada, and Australia all continue to be solid markets; Germany is decent; and France remains weak. Giving credit where credit is due, McDonald's has done a nice job in these markets - and I do see some hope that businesses elsewhere can follow their lead.
High Growth Markets
A 1.6% same-restaurant sales increase off a -1.4% comparison isn't particularly impressive. On the Q2 conference call, Easterbrook called out strength in China - where comps were +2.1% - and Russia, which was positive. But China same-restaurant sales are below 2014 levels - Q2 2015 comps were -3% per the Q2 2015 conference call - and Russia had a negative comp in that quarter as well, per that quarter's 10-Q.
Margins did improve substantially, in part due to "other operating income" (i.e., gains on refranchising sales), per the earnings supplement. But, again, comparisons helped: it was China, Russia, and the U.S. who dragged down margins a year ago. This isn't the type of growth investors should be expecting from emerging markets, or from a category that McDonald's itself calls "high growth".
Probably the best news of the quarter was the Foundational Markets category, which is basically the "everywhere else" group geographically: Japan represents about 28% of the category, Brazil 8%+, the Philippines and Taiwan 4% each, with the rest smaller countries around the world.
Comps were up 7.7%, which even against a 3.4% decline looks like progress. But again, the key driver appears to be Japan, which has been a very difficult market after a food supply scandal led McDonald's sales to plunge. (And McDonald's only owns 50% of its business in that region, and is looking to sell more.) Like in several other markets, the gains there aren't the result of customer demand or strength; sales simply aren't as bad as they were. That seems a common theme across McDonald's Q2.
All that doom and gloom aside, adjusted EPS did increase 13% year-over-year on a constant-currency basis. And that came despite a big jump in the tax rate (to 33.8% from 29.8%). But share count fell 9% - meaning adjusted net income was basically flat including currency, and up ~3% year-over-year without it. Operating income, adjusted for charges in both years and one-time gains from restaurant sales, appears to have increased in the high single digits year-over-year, and pre-tax income (given higher interest expense) increased a bit over 4%.
Combined with the relatively weak top line numbers, I'm not sure that's very impressive. From my standpoint, that's not the foundation of a good business; that's not evidence of some magical turnaround. It's not evidence that the refranchising strategy is going to be successful. It's a step in the right direction, but still modest growth despite a series of top-line initiatives and commodity costs that have fallen ~4% on average. Notably, restaurant margins increased 150 bps year-over-year; 210 bps came from food & paper. That level of improvement isn't going to last, as even management admitted on the Q2 call. A lot of the seeming strengths in McDonald's at the moment are simply coming from easy comparisons, beneficial commodities, and not screwing up. McDonald's is going to need more going forward.
The Franchisees' Problem
Effectively, we're swapping company-operated margin dollars for franchise-owned margin dollars, and certainly then spending less G&A and capital to generate those franchise margin dollars...Certainly on a free cash flow basis, you should expect that it would be accretive, because, as I said, we're generating more income, more cash flow, and not spending as much capital.
This was CFO Kevin Ozan's explanation of the refranchising benefits on the Q2 conference call, and I understand why that's attractive in theory. A leaner, high-margin McDonald's is easier to run, easier to value, and given that it's taking a royalty on sales - not profits - the company escapes much of the brunt of potential margin pressures from commodities or labor.
Here's my question: who's on the other side on the deal? What McDonald's basically is saying, in public, is that, with rare exceptions, it wants no part of actually running a McDonald's restaurant because, in the opinion of Easterbrook and Quon, capital is better spent elsewhere (like repurchasing shares). Its plan requires that the immediate cash flows from refranchising deals will be more valuable than the net present value of the operating profits McDonald's is selling. It requires that franchisees put capital into the same restaurants that McDonald's corporate feels don't support sufficient returns on that very same capital.
It's an odd sort of bull case - to me, it feels like something that works better in theory than in practice. It certainly seems to explain why McDonald's isn't getting the bids it wants in Asia. And if those hopes are indeed driving some (or most) of the optimism toward MCD at the moment, it also seems like putting the cart in front of the horse. McDonald's might be better served getting its operating business in order before it tries to sell ~3,500 locations over the next two-plus years. If you look deep into the numbers, that's certainly not the case.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.