Can McDonald’s Maintain Its High-Wire Act?

It’s hard to believe, but restaurant stocks have been on a tear the last decade, and no one’s benefited more than McDonald’s (NYSE:MCD), whose shares haven’t seen a negative annual return since 2002. Its stock is within 4% of an all-time high of $91.22. McDonald’s personifies successful restaurant operations. It’s hard to argue against such an iconic brand, but that’s just what I’m going to do. It might be a great business, but its stock is due for a fall.

Comparable Sales

August was the hundredth consecutive month McDonald’s delivered positive global comparable-sales growth. That’s more than eight years without a decline in sales. You can’t ignore that kind of success. However, a few cracks in its armor have begun to appear and, although they’re tiny, it’s reasonable to at least ponder the question of whether the share price has gotten ahead of its growth story.

McDonald’s delivered 3.5% global comparable-sales growth in August. Analysts expected 5%. That’s quite a gap. Its U.S. comparables grew 3.9%. Analysts were expecting 4.5%, and last year’s number was 4.6%. That’s crack No. 2. Its Asia, Africa and Middle East region saw a sales decline of 0.3%, the first since November 2009, while analysts were expecting a 3.7% increase. Hardest hit was Japan, with a decrease of 8.2%. Those numbers will increase next August with the earthquake a distant memory. Probably most disappointing were the results in Europe. Although comparables grew by 2.7% — a 50-basis-point increase from August 2010 — they were far less than the 6% predicted by analysts.

Tie this up in a neat little package, and what you get is a dominant company having a hard time dealing with a weak global economy, just like any other business. The news won’t send its stock spiraling downward, but if the same thing happens in September it will bring the stock’s momentum to a screeching halt.

Share Repurchases

During the past five years, McDonald’s spent $17.2 billion repurchasing its shares at an average price of $51.46. That’s an annual return of 9.7% based on its Sept. 14 closing price of $86.75. It’s debatable whether the company could have found better returns reinvesting in its operations. It already spends more than $4 billion annually.

Perhaps it could have paid out more of its earnings. Its current dividend is 61 cents per quarter, yielding 2.8%, which is a payout of 48%. Why doesn’t it pay more — say, 75% or so? The analyst consensus for 2011 earnings per share is $5.20. A 75% payout puts the dividend at $3.90 with a yield of 4.5% — a 61% increase from the current one. This grand gesture would cost McDonald’s an additional $1.8 billion annually in dividend payments. It allocates $3.3 billion annually on share repurchases, so all of the increase could come from reducing its buybacks in half.

Of course, as nice a person as CEO Jim Skinner probably is, this isn’t going to happen because although McDonald’s is a dividend aristocrat, dividends don’t boost earnings per share, at least not tangibly. McDonald’s has done a reasonable job repurchasing its shares over the years. However, while its dividend per share has increased 144% in the past five years, its dividend payments in total dollars has increased just 98%. If McDonald’s truly cares about shareholders, it would cover the shortfall through special dividends.

Total Return

During the past decade, McDonald’s annual total return averaged 13.1%, with approximately 16% from dividends and the rest from capital gains. The restaurant industry did slightly better, at 13.4%, while the S&P 500 averaged 2.8%. Not too many industries can make this claim. My question to you is a simple one: Do you think this outperformance can continue for another decade?

According to Morningstar, most companies in the restaurant industry, including McDonald’s, will take almost nine years to earn back its current share price based on estimated future earnings growth. Morningstar calls this the PEG payback period. Other restaurant stocks, such as Brinker International (NYSE:EAT), will pay back earnings in less than six years. If so, why would anyone own McDonald’s stock? The answer is simple. McDonald’s is less likely to stumble and fall. This doesn’t mean it won’t happen, and given the record price at which its stock currently trades, any bad news will most definitely hurt its stock. If you’re an income investor, this doesn’t apply. Those looking for capital gains, however, might want to consider that its stock’s average annual return since 1970 is 15.4%. In the past five years, it’s been more like 21%. It can’t go on forever.

Bottom Line

McDonald’s is a great company. However, like all great businesses, it will stumble at some point in the future, and when it does, so too will its stock.

As of this writing, Will Ashworth did not own a position in any of the stocks named here.

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