Should I Sell McDonald’s?

I first bought McDonald’s (MCD) in July 2013. I purchased 30 shares at that time for 100.999/share. I have collected $175.69 in dividends, which I reinvested back into the company, purchasing an additional 1.8391 shares. Despite purchasing nearly all the reinvested shares at a lower price than my initial purchase, my cost basis is still 100.96 due to the small amounts of shares purchased. Given today’s closing price, I have an unrealized loss of $149.15.

Now, as any true dividend growth investor will tell you, provided the fundamentals haven’t changed, an unrealized loss in a stock provides a good opportunity to buy more of it and reduce the cost basis while, at the same time, collecting a higher dividend yield. The thought is: I liked the stock at the price I initially bought it so I must like it even more now. The reinvested dividends are also more “potent” the lower a stock has fallen and will (read should) lead to increasing compounding returns in the future.

The key rests on strong underlying fundamentals.

An example of this is with the fall of the oil stocks. I took the opportunity to purchase more BP, Chevron, and BHP Billiton. Energy now makes up about 13% (approximately $18,000) of my portfolio.

MCD had dropped to as low as 87.62. Should I have purchased more shares of MCD at that price to reduce my cost basis and collect a high dividend? Possibly yet I didn’t.

It’s not that I don’t think MCD is a great company. There are stores everywhere in the world. The food is decent and the service is quick. They have even started adding healthier choices to the menu as well.

I remember a few years ago when I stopped at a Burger King to grab a quick bite during a road trip. (I actually prefer Burger King burgers, but that’s another story!) I was the only customer at this Burger King and asked one of the workers as I stepped around cleaning supplies on the floor, if they were actually open! Mind you, the McDonald’s across the street was packed with additional people going through the drive-through. Just before I left I decided to grab a coffee to keep myself awake the rest of the drive. I paid and about 5 minutes passed without being handed a coffee. I was still the only person in the restaurant at this time. I finally got the attention of what seemed to be the sole employee working there and was told that he had just started brewing some fresh coffee and it would be another couple minutes. Not wanting to wait any longer I asked for my money back and got a great cup of coffee from the McDonald’s across the street.

It was stories like that that affirmed my belief that I had purchased a strong company. And, even today, the McDonald’s around here always seem to be packed.

So why the change in heart about MCD?

I’m investing for the long-term. Strong companies will be able to adapt to a changing marketplace. It’s not like McDonald’s current troubles all stem from unhealthy choices either. Yes, many of the currently fashionable restaurants offer organic or grass-fed food, but companies like Taco Bell, Chiptole, Qdoba, and even Burger King/Hardees aren’t any healthier than McDonald’s.

The issue was really brought to a head in one of the latest episodes of the Wall Street Unplugged podcast, produced by one of my favorite podcast producers and newsletter writers, Frank Curzio. He also talked about it here: Is the World’s Greatest Blue-Chip Stock About to Fall 20%?. Fast forward to the education segment at 53 minutes to get to the portion about MCD. I’d recommend reading his blog post and listening to the less than 10 minute section of the podcast.

His point: You buy McDonald’s for safety and income and now that safety and 38 year dividend streak could be in jeopardy.

I’ll recap below some of the points that Frank brought up on his blog post and discussed in the podcast:

1) 3 straight years of falling sales
– $28 billion in sales in 2013 to $27 billion in 2014 and expected to fall to $25.5 billion in 2015, according to estimates.
– sales are expected to remain flat through 2017
– sales are flat despite McDonald’s being aware of a trend towards healthier foods and changing some of its strategy to try and capture some of this market

2) Earnings increases due to buybacks and cost-cutting (manipulation that MCD no longer has the free cash flow for)
– earnings from 2014 to 2017 are expected to increase from $4.82 to $5.79/share

3) capex spending will be cut from $3 billion to $2 billion in 2015
– one way to increase sales is to open additional stores. However, sales have remained stagnant despite opening 1300 new stores in 2014
– imagine how sales would have decreased without the benefit of those new stores

4) free cash flow problem
– MCD paid out over $3 billion in dividends last year and paid out more than $3 billion to buy back their stock
– yet MCD generated only $4 billion in free cash flow last year
– it will be difficult to increase or even maintain the current dividend without improving sales…not much has worked so far, including opening new stores
– payout ratio is approaching 70% even now
– additional problems include higher wages, higher food costs, and increased competition

5) loss of talent
– last year MCD chose not to pay any incentives to corporate US employees
– how long before talented management seeks better job opportunities at MCD competitors?

6) high PE
– MCD has a price/earnings ratio of 19.9
– for comparison, the PE of AAPL is 16.9, with T being at 27.7, and GE at 16.5; does it really seem that MCD should command a higher growth multiple than most of these companies?
– MCD currently has a high growth multiple yet is failing to grow sales, has a free cash flow problem, and has a high dividend that it will feel forced to pay

So, that basically sums up Frank’s argument for why he recommends selling McDonald’s. MCD is my only current exposure to the Restaurant sector. I would continue to like some exposure to this market. However, Frank does make some great points that have me worried.

I am holding McDonald’s for both long term stock appreciation and for dividend income. Since it seems that some of this safety/dividend and growth may be in jeopardy, the question that I now have to address is this: Do I sell now before the threat of a dividend cut is factored into the stock price?

Since I don’t see much upside potential of the stock over the next few years despite being a continued threat of a greater downside risk, I’m leaning more towards selling my shares of MCD and reallocating those funds to another dividend paying restaurant stock. Should MCD make a turn-around, I could always buy back into MCD. And if MCD were to cut the dividend, I could also take a wait-and-see approach and begin again buying McDonald’s once they have a growth strategy in place. This approach is kind of like how I approached GE. I initially sold after the dividend cut but have now begun buying its shares once again.

For most companies in my portfolio I would usually be okay holding onto and collecting the dividend while waiting for the growth strategy to get worked out. MCD is not going bankrupt and will eventually get this new market figured out. However, the dividend being hurt in the process is a true possibility.

What do you guys think of this strategy? Would dividend growth investors take this research and preemptively sell prior to a dividend cut or non-increase? Thanks for reading!

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6 Responses

  1. Some good points raised, Scott. I realize that MCD is a fav amongst dividend growth investors, but the way I see it is that there is no moat. Anyone can make good burgers (and most burgers out there are better than MCD burgers). There are so many new chain popping up – InNOut, ShakeShack etc. The only competitive advantage they have is that they have a more wider chain across the world – although a lot of the franchises are unhappy with the management and the demands that come with the business model.
    But having said that, if anyone can turn things around, MCD can. They have the infrastructure in place and can turn things quickly – if they can find the right balance and offer good food, instead of serving nasty food at rock bottom prices. Hopefully the new leadership is better than the old one.

    Its a company that I would never invest in and would rather look elsewhere for my food business exposure.

    Best wishes
    Roadmap2Retire recently posted…Parker-Hannifin Dividend Stock AnalysisMy Profile

    • scott says:

      Thanks for commenting, R2R. You brought up some good points. If anyone can turn this around, MCD can. One of the great things that I like about MCD is its vast real estate ownership. They have stores in some prime locations. However, if they will ever be able to get back to the growth plus dividend safety that they have had in the past, I just don’t know. I have not completely decided yet, but I might choose to sell and look elsewhere for my food business exposure. YUM brands is one that is on my mind, but I’ll have to do more research first.

    • Martin says:

      Tend to disagree that there is no moat. MCD currently holds the best locations ever. I believe this company will get over its difficulties and will prosper again. So although I do not purchase more shares I am in a hold mode.
      Martin recently posted…Kinder Morgan (KMI) increases its dividendMy Profile

  2. DivHut says:

    I’m keeping my MCD for the long term with no plans to sell. Anytime I have a stock that goes into the red I simply average down. Sure MCD is facing some serious headwinds and fierce competition but this isn’t the first time MCD has faced tough times. I remember about 10 years ago MCD was trading in the teens. They turned themselves around in great fashion. So bumps in the road appear once again. So what. As long term dividend investors I feel many are too quick to sell some really solid companies only to regret the sale down the road. As long as MCD is MCD (whatever that means to you) I feel it might be more a broken stock than a broken company. Likewise many are selling GE because of a dividend freeze. I kept my GE during the major cut several years back and added more to my position. Just don’t be too quick to sell.
    DivHut recently posted…Recent Stock Purchase – April 2015My Profile

    • scott says:

      I agree with you, DivHut. In most cases I’d be more than willing to average down. I’ve done that recently with CAT, BBL, and CVX. I think in this case though with GE I get a higher dividend, better growth potential, and a “cheaper” stock (especially if you compare its PE to the market).

      I held on to GE for awhile after the dividend cut (had owned it in a direct investment plan since 2004). I think it was in 2011 then that I sold all of GE and used it to buy other stocks. HRS was one of those stocks that I had bought. It is up 81% since then. If I had held onto GE I would still be at an unrealized loss even today. By changing out of GE I am now at a much better position. In MCD’s case, I’m basically only out a $100 or so…not that much of a loss at all. If or when it drops to be a better value, I’ll be back in in a heartbeat.

      Thanks again for commenting!

  3. ragiwe says:

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