All income-minded investors can agree that, generally speaking, higher yields are better than lower yields. Still, wise investors know to be suspicious when a dividend stock’s yield reaches unusually high levels. It could be a temporary entry opportunity. Or, however, it might be the result of weakness that’s ultimately a red flag.
That’s the challenge anyone eyeing a new stake in fast-food restaurant chain McDonald’s (NYSE: MCD) is facing right now. Shares of the usually strong performer have tumbled 26% from their February peak, pushing the stock’s forward-looking dividend yield up to a multi-year high of 3%. Is this an opportunity to plug into a long-proven powerhouse name at a bargain price, or is McDonald’s a value trap?
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First things first.
What’s a value trap?
If you’ve never heard the term or don’t know what it means, it’s pretty simple — a value trap is a stock that seemingly seems too cheap to pass up, but ends up continuing to underperform because the same deterioration of its business that prompted the weakness in the first place remains in place.
That deterioration can take many forms, including the obvious ones like falling sales or shrinking profits. Other times the cause of a stock’s weakness isn’t as overt. A pharmaceutical company’s drug portfolio is facing a wave of patent expirations, for instance, or a tech company’s competitor is working on a new product that will undoubtedly disrupt the market. Maybe even a heavy indebtedness is preventing a company from investing in its own growth as much as it needs to.
Whatever the cause, the symptoms are typically the same. It’s a valuation that seems too good to be true.
McDonald’s just missed the mark for this environment
So what’s upended MCD stock since February, when it was flying so high? Since then, the ticker’s trailing price/earnings ratio has fallen from well above 25 to just above 20 (a huge swing for this consumer staples name), while its trailing dividend yield grew from 2.3% to nearly 3% (also a huge swing for a stock of this ilk)?
If you aren’t already aware, you won’t be surprised to learn this tough economy is taking a particularly big toll on this restaurant chain’s core customer. Although the stock’s sell-off started well before the company confirmed it, during the company’s Q1 earnings conference call held in May, McDonald’s CEO Chris Kempczinski said we’re in a “challenging environment,” adding that “it’s certainly not improving, and it may be getting a little bit worse.” The market took that ball and ran with it, so to speak.
And perhaps rightfully so. The company’s second-quarter results released in early August indicated that systemwide same-store sales were only up 1.3% for the three months ending in June, and only improved by 0.8% year over year within the all-important U.S. market. Management conceded that McDonald’s as a whole just didn’t offer enough of the right value propositions to meet its customers where they are in these difficult times. Once again, investors responded with concern that the fast-food restaurant chain may not be able to fix what’s broken.
That’s unrealistic and unnecessary pessimism, however.
Improvement ahead
Don’t misunderstand. McDonald’s management team still has plenty to figure out. It’s far from being dead in the water though. It’s still got decades’ worth of great brand recognition and familiar to leverage, and sheer size, which ultimately translates into promotional firepower.
Moreover, it knows exactly what to fix and how to fix it. As Kempczinski conceded during last month’s earnings call that “although we’ve restored our overall value and affordability leadership, our restaurant level results show that execution was inconsistent across the system.” The company’s response to that inconsistency was already underway by the time he offered the observation.
Image source: Getty Images.
Meanwhile, investors are collectively looking right past the so-called “McDonald’s>NEXT” overhaul unveiled in June that’s wholly intended to make the chain a consumer’s first choice among any and all competing restaurants. While it’s like any other top-down revamp, this one’s somewhat predictable while glossing over obvious challenges unique to the current consumer environment. But, it is a plan, and even a mediocre plan is a framework for improvement.
Opportunity knocks
In the end, this constituent of the Dow Jones Industrial Average isn’t cheap because it’s a value trap. Rather, its relatively low valuation and relatively high dividend yield are a buying opportunity that will likely be fairly short-lived. McDonald’s is just too good at what it does, and has proven more than once in its past that it knows how to fight its way out of the very same value and cyclically economic challenges that it’s facing now.
The analyst community is on board with the argument anyway. Their consensus price target of $313.50 is 24% above the ticker’s current price, which isn’t a bad tailwind to start out a new trade. The sizable dividend yield bolsters the bullish argument as well, particularly given that the company is probably less than a few weeks away from announcing its 50th consecutive annual per-share dividend increase.
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James Brumley has no position in any of the stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. The Motley Fool has a disclosure policy.
