One of the most confusing parts of this quarterly earnings season was the market's reaction to McDonald's Corp.'s (NYSE:MCD) report. To be blunt, the results were downright ugly. McDonald's posted an alarming drop in the key metrics that matter most -- namely, global comparable sales (which measures sales at restaurants open at least one year) and earnings per share.
Of course, this is nothing new. McDonald's also performed poorly in 2014. But this report was especially bad, even for McDonald's. Yet a funny thing happened: The stock went up 5% after the earnings report and continued to rally in the days following.
As a result, McDonald's stock is now close to a five-year high. Since EPS is still in decline, the stock's valuation has soared.
Perhaps this is an opportunity for investors to cash out before the market comes to its senses.
Nothing to brag about
Global comparable sales fell 2.3% last quarter at McDonald's, a result of falling guest traffic across geographic segments. Comparable sales fell 2.6% in the U.S., 0.6% in Europe, and 8.3% in the Asia-Pacific, Middle East, and Africa region.
Total revenue dropped 11% -- although to be fair, much of this drop was due to unfavorable currency movements. The strengthening U.S. dollar has taken a big bite out of sales for multinational corporations such as McDonald's. Still, excluding currency effects, total sales declined 1%.
More troubling was that currency-neutral earnings per share collapsed by 23%. As if that weren't bad enough, McDonald's also announced that it will close at least 900 of its restaurants around the globe. This decision throws a wrench into its aggressive worldwide restaurant opening strategy, which previously was one of the company's key growth initiatives.
But the stock rallied after earnings, though there seems little reason for such optimism. One possible explanation could be that investors are looking forward to a new round of strategic initiatives, which are expected to be unveiled at a May 4 investor event. One of the topics likely to be presented is an expansion of delivery.
McDonald's currently has a website devoted to the idea, which it refers to as "McDelivery." On this site, customers can place McDonald's orders in bulk. Among the available options are traditional hamburgers and fries, as well as some surprising items, such as -- believe it or not -- McSpaghetti.
Is there light at the end of the tunnel?
A turnaround is far from guaranteed. More certain is that the rally in McDonald's shares has presented a compelling opportunity to cash out. Right now, the stock's earnings multiple is at a five-year high:
That's because the stock price is going up, but earnings aren't, and so the P/E ratio has significantly expanded. Investors appear to be more excited about McDonald's than at any other point in the past year, but all the evidence suggests that the company's turnaround still hasn't gained traction. The stock trades at 22 times earnings, which is even a premium to the S&P 500 Index, which trades for 20 times earnings.
The end result is a dangerous scenario. Should turnaround hopes fail to meet rising expectations, investors are at risk of significant multiple contraction.
I'd argue that McDonald's doesn't deserve even a market multiple, let alone an above-average multiple. The company's historical valuation over the past five years sat around 16-18 times earnings. Only recently has the stock reached this elevated valuation level. Should McDonald's return to a more normal valuation, investors would suffer significant losses.
As a result, if the turnaround plans turn out to be more bark than bite, I'll consider using this unexpected rally as an opportunity to sell my shares and reinvest the proceeds elsewhere.