Companies Play a Dangerous Credit Game

 | Mar 13, 2014 | 10:30 AM EDT  | Comments
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Stock quotes in this article:

mcd

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cmg

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pm

I am short McDonald's (MCD), and it was up the most in three years a few days ago. That's about how my week's been going. I think out of every stock in the S&P 500, McDonald's has more warts on it than any other name.

Let's list some bullet points here:

• Same-store sales just keep going down. Not only do they keep going down in the U.S., they are going down in emerging markets, where all the growth supposedly is. This is starting to look like a run-off business, like tobacco.

• The menu is a byzantine mess. Look at Chipotle's (CMG) menu. There are, like, four things on it. When you pull up to the drive thru in McDonald's, you have to sit there and scratch your head for five minutes. And what's worse?

• McDonald's is in a price war with other fast food operators. Ever hear of this thing called fast casual? Chipotle can charge a premium price because the product is, quite simply, superior. Fast casual is killing fast food. Better product at a decent price point. McDonald's and others are in a race to the bottom.

• McDonald's does not have control over costs. Commodity prices aren't going down, that's for sure. And a minimum wage increase is all but inevitable.

• It's not an accident that fast food and tobacco stocks are underperforming together. Consumer preferences are shifting away from things that are bad for you -- and even if they weren't, multiple levels of government are busily contemplating ways to regulate what you put in your body.

I know I'm leaving some stuff out, but that's a good start. McDonald's, however, has been one of these low-volatility, dividend-paying staples names that people have been hiding out in for the last two years. With interest rates near historic lows, people have been yield-hogging in the stock market. So earlier this week, McDonald's' management said that they could probably lever up a little more without affecting the credit rating. They pledged to issue bonds to increase the dividend even more.

So let me get this straight. McDonald's' core business is basically in full panic mode, there is negative growth and rather than deal with the problems from a strategy standpoint, they are going to play corporate finance tricks. They are using smoke and mirrors to bribe stockholders in the hopes that the stock, which has gone nowhere in almost a year, starts going up again.

I am also short Philip Morris (PM). Philip Morris has been at this for a number of years now. They have been ramping up the financial leverage more and more to the point where the business can barely withstand an unexpected decline in revenue. PM also has been watching while its competitors wage e-cigarette wars. But instead of trying to ward off what is surely an existential threat, they, too, are playing corporate-finance three-card monte -- using debt to fluff up the dividend as much as possible.

I've had discussions with people over what might cause corporate credit to deteriorate. Credit conditions no doubt are very easy, with covenant-lite and all that stuff going on. But the credit meltdown might actually start with a stable, "safe" consumer name like McDonald's or PM.

I am short McDonald's and the problem is that the chief financial officer has just added a lot of time on the clock. This might sound obvious, but being short the credit is probably the better trade.

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