Famous restaurant chain and Dividend Champion McDonald’s Corporation (MCD) is one of the famous brands of American culture. The company’s rapid growth since the 1940s and long track record of raising its dividend payment has generated immense wealth for shareholders over the years. However, there are some circumstances forming within the fundamentals of the stock that could stunt total returns moving forward. McDonald’s balance sheet is eroding, and the stock is priced aggressively when considering the company’s maturity. We detail our concerns, and what investors could expect from the stock if conditions worsen.
Only So Much Juice Left To Squeeze From Its Franchising Model
In recent years, the company began to franchise its restaurants. By shedding ownership of the restaurants from corporate, it has shifted the majority of overhead responsibilities to franchisees. McDonald’s no longer makes its money by selling food (at least directly), it’s now a branding machine that collects rent, as well as royalties on the sales of its franchised locations.
The increasing margin has helped McDonald’s become more FCF efficient. Its current FCF conversion rate of 20.09% is an excellent output. We typically benchmark 10% as a goal to look for with most companies.
Our first concern is that while this transformation has positively impacted McDonald’s operating model, we appear to be approaching the end of this agenda. Out of the company’s total restaurant base of 38,298, just 2,635 remain under corporate operation. This means that the franchisee-owned rate of 93.1% leaves little room for benefit of franchising. The company’s target franchise rate is only slightly higher at 95%.
(Source: McDonald’s Corporation)
With McDonald’s approaching a plateau of model efficiency, it will need more sales growth momentum to drive future cash flow growth. This becomes a more difficult endeavor because of how ruthlessly competitive the sector is.
Fortunately, comparable sales have remained relatively steady. Through nine months of 2019, corporate comparable sales are up 5.9%. There is also an underrated degree of stability in McDonald’s. Despite it being a restaurant brand, the company actually generates more revenues in rent from its franchisees than in royalties. In other words, McDonald’s is almost more a real estate business than a food business.
(Source: McDonald’s Corporation)
Our drive home point is that while McDonald’s has a well-deserved reputation as a defensive and cash-rich business, investors will need to rely on sustained sales growth to drive future cash flow streams. There isn’t much efficiency left to gain by franchising its locations.
Balance Sheet Is Continually Eroding
Our review of the company’s revenue streams and franchising agenda was intended to shine some light on what aspects of the business will be leaned on to produce moving forward. The reason for that is because the company’s performance has not kept up with management’s cash expenditures.
The company has been aggressive in putting money into the hands of shareholders. This has been accomplished two different ways. The first is McDonald’s long-renowned dividend. The dividend currently pays an annual total of $5.00 per share, and has been increased for each of the past 44 years.
McDonald’s has also aggressively bought back shares to help drive EPS growth. Over the past decade, the company has spent billions to retire a staggering 30.4% of its entire share count. This has driven EPS to a 10-year CAGR of 7.02%, while net income itself has grown at a 3.11% rate.
The problem over the past five years or so is that these cash outlays (as much as investors appreciate them) have begun to strap the balance sheet. The company’s cash balance has shrunk to $1.1 billion, against gross long-term debt of $32.85 billion. The resulting leverage ratio of 3.13X EBITDA is now exceeding our cautionary benchmark of 2.5X that a company is overleveraged.
This isn’t a call that the metaphorical sky is falling, but it will eventually impact investors in a negative way. If cash flow doesn’t continue growing over the long term, the company will eventually be forced to cut down on buybacks (slows EPS growth) or slow its dividend growth rate (8.7% CAGR over past 10 years). The company’s most recent dividend increase of 7.8% is still quite aggressive when considering the balance sheet. To summarize, it’s difficult to imagine McDonald’s being able to afford spending at the same rate over the next five years as it has over the previous five.
The Stock Is Priced To Perfection
Despite the possibility of plateaued margin expansion and increasing debt levels, McDonald’s stock is faring well in the market. Shares have rebounded from a recent dip to challenge 52-week highs at over $211 per share.
We will see how McDonald’s closes 2019 (and perhaps get a peak at 2020) on Wednesday when the final earnings for the year are released. Analysts are currently projecting full-year EPS of $7.84. This would put an earnings multiple on shares of 26.92X. Compared to the stock’s 10-year median P/E ratio of 18.74X, the current share price represents a 43% premium to decade norms.
The average estimate of the analyst community is projecting McDonald’s to grow earnings at an average rate of 6% over the next five years. If the stock maintains this multiple, total returns would be about 8-9% per annum. But even the slightest P/E compression from such an outlier multiple will doom investors to low- to mid-single digit total returns. Given how unsustainable management’s five-year spending patterns appear to be over the coming years, we see more downside than upside from the current price of shares. If we give credit for the company’s margin expanding franchising over the past five years, we could possibly see a case for 20X earnings – even in the face of deteriorating financials. But even at 20X earnings ($157 per share), there is potential downside of 25% from the current stock price.
The first step in identifying any potential investment is to find a strong business. McDonald’s certainly fits that bill, and has expanded its margins by franchising its restaurants in recent years. However, investors need to be aware of the relationship between expected future performance and valuation. While McDonald’s will generate stable, modest growing revenue streams for years to come, the current trajectory of the business does not mesh up well with the stock’s valuation.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.