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Summary

  • McDonald's sports a market cap of $92 billion and a yield of 3.5%.
  • The company is getting a lot of press about 8 store closures in Russia, but the market might be ignoring the conservative balance sheet and strong cash flow.
  • The liquid balance sheet and strong dividend coverage ratio would support a 10% dividend increase, while still giving the company flexibility to repurchase shares.

McDonald's (NYSE:MCD) stock has been hit lately, falling from about $102 in late May 2014 to currently $94 per share. My goal with this article is to visit some of the positives surrounding the company and its very strong franchise value.

While investors see the current yield of 3.5% as very attractive, the powerful business model and the ability to raise the dividend mandates that investors looking for growth give this stock another look.

How Safe is the Dividend?

Cash flow summary
($ in Billions)

Six months ended 6/30/14

FYE 12/31/13

Six months ended 6/30/13

Cash from operations

$3.4

$7.1

$3.2

Capex

($1.2)

($2.8)

($1.2)

Borrowings/(Repayments)

$1.2

$0.5

-

Dividends

($1.6)

($3.1)

($1.5)

Repurchases of common stock

($1.1)

($1.8)

($0.8)

Dividend coverage ratio*

1.4x

1.6x

1.3x

In the above chart, negative numbers are a usage of cash, while positive numbers are a source of cash.

The cash balances at 6/30/14 was $3.7 billion.

* I define the Dividend Coverage Ratio as Cash from Operations less capex divided by the dividend. For example, in the first half of 2014, this was (3.4 minus 1.2)/(1.6), or 1.4x.

For more comparisons on other large cap dividend coverage ratios, see this article on Under Armour (NYSE:UA) or this article on Wal-Mart (NYSE:WMT).

I have always been impressed with McDonald's ability to operate with low inventories. Of course, this is vital for any restaurant. Who wants to eat fish that is 8 weeks old?

To illustrate how efficient MCD is with inventory control, at 6/30/14, MCD showed inventories of $111 million. Now the company operates 6,689 restaurants. This indicates that each of the company-operated restaurants has about $16,500 of inventory per store. That assumes that the franchised stores (of which there are 28,994 at 6/30/14) do not require any inventory on the balance sheet of MCD. Said differently, much of the inventory required to run McDonald's global system is on the balance sheet of the entrepreneur running the franchise or the balance sheet of the supplier. These might be suppliers of napkins, frozen beef, lettuce, potatoes and carbonated beverages.

McDonald's and the Cash Conversion Cycle: Strong Evidence of a Powerful Business Model

Let's take another look at another way to measure efficiency. I recently explored Amazon.com (NASDAQ:AMZN) and a financial ratio known as the Cash Conversion Cycle.

I concluded that AMZN gets to hold on to more of their supplier's cash, effectively borrowing it from suppliers. By sitting on a supplier invoice for an additional three weeks, AMZN has a incredible source of cash when multiplied over $74 billion in annual sales. For AMZN, Accounts Payable is an unencumbered source of value, and it comes without any interest costs. AMZN can dictate terms to suppliers, and then invest the float in other projects. However, for many investors and analysts, it is unclear whether AMZN is reinvesting the float into profitable projects!

While MCD and AMZN have much different business models, a look at the balance sheet and income statement will indicate how efficiently the company is safeguarding shareholder capital.

FYE 12/31/13

Six Months

ending

6/30/14

($ in billions)

$28.1

$13.9

Total revenues (at company-operated restaurants and revenues from franchised restaurants)

$1.3

$1.3

A/R

16.9

17.1

(1) Days receivables {(Receivables/Sales)*365}

FYE 12/31/13

Six Months

ending

6/30/14

$19.3

$9.8

Total operating costs and expenses

$0.1

$0.1

Inventory

1.9

1.9

(2) Days inventory {(Inventory/Cost of Sales)*365}

FYE 12/31/13

Six Months

ending

6/30/14

$19.3

$9.8

Total operating costs and expenses

$2.3

$2.2

Accounts Payable, Accrued Payroll and other

44.4

40.5

(3) Payable Days {(Acct. payable/Cost of Sales)*365}

-25.6

-21.5

Cash conversion cycle {1+2-3}

The cash conversion cycle is the amount of time between a company spending cash and receiving cash per each sale. It is a measure of efficiency and how long cash is tied up in working capital.

In 2013, MCD held inventory for 2 days plus 17 days to collect receivables, or 19 days in total. MCD pays accounts suppliers in 44 days, thus achieving a negative cash conversion cycle.

2014 and 2015 Outlook

McDonald's expects capital expenditures for 2014 to be between $2.9 billion-$3.0 billion. Over half of this amount will be used to open new restaurants. The company expects to open about 1,500-1,600 restaurants, including about 500 restaurants in affiliated and developmental licensee markets, such as Japan and Latin America, where MCD does not fund any capital expenditures. MCD expects net additions of between 1,000-1,100 restaurants. The remaining capital will be used to reinvest in existing locations, in part through reimaging. Over 1,000 restaurants worldwide are expected to be reimaged, including locations in affiliated and developmental licensee markets that require no capital investment from MCD.

McDonald's expects to return approximately $5 billion to shareholders through dividends and share repurchases in 2014.

The company has established a 3-year cash return target of $18 billion-$20 billion for 2014 to 2016. This target is based on several ongoing factors, including the significant free cash flow generated from our operations, as well as the use of cash proceeds from debt additions and refranchising of at least 1,500 restaurants.

Another Competitive Advantage: Revenues are Not Solely in US Dollars

A significant part of MCD's operating income is generated outside the U.S., and about 40% of its total debt is denominated in foreign currencies. Accordingly, earnings are affected by changes in foreign currency exchange rates, particularly the euro, British pound, Australian dollar and Canadian dollar. Collectively, these currencies represent approximately 65% of the company's operating income outside the US.

Conclusion

Given the above outlook, I surmise that MCD will serve up a 10% dividend increase in late 2014 or early 2015. I base this on the state of the credit markets for corporate borrowers, the growing operating cash flow, and the the $3.7 billion in cash on the balance sheet. While US sales are not growing, and Chipotle (NYSE:CMG) seems to be stealing market share from all restaurants, MCD is still a money spinner.

If we assume a 10% dividend increase to $0.89 per quarter and a current stock price of $94, MCD could yield 3.8% in the near future. This is more than twice the yield of the S&P 500.

The above article is an opinion, and not investment counsel.

Source: McDonald's May Serve Up A 10% Dividend Increase