Refranchised And Repurchased: Restructuring Continues At McDonald's

| About: McDonald's Corporation (MCD)


Financial results hindered by the strong dollar.

4,000 restaurants to be refranchised through 2018.

$30 billion returned to share holders for the 3 year period ending 2016.

As the turnaround effort proceeds, McDonald's (NYSE:MCD) reported a 5% decline in earnings for the full year in 2015. Revenue shrank by 7% and operating income by 10%. Thanks to share repurchases, earnings were essentially flat on a per share basis, coming in $0.02 lower than 2014. While the income statement isn't looking pretty, adjusting for shifting exchange rates presents a very different picture. Excluding currency translation, revenue was up 3%, operating income remained flat, and net income grew 5% instead of a 5% decline. Helped by repurchases, this comes out to a 10% growth in earnings per share.

Investors have been hurt by the stronger dollar, but when it comes to the actual business of selling burgers and fries, McDonald's is doing ok. While guest counts were down in 2015, higher average checks pushed comparable sales to grow 5% with all segments reporting increases. This report also gives us our first taste of McDonald's All Day Breakfast which is being credited as a primary driver of a 5.7% increase in comparable sales for the fourth quarter in the US. This comes as part of a plan to revamp the US business by "delivering outstanding customer service through comprehensive simplification efforts, core menu enhancements and a compelling everyday national value platform."

McDonald's plans to refranchise 4,000 restaurants by the end of 2018 with a stated goal of becoming 95% franchised. To put this in perspective, they finished 2015 with 36,525 restaurants, 82% of which were franchised. Why is refranchising a good move? Well company-operated restaurants represented 65% of sales in 2015, but they accounted for 76.5% of operating costs. In contrast, franchised restaurants are responsible for less than 10% of operating costs. Company-operated restaurant margins came in at 15.2% for the fourth quarter while franchised restaurants exhibited 82% margins. These numbers may make it seem like a no-brainer, but herein lies the rub: for each company-operated restaurant, $2.6 million in sales was generated in 2015 compared to $0.3 million per franchised restaurant. Company-operated assets create greater overall profit per restaurant, but at a greatly reduced margin. They also carry exposure to all the risks associated with owning and operating a restaurant.

The refranchising endeavor progressed in 2015. For the year, 537 franchises were added while they finished the year with 270 fewer company-operated restaurants. Of that 537 net gain in franchises, 470 were refranchised. You can see the effects in the income statement, too. The share of company-operated revenue fell from 66.2% of sales in 2014 to 65% in 2015 with all segments of the business reporting franchise revenue growth when exchange rate effects are excluded.

McDonald's also plans to continue returning cash to shareholders with a stated goal of $30 billion for the 3 year period ending 2016. So far, $16 billion has been used towards dividends and share repurchases, which means MCD will be throwing a lot of cash at investors in 2016. For context, dividends and share repurchases totaled $9.6 billion in 2015. This resulted in a 5% decrease in shares outstanding. McDonald's repurchased roughly one in every 20 shares of existing stock. With a current market cap of about $109 billion, barring any special dividends, this means repurchases could total in the neighborhood of 10% of shares outstanding in 2016. How does management plan to fund these dividends and share repurchases when they've only been able to return cash at an average rate of $8 billion a year so far? Easy. Continue to return $8 billion a year from operations and fund the remaining $6 billion with newly issued debt. As for the effect of all this new debt, interest costs are expected to rise 40% to 45% as a result. That's over a quarter billion of interest expense added to the income statement.

Looking forward through 2016, McDonald's expects new restaurants to add 1% to system wide sales, adding 4 cents to the bottom line. Commodity costs are expected to fall 1-2% in the US while remaining flat for the rest of the world and SG&A is anticipated to decline 1-2% even with the addition Olympic sponsorship costs. $2 billion has been budgeted for capital expenditures. Half will be used to fund a net addition of 500 restaurants with the other half reinvested in existing assets. Other plans from McDonald's include $500 million reduction SG&A by the end of 2017 with the majority of cuts coming in that year. They expect to have made $150 million in cuts by the end of 2016, with about half that progress already made in 2015.

The net result of refranchising and changes to the capital structure is a much more highly leveraged business. It will be important for investors to remember that leverage cuts both ways and the effects of any missteps during the restructuring process will be magnified. While progress is being made towards these goals, the pace appears slow to start. Majority of the planned changes are slated to take effect in the next couple years and it remains to be seen whether McDonald's is yet to hit its stride and pick up the pace as their objective deadlines approach or if they'll stumble as they near the finish line.

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