McDonald's (NYSE:MCD) is making good progress on its target of 93% franchising by 2018 and 95% in the long-term. The company has closed the deal to sell its China assets and bids are being invited for the Japanese business as well. The sale of these businesses will affect the company in a positive way and ensure healthy earnings and margin growth.
The sale of Chinese assets will bring in $2.1 billion and will improve the credit profile of the business. Moody's is calling it a credit positive event for the company. They believe that the earnings volatility will be reduced which is certainly a positive. Franchised business will eliminate the fear of incurring capital spending and any increase in costs. Since the royalty payments are based on the sales figures, the earnings are likely to remain strong. There might be a fear that relying on royalty payments alone might result in lower sales growth. However, it should be kept in mind that the new buyers have an incentive to grow sales. Since the franchisee will be bearing all the costs, it is logical that in addition to managing costs, robust volume growth will be key for higher profitability. This focus on sales growth will be good for McDonald's as the royalty payments will also rise.
Also, the franchisee is looking to add 1,500 new restaurants in the next five years, which will take the total restaurants to more than 4140 in China and Hong Kong. This means that substantial earnings growth can be expected from China and Hong Kong in the next five years if the franchisee acts on the pledge to add more restaurants.
The company already had a strong fundamental base and its credit profile was still secure despite a considerable increase in debt over the last two years. The image below shows the trend in different key metrics in the last six years.
Source: SEC Filings
McDonald's debt has more than doubled in the last six years while the EBITDA figure has remained largely the same. As a result, leverage ratio (Debt/EBITDA) has more than doubled. However, it still remains below 3x. Going over 3x will make it a bit riskier and might bring it under watch. However, ratings agencies are likely going to be impressed by the franchising efforts as it will increase earnings without the need for capital spending. Interest expense has also been rising in the last two years, which has cut the interest coverage ratio in half as well. Rising interest expense is not the only reason for the falling interest coverage. Operating income has also been falling in the last three years. This is something that will also improve due to the franchising agreements as the operating expenses will decline. Cash received from the deal will enhance the liquidity as well as the net debt ratios. So, it is a good lift for the metrics in the short-term.
Chinese sale comes at a nice time. The company was facing increased competition in the country. Transferring this business to a franchisee reduces the risk for the company and shifts the costs of running the business future growth to the franchisee. In order to achieve its target of franchising, the company is also looking for bidders for its Japanese operations. Wall Street Journal is reporting that McDonald's is looking for buyers for its 33% stake in the Japanese business. Like China, McDonald's is not going to sell its operations entirely in Japan as well. The company has just under 50% stake in the Japanese business and it will maintain some share. McDonald's will also maintain a 20% share in China and Hong Kong after the sale and the franchising agreement will be for 20 years. The sale of Japanese assets will also generate some cash which should result in further uplift for the metrics and liquidity. However, the real impact will be on the margins and EBITDA as the company will have lower costs. Like China, Japanese Franchisee will also most likely look to expand the business in order to gain the maximum out of the deal. If this happens then the future earnings should get another boost.
McDonald's is making the right decisions as franchising will enhance its margins. The company has strong cash balances and debt maturities in 2017 are just above $1 billion. Internal cash balances can take care of these debt obligations. The available liquidity is also enough for the working capital needs. If the company is able to sell its Japanese operations as well then, the working capital needs will further come down. Overall, McDonald's is becoming a leaner but more efficient business. It is a good stock to hold for the next 3-4 years as the earnings growth is going to be robust.
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