McDonald's Ambitious Capital Allocation Plan

| About: McDonald's Corporation (MCD)


McDonald's recently completed a 3-year capital allocation program and announced another one through 2019.

This plan looks great for potential shareholder returns, but it could be a bit ambitious.

This article looks at why it might be prudent to reduce your expectations in this area.

On March 1st, 2017, Illinois-based fast food operator McDonald's (NYSE:MCD) unveiled its new global growth plan. Among the things mentioned were items like enhancing digital capabilities, experimenting with different delivery methods, progress made on the refranchising efforts and outlining financial expectations for the next few years.

One line in particular - cash return to shareholders - could be of particular interest. McDonald's announced a new $22-24 billion cash return target for the 3-year period ending 2019 (as compared to a $30 billion program the company achieved for the 3-year period ending 2016). Let's see what those types of assumptions could mean moving forward.

Here's a look at the company's total dividends and profits for the last 6 years:

The second and third columns show total earnings and dividends (in millions) followed by the respective year-over-year growth rates. The final column indicates the dividend payout ratio for each period.

This can be instructive for a number of reasons. For one thing, you can see that McDonald's has actually had a pretty tough go of it when we're talking about company-wide earnings growth over the last five years.

Its dividend payment has mostly been increasing. And with a stagnating or declining net profit number, we can see that the payout ratio has been climbing: from about 47% of profits in 2011 to about 65% last year.

One other note: we can see the indirect influence of share repurchases during this time as well. Notice that the total amount of dividends McDonald's paid last year actually declined. Yet, a casual observer of the company's storied dividend knows this was not the case on a per share level.

Here's a look at both dividends and share repurchases during the same time period:

This is an important addition. On the dividend front, you might consider the payout ratio to be a touch high. When you add in share repurchases, you can see that McDonald's has been consistently paying out more than it makes. This could be worrisome for future projections (more on that below), but for the moment, let's reflect on how this influences results at a shareholder level.

Here's a look at the share count and per share metrics over the years:

You can see the material decline in common shares outstanding: from about 1.02 billion, down closer to 819 million. In turn, you can also see the influence on the per share numbers. In 2012, as an example, company-wide earnings were down 1%, and yet, per share earnings were up 2% as a result of fewer shareholders to divide the earnings pie. Likewise, total dividends paid were about 5% lower on a company-wide basis last year, and yet, the per share dividend was about 5% higher for the year.

This is why capital allocation can be important. It influences how shareholders ultimate receive business results. There's an additive factor that comes into play beyond what the business results alone would indicate.

So let's see what McDonald's capital return goals for the next three years could imply.

As we can see from above, last year's dividend payment was around $3.06 billion, roughly 5% less than the total payment made in 2015. For our purposes, let's start off by presuming that this payment - call it $3.1 billion - stays the same. This, in turn, would mean a dividend that grows via reduced share count. McDonald's is anticipated to earn around $5 billion this year, so that can be another baseline for the next three years.

Using $3.1 billion for dividends results in payments of $9.3 billion over the period. This leaves between $12.7 billion and $14.7 billion for share repurchases according to McDonald's plan. Let's err on the low side and use $12.7 billion, or $4.233 billion on average per year.

Here's what that could look like:

Do you see anything potentially wrong with this picture? Under those assumptions, freezing the company-wide dividend and adding in the low end of share repurchases, you'd still be looking at a total payout ratio of nearly 150%.

This is doable via balance sheet flexibility; however, I would still use caution in making these sorts of estimates. You can pay out more than you earn for a while (see 2011 through 2016), but eventually, something changes.

In any event, suppose McDonald's goes on with its capital allocation program as recently indicated - $22-24 billion in the next three years - implying $3+ billion annual in dividends and $4+ billion in yearly share repurchases. Balance sheet flexibility is most certainly required (unless the company suddenly starts earning $7 billion+ instead of $4-5 billion).

Under this circumstance, you might anticipate McDonald's paying out $12 or so in per share cash dividends and retiring perhaps 95 million shares. Using the same earnings multiple as today, you'd come to an anticipated share price of about $146, or a total expected value of $158. Your total gain would be about 7% per annum.

And remember, this is with company-wide earnings growth stagnating. Should the business pick up a bit, the results would conceivably be even better.

So, if you believe in the company's capital allocation potential - $22 billion+ plus in the next three years - and you are content with the added stress on the balance sheet, you would probably be cheering the recent announcement. (It should be noted that you'd have to be content with valuation as well.)

However, personally I'd advocate modeling something much lower, especially on the share repurchase front, as your baseline. McDonald's could very well meet its capital allocation goal again, but this gets harder and harder to do with three items in mind: 1) a higher dividend payout ratio, meaning less room for "organic" share repurchases; 2) a historically lofty valuation; and 3) the stress already placed on the balance sheet.

To review, the company had a 3-year target of returning $30 billion in cash to shareholders by the end of 2016, and it hit this mark. So, when it mentions a $22-24 billion plan for the next three years, this may seem well within the realm of reason on a comparable basis.

Yet, this previous achievement came at a cost. In the last three years, McDonald's earned nearly $14 billion in net profits, paid out $9.5 billion in cash dividends and used $20.5 billion to retire shares. The company allocated $30 billion towards dividends and share repurchases - over twice what it earned.

And this showed up on the balance sheet in a big way. At the end of 2013, total assets for McDonald's sat at $36.6 billion, against $14.1 billion in total debt and a shareholder equity number of $16 billion. At the end of 2016, total assets had decreased to $31 billion, total debt had jumped up to $26 billion and shareholder equity was a negative $2.2 billion. There's a cost associated with consistently paying out more than you earn. This could very well carry on for a while, but personally, I'd keep a close eye on this trend.

Disclosure: I am/we are long MCD.

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.

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