McDonald's: Dividend Growth Potential Vs. Debt Pile

Summary

• McDonald's has doubled its debt in the last five years, and in 2016 the company paid $885 million in interest.
• Revenues, operating income and cash flow are declining because of the mandate to be franchise-heavy.
• Will debt levels start impacting the company's dividend capabilities?

McDonald’s (NYSE:MCD) management’s decision to change its business model towards a highly franchised restaurant operator has made the company an attractive investment choice for dividend investors. But the company’s rising debt profile remains a huge concern for any investor who wants to stay in it for the long haul. Are dividends under threat? Does the current debt level make dividend growth unsustainable? What should investors do at this point?

As the company embarked on its journey towards running a 95% franchised restaurant model, it has been aggressively changing its capital structure as well. The reasoning behind taking the highly franchised route is to reduce risk that comes along with company-operated restaurants, curb capital investments in return for stable revenues, and enjoy high operating margins and steady cash flow. With the requirement to re-invest in the business becoming lower in this model, the freed-up cash can be returned to shareholders in the form of share repurchases and dividends.

But McDonald’s had gone one step further and used the current low interest rate environment to eat up debt for breakfast, lunch and dinner. In the last five years, McDonald’s total debt shot up from $12.5 billion in 2011 to $25.956 billion in 2016, while total revenue, operating income and operating cash flow kept declining, thanks to the company reducing the number of company-owned restaurants from 6,435 to 5,669 units during that period.

As the number of company-operated restaurants came down, capital expenditure declined from $2.730 billion to $1.821 billion. So where did all that debt go, then? McDonald’s added $13.456 billion in debt to its balance sheet during the 2011-2016 period, while spending $17.324 billion in share buybacks in the last two years alone. It’s clear that McDonald’s used most of its debt as well as cash flow over the last few years to keep buying back shares.

The total number of shares outstanding was cut down from 1.021 billion shares in 2011 to 819 million in 2016, which allowed the company to raise its dividends per share from $2.53 to $3.61. But the total amount of cash paid for dividends moved up only by $448 million during that period.

The aggressive share buybacks reduced the amount of cash McDonald's needed to pay as dividends every year. But it wasn’t without any drawbacks because, in 2016, McDonald’s paid $884.8 million as interest compared to $576.4 million in 2014, and expects interest expense to increase by 5% to 10% in 2017.

According to the 2016 Annual Report:

Interest expense increased by 39% and 11% in 2016 and 2015, respectively, primarily due to higher average debt balances in connection with the company's strategy to optimize its capital structure, partly offset by lower average interest rates.

McDonald’s has been using the current interest rate environment to its advantage as it loaded up on debt, reduced shares outstanding and lowered the amount it needed to pay as dividends.

This should ideally allow the company to keep increasing dividends over the next several years. As you can see from the chart above, the weighted average annual interest rate of total debt actually moved down by 50 basis points in the last two years.

McDonald’s still has a long way to go before it hits a 95% franchised restaurant ratio, a point at which the company expects its operating margin to hit the 45% range - not an impossible target for a highly franchised restaurant chain. At that point the company will be cash generator but will generate much lower revenues than what it does right now.

With interest expenses already nearing a billion dollars a year, the company might reduce the leverage only when interest rates start climbing north, which may take many more years to happen.

McDonald’s debt binge may be nearly over, and the company is more likely to focus on using its cash flow to pay the interest and dividends, and buy back shares as much as it possibly can. That further strengthens their ability to grow dividends despite the debt pile.

Analyst’s 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.