This article is written for INVESTORS, not traders.
Nearly 35 years after Wendy’s (WEN) and the lovable Clara Peller made famous the catch-phrase, “Where’s the beef?” in the American lexicon, shareholders of McDonald’s (NYSE:MCD) should be asking a similar question:
Where’s the CASH?
Investors have been told, repeatedly, by sell-side analysts that the burger giant was a good investment. Perhaps that was true, as the stock reached nearly $180 at the end of January. Or perhaps it was just another case of Wall Street bulls forming a herd and bidding up the stock well beyond its actual value.
Since January of this year, though, MCD has retreated, falling below the $150 mark early this month on the general market volatility and decline and on an analyst’s downgrade.
We’ve been down on McDonald's long-term prospects for over two years, since the end of January 2016 when shares were just around $120. And, yes, we’ve been hammered on that view with the stock run-up since then. But we generally have a longer timeline than traders, and McDonald’s most recently filed Form 10-K seems to justify our long-term negativity, particularly when compared to 2013.
Let’s look at some numbers: Since 2013, McDonald’s has doubled debt and reduced its book income by more than 40 percent. 
Note that book income does not take account of the $702 million "one-shot" accounting adjustment discussed below. SOURCE: EDGAR Interactive Data for 2017 and 2013.
On Clara’s “Where’s the cash?” point, we see that McDonald’s nominal cash flow has increased by more than 130% since 2013, but a closer look shows that, once one removes borrowings, stock repurchases, and other “one-shots” (like a loss on restaurant sales and proceeds from the sale of China), cash flows from ongoing and continuing "bread n' butter" business operations actually dropped by nearly 30%. McDonalds 2017 financial statements show considerable gains from its sale of the China operations and deserve scrutiny with a skeptical eye vis a vis continuing cash flows.
Management attributes the decline to its book and operating income to refranchising efforts that boost margins, and that is a reasonable explanation, but other aspects of the company’s financial condition - and concerns about sustainable cash flows, trouble us.
Now let's dissect the MCD P&L:
As can be seen, McDonald’s operating income of $9,552.7 billion for 2017, summarized here and above, included $1,163.2 billion of “other income.” That “other income,” in turn, included a net reversal of impairments, in the amount of $702.8 million. While MCD doesn’t explicitly state the nature of the impairment that was reversed - it could be something as obscure as the reversal of an earlier write-down of a tax benefit that MCD believed it could not realize - the important point to note is that it’s a non-recurring accounting adjustment that increased income.
So if we reduce book income by that impairment reversal, we end up with just $8,849.9 billion of operating income. That compares to $8,764.3 operating income for 2013! That's less than a 1 percent increase in operating income in four years!
The adjustment also reduces book income in 2017 to just $4,489.5 billion, compared to $5,585.9 billion in 2013. Even with the reduction of shares from 2013 to 2017, (some 191 million average shares, fully diluted), the 2017 EPS after the adjustment works out to just $0.30/share more than the EPS for 2013! That works out to just around a 5.5% increase in EPS in four years!
But when MCD printed its 2013 Form 10-K in late February of 2014, its shares were going for around $96 per share. When it printed its 2017 Form 10-K, shares were selling for around $164 a share. In effect, MCD shareholders are paying 70% more for a pretty crummy 5.5% increase in EPS!
Those weren’t the only ratios that changed for the worse since 2013. These other ratios from the two years should be disconcerting. Take a look at these:
| Selected Ratios: | 2017 | 2013 |
| Total debt as a percentage of capitalization: | 112% | 47% |
| Cash provided by operations as a % of total debt | 19% | 50% |
| Return on Average Assets* | 29.0% | 24.8% |
*If 2017 operating income and average assets are reduced for the one-time $702 million accounting adjustment discussed above, return on average assets for the year would be just 27.4%, or just 2.6 percentage points higher than 2013.
Source: EDGAR 2017 and 2013.
Aside from All-Day Breakfast, we haven’t been at all impressed with MCD’s operations. We called a failure on Signature Crafted Sandwiches a while ago. The “Dollar Menu 2.0” has been called a failure by others.
Order kiosks might cut operating expenses over time, but those savings will largely be realized by the franchisees, MCD would see far less. And delivery - especially when there are other alternatives available - doesn’t seem particularly promising. The very costly MCD order app only rates a 3.7 out of 5 at the app store, although it has had 10 million downloads.
Even the recent fresh beef initiative, rolled out this week in some locations, while generally reviewed as better than the frozen patty, is getting a mostly mixed review on single-patty sandwiches (the review said the fresh beef taste is overwhelmed by other flavors) . And, besides, there’s always Wendy’s.
We also see, for income investors, a rise in interest rates - especially after Friday's jobs report - rising interest rates that will tend to strangle the high MCD's relative return during the low interest rate recovery. How will the MCD dividend -- largely leveraged -- compare to a 3+ percent 10-year for income investors?
Admittedly, we have been wrong before about the direction of the stock. But we’re mostly fundamental analysts. We attribute most of the MCD stock run-up to its highly leveraged dividend and stock buy-back program and the same kind of financial engineering we saw at GE in its prime. We expect that the “choppy” earnings that management said that it expects in the next year or so in the last earnings call is a consequence of a largely empty MCD’s cupboard of "one-shot" earnings boosts - cost cutting, refranchising, and sales of foreign operations.
There are some things Easterbrook & Co. still might do to continue their run - a stock split or even the REIT scenario that MCD purportedly ruled out a few year ago. They might even follow the suggestion we wrote here to become kind of a merchant bank for new QSR concepts and tastes.
But just trying to keep the fundamentals of a fading, albeit ubiquitous, brand that is being out-maneuvered by "better burger" brands is a recipe for McFailure.
We don’t foresee any real menu innovation - something that MCD never seems to manage well - or any real ability to re-brand MCD as a higher-margin “fast casual” brand. Management is adding 3,000 new restaurants because there is no other means for growth now.
We anticipate MCD shares to retreat to the $85 to $95 per share mark over the next five years.
_________________________
Author's note: Our commentaries most often tend to be event-driven. They are often written from a public policy, economic, or political/geopolitical perspective. Some are written from a management consulting perspective for companies that we believe to be under-performing and include strategies that we would recommend were the companies our clients. Others discuss new management strategies we believe will fail. This approach lends special value to contrarian investors to uncover potential opportunities in companies that are otherwise in downturn. (Opinions with respect to such companies here, however, assume the company will not change).
