Investment overview
McDonald’s Corp. (MCD, Financial), which is currently trading at a dividend yield of 3.1%, can be considered a good dividend stock for income investors. The company raised its quarterly dividend by 6%, bringing the fourth-quarter dividend payout to nearly $800 million. Considering the company’s vision of expanding its franchising business, I believe McDonald’s will have better margins and cash flows to create long-term value for all shareholders.
Company overview
McDonald's is a fast-food service restaurant with more than 36 thousand restaurants in around 100 countries. With a market cap of $100 billion, the company has the largest position in the fast-food industry in the U.S., with Yum Brands (YUM, Financial) being its closest competitor. The company sells burgers, fries and sandwiches with the vision of providing great taste, modern choices and real ingredients. McDonald's is constantly trying to find new ways to strengthen the nutritional profile of its menu items while maintaining taste.
The nutritional value differs depending on the region in which the company is operating however. By 2020, the company hopes to serve 100% more fruit, vegetables and low-fat dairy or whole grain products while reducing salt, sugar and saturated fat across the menu. The primary goal is to offer healthier products to its customers and increase awareness of healthy eating habits.
Business model
McDonald's uses both a franchise model and a company operated model – the two most commonly used models in the restaurant industry. Apart from McDonald's, Yum Brands and Carrols Restaurant Group's Burger King (TAST, Financial) also follow the same model. Currently, 80% of the company's restaurants are franchised worldwide and 90% are franchised in the U.S.
The company aims at being 95% franchised in the long term because franchising helps an individual to own the business and maintain control over staff, purchases and prices while providing global experience. It also provides locally relevant customer experiences, which drives profitability. This strategic direction towards a franchised-based operation has been a key to McDonald’s long-term success.
Asian deals to further drive growth
McDonald's operates under four segments with similar characteristics, challenges and opportunities for growth - U.S. market, international market, high growth and foundational markets. The high-growth market has huge restaurant expansion and franchising potential in eight key markets of Korea, China, Russia, Poland, Italy, Spain, the Netherlands and Switzerland.
The company’s decision to sell its Chinese assets and willingness to strike a deal for its Japanese business will have an upside impact on its earnings and margins. The company has sold the control of its Chinese business to CITIC (HKSE:01091, Financial) and Carlyle Group (CG, Financial) with 52% ownership to CITIC, 28% to Carlyle Group and 20% ownership to McDonald's.
The deal is valued at $2.1 billion and the company expects to add 1,500 outlets in the next five years. I believe the sale is a strategic move towards its 93% franchised ownership by 2018. Â Considering CITIC and Carlyle’s expertise in the region, the company will have access to customers outside Tier 1 and Tier2 while developing menus and operational strategies that appeal to Chinese customers.
The China deal will have an impact on the company’s financials. This is because the franchising business will eliminate capital payments and any increase in costs, which would have a positive impact on earnings. This would eventually boost both the EBITDA margin and cash flow, helping them to further deleverage.
In addition to the sale of its assets in China, McDonald's is also looking for deals in markets like South Korea, Japan and Southeast Asia. This is again to streamline its business and focus on the quality of its offerings. McDonald's plans to sell its assets in Malaysia, Singapore and Saudi Arabia. The company is in talks with Saudi Arabia’s Reza group and the sale of 20-year franchise rights in Southeast Asia could fetch them more than $400 million. Therefore, McDonald's is becoming more attractive in terms of its business. Considering its vast presence, the company has huge upside potential going forward as it becomes less capital intensive.
Balance sheet looks firm
Although the company has total debt of $26 billion as of Sept. 30, 2016, no debt is due in the short term. Assuming cash and cash equivalents of $3.1 billion for fiscal 2016 (nine-month cash and cash equivalents of $2.3 billion) and expecting a conservative increase of 20% for operating cash flow, operating cash flow for fiscal 2017 would be $8.3 billion. Thus, the company has total liquidity of $11.4 billion, which is sufficient to meet its capital expenditure requirements, dividends and share repurchase program. This also suggests that while the debt looks huge, it is well managed and there are no liquidity issues.
Conclusion
McDonald’s plans to refranchise around 4,000 restaurants by 2018 in order to be 93% franchised. The majority of this will be in high-growth and foundational markets. Considering the huge potential in these markets and improving per capita spending, McDonald's is expected to benefit in the long run. Moreover, the company has been consistent in its dividend growth, further making the stock attractive for income investors.
Disclosure: No positions in the stock discussed.
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