- Even though revenues are still down compared to 2014, operating margins have been lifted by successful re-franchising in many segments.
- The market will look to high growth markets like China for McDonald's next wave of growth.
- Dividend investors will be mindful of the company's rising debt to equity and dividend payout ratios.
McDonald's (NYSE:MCD) earnings for its fourth quarter were out on 25th January 2016 and the company delivered a beat demonstrating that the momentum from the results from its third quarter has definitely continued. The restaurant chain reported a profit of $1.21 billion (or an EPS of 1.32) on $6.34 billion revenues which were well ahead of analysts revenues projections of $6.22 billion. McDonald's stock rallied well past $119 a share on the news despite the S&P 500 (INDEX:SPAL) dropping almost 30 points down to 1,877.
As I pointed out in a previous article, I feel that the momentum McDonald's generated in its third quarter is now priced into the stock. Not just did the company report positive sales comps across all segments in the fourth quarter but also for 2015 which illustrates how quick this turnaround has really taken place. Investors who were bearish on McDonald's due to its shrinking operating margins must have been surprised to see a 7% increase in consolidated operating income in the fourth quarter.
Furthermore, even though revenues slid in the fourth quarter (4% year on year) and in 2015 (7% decline compared to 2014), if the positive trend continues I expect McDonald's to easily beat 2016 expectations especially if we get some dollar weakness thrown into the equation. Nevertheless, McDonald's stock is trading at all time high with an expensive valuation so the following initiatives need to fall in place to ensure this stock remains around $120 a share.
Firstly, what is helping earnings at present is higher franchise margins which will be ongoing all the way through 2018 and net annual G&A spending cuts which should have most of its $500 million cuts done by 2017. McDonald's hopes to have 4,000 restaurants re-franchised by 2018 which is crucial considering that the company's operating income metric is still about 20% lower than in 2011 and 2012.
Why is this important? Well in the event of the Fed going through with its tightening cycle, you are going to see more dollar strength which is going to affect top line sales internationally. This has been the story up to now and the market will need to see growth triggers internationally because US growth has now been already priced due to its sheer size (14,000+ restaurants) and present momentum.
Furthermore, China and other high growth markets, in my opinion, will determine to a large degree the growth path of McDonald's and this particular segment performed very well in Q4 in that it reported a 27% increase in operating income. However this figure has to be taken with a grain of salt because of what happened in China last year (meat scandal) but this region is crucial because if it shows the market consistent increases in sales and operating income through new restaurant openings and higher numbers of re-franchised efforts, I'm sure the market will take note.
Wall Street is fickle in the sense that it is always devising future. It will value a stock more on potential future sales than existing sales comps. China has only 2,000+ stores, which is in no way servicing the massive population of 1.3 billion+. More strategically placed re-franchised restaurants would really move the needle for McDonald's stock here as expected US growth alone moved the stock 20% over the last 3 months.
McDonald's stock is an extremely popular dividend stock and always sells at a premium. In saying this, its trailing 12 month free cash flow metric is about $4.6 billion. McDonald's currently is selling more restaurants in its history and investors should be aware of what this is doing to its balance sheet. Despite the company spinning off billions of free cash flow every year, equity in the company has been decreasing because McDonald's has been borrowing to reward shareholders.
The company has chosen debt as the vehicle to reward shareholders in the near term which brings its own risks to the table. In the fourth quarter of 2015, $2.3 billion was returned to shareholders in the form of dividends and share buybacks meaning that company is still on the hook to return $14 billion to shareholders in 2016 (if it achieves its 3 year $30 billion goal).
Dividend increases are fine but the payout ratio has never been higher, so it will be interesting to see if McDonald's can hike by at least its 3 year average which is 9%. I feel the company will, but investors have to watch the balance sheet as the company is trading at high valuations and any more setbacks could mean an exodus of dividend investors especially.
To sum up, McDonald's came out with an excellent set of earnings in its fourth quarter which was slightly ahead of analysts estimates. Momentum should undoubtedly continue as the "All Day Breakfast" has been a big success since its inception a few short months ago. The potential rolling out of this internationally combined with initiatives such as "Mc-Pick 2", "Experience of the Future" and "Create Your Taste" should keep growth levels elevated. Nevertheless to get to a new level, the restaurant chain has to up its game internationally especially in China whilst at the same time continue to reward shareholders and keep its balance sheet in check.