What Does McDonald's Do With Its Free Cash?

Many companies talk about the ways they enhance shareholder value by returning cash via dividends or stock buybacks, but investors shouldn't just take the company's word for it.

In this series, we'll investigate how companies spent free cash flow over the past five years. By doing so, we hope to gain insight into whether the company's management might be good stewards of shareholder capital.

Today, we'll kick off our research by looking at global restaurant giant McDonald's (NYSE: MCD).

How do they spend free cash?
First, let's have a look at how much free cash flow the company has generated in each of the last five years and how much of that has gone to dividends and buybacks.

Source: Capital IQ as of June 28, 2011. Free cash flow = net income + depreciation - capital expenditures - change in noncash working capital.

McDonald's has generously increased its dividend payout by 27.5% annualized over this period in addition to a consistent buyback program.

However, McDonald's has been spending more on buybacks and dividends than it's been producing in free cash flow, and the gap was likely filled by borrowing money. This might help explain why total debt increased from $8.4 billion in 2006 to $11.5 billion in 2010.

Is the dividend covered?
Next, let's see how much of the company's free cash flow has gone to dividends.

Source: Capital IQ, a division of Standard & Poor's.

This is what you want to see -- a dividend that's regularly covered by free cash flow and by itself doesn't need debt financing. It could always pare back its buyback program and maintain the dividend without needing extra debt.

McDonald's doesn't appear to have paid out too much in dividends too quickly, but investors should keep an eye on this ratio in the future since it has increased to nearly 70% since 2008.

Are they good investors?
Companies are notoriously bad investors in their own stock. Consider that in 2007, when the market was hitting record highs, S&P 500 companies bought back a record $589 billion versus $246 billion in cash dividends; in 2009, when the market was around its nadir, buybacks hit record lows.

Is McDonald's an exception?

Source: Capital IQ.

In hindsight, it looks like McDonald's has done a fairly decent job timing its repurchases, and unlike many companies, it continued buying back stock in 2009 when the market was hardly optimistic.

Competitors
How does McDonald's use of free cash flow stack up against some of its major competitors?

Source: Capital IQ. All figures in millions as based on trailing-12-month data.

The biggest difference between McDonald's, Yum! Brands', and Starbucks' use of free cash flow is that the latter two seem to be able to fully fund their programs without the need for raising debt or tapping cash savings.

Foolish bottom line
McDonald's seems to be making good use of its free cash flow by funding a generous dividend that's currently yielding 3% and supporting a meaningful buyback program.

The fact that it's spending more on those programs than it's generating in free cash flow might be more concerning if we weren't talking about a company as strong as McDonald's. Nevertheless, it's not likely a sustainable model in the longer run.

Morningstar's "AA-" credit rating for McDonald's implies that it can borrow money cheaply, but if rates rise in a meaningful way or the company's free cash flow dries up, McDonald's buyback program will likely be decreased and dividend growth potentially diminished.