Is McDonald's Cash Balancing Act Viable?

A presentation by McDonald's management highlights the tension between two significant priorities.

Jun 5, 2014 at 5:19PM

McDonald's (NYSE:MCD)management team might need some BC Powder as it looks ahead to the next three years. While the company must allocate resources to jump-start sales across the globe, its shareholders have come to rely on decent cash returns in the forms of a regular 3.2% dividend and constant share repurchases.

The company's solution to this conundrum, unveiled at last week's annual Sanford C. Bernstein Strategic Decisions Conference, is to increase dividends and share buybacks while rolling forward new product innovations and reappraising its general and administrative costs. Put simply, McDonald's intends to work smarter, not harder. Let's look at specifics of this plan and see if the two priorities -- shareholder cash and revenue growth -- can be balanced successfully.

New shareholder return targets: manageable, or an overreach?
McDonald's intends to return $18 billion to $20 billion to shareholders between 2014 and 2016 in what the company termed "a 10% to 20% increase over the amount of cash returned between 2011 and 2013." It will use cash from operations, debt offerings, and proceeds from refranchising to finance the shareholder returns. Refranchising is the process by which a franchisor sells company-operated stores to existing franchisees. 

On the surface, this strategy should worry investors. After all, since posting a 12.2% revenue increase between 2010 and 2011, McDonald's annual sales have stalled. The company only increased revenue by a cumulative 4% over the last two years, increasing its top line from $27 billion in 2011 to $28.1 billion last year. Shouldn't McDonald's plow all available cash into increasing market share internationally, while parrying the threat from North American fast-casual chains such as Chipotle and Panera Bread?

The strategy should bear out for two reasons. First, McDonald's can achieve the 10%-20% increase without too much resculpting of its current capital allocation, as we'll see below. Second, the company is already focused on some primarily nonfinancial drivers of future revenue -- it's a truism that not all problems can be fixed by money alone.

How McDonald's will hit its numbers
During the years in which the octane in McDonald's revenue dwindled, management has worked aggressively to ensure that the company's cash flow remains strong. Operating cash flow is actually growing faster than revenue, hitting a compound annual growth rate, or CAGR, of more than 4% annually over the last three years. If the company's focus on "scrutinizing" general and administrative costs results in a 1% improvement in annual operating cash flow growth (for a 5% compounded growth rate), McDonald's will produce roughly $23.5 billion in operating cash flow over the next three years.

If the company then maintains its four-year average net debt acquisition of $900 million, and holds to its current capital investment of roughly $2.8 billion annually, it should have the roughly $17.8 billion needed to hit the 10% mark in increased shareholder returns. Further proceeds from refranchising will cover any returns past $18 billion, or alternatively provide funds for normal working capital activity such as repaying short-term borrowings.

The rule of the mere handful
If McDonald's is returning so much cash to shareholders, won't its growth prospects suffer? Ironically, much of what McDonald's needs to spark its business isn't particularly cash-intensive. For example, after years of increasing menu complexity, management seems to have realized that providing innumerable food options doesn't just burden its franchise operators, it often confuses customers. In addition to paring down menu complexity, the company plans to focus more on core items.

CEO Don Thompson mentioned at the Bernstein conference that 40% of all McDonald's sales derives from five items, which include three stalwarts: the Egg McMuffin, the Big Mac, and McDonald's fries. In both the quick-service and fast-casual restaurant businesses, you can forget the 80/20 rule (meaning, in this case, that 80% of revenue comes from 20% of products). Success in this sector often turns on building a revenue stream around four or five flagship items that customers return to visit after visit.

For proof of this concept, look to Chipotle, which continues to pocket McDonald's and other fast-food peers' customers. Chipotle's entire menu could fit on one side panel of the typical McDonald's menu. In fact, the Mexican eatery's basic offering consists of a grand total of four items: the burrito, the bowl, the salad, and tacos. All variation results from what customers add to these core items:


"Chipotle Diet;" courtesy Jason Lander under Creative Commons License.

While it may never look as clean as the image above, shareholders should be relieved that McDonald's menu will trend toward simplification in the coming years.

Cash is king, but crisp decisions certainly help
During the conference, the company gave a few other examples of how McDonald's will attack revenue growth. Many of the gains will derive from simply better understanding the subtleties of the various national markets in which McDonald's competes. In Germany, management has observed that it needs to present items in "small bundles" to entice the thrifty German populace, which is more likely to open its collective wallet when a discount or perceived deal is served. Thompson also relayed that local menu teams are sharing innovations with counterparts around the world. McDonald's promotes a high degree of menu differentiation in each country in which it sets up shop, so it makes sense to share promising innovations across ever-widening geographic regions.

During the presentation, CFO Pete Bensen neatly summed up McDonald's desire to increase revenue and manage costs using thoughtful decision making:

What we are just trying to acknowledge ... is certainly in a global organization as large as ours, there are opportunities to look for additional efficiencies. So on the same token with that level of spend we are not going to cut our way to prosperity and provide meaningful value through a one-time kind of G&A effort. It's about being smarter with those resources...

Source: Transcript of Sanford C. Bernstein 2014 Strategic Decisions Conference

If McDonald's can indeed be "smarter with those resources" over the next three years, it's likely to easily supply the projected cash returns to shareholders, and investors may see revenue growth finally wake up as well.

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Asit Sharma has no position in any stocks mentioned. The Motley Fool recommends McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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