McDonald's and Yum! Brands: Do They Still Belong in Your Portfolio?

Fast-food chains McDonald's (MCD -0.05%) and Yum! Brands (YUM 1.22%) have recently faced their share of difficulties, ranging from declining customer traffic domestically to the avian flu scare in China. This information may leave you wondering whether or not these companies still have any life left in them. Let's take a look under the proverbial hood at their financials to see if these companies stand on solid footing and if they still deserve a spot in your portfolio.

Where are the customers?

McDonald's and its franchisees operated 35,000 restaurants globally as of the most recent quarter. McDonald's continues to struggle in getting customers through the door in the U.S. In the most recent quarter, the company saw its same-store sales decline 1.7% domesticall, serving as a drag on overall same-store sale, which only expanded 0.5%.

The number of same-store transactions decreased 3.1% during that time, which includes stores temporarily closed for remodeling. However, bright spots remain: Same-store sales increased throughout the rest of the world as global expansion, expanded store hours, and menu reengineering helped on that front. 

McDonald's still maintains OK fundamentals. Overall, its revenue increased 1% during the most recent quarter, helped by its non-USA regions. However, McDonald's net income declined 5% while its free cash flow increased 29%. Lower operating income in the U.S. due to lower customer traffic as well as lower operating income in the Asia-Pacific, Middle East, and Africa (or APMEA) region due to lower gains on the sale of some of its restaurant units contributed to the decline in net income. Gains in working capital and decreases in capital expenditures contributed to gains in free cash flow.  

McDonald's $2.7 billion in cash equated to 17% of stockholder's equity last quarter. Its long-term debt-to-equity ratio stood at 86% versus 88% at the same time in 2013. Investors should look for companies with long-term debt-to-equity ratios of less than 50%. Companies with a great deal of debt may find their profitability hindered by interest expense.

However, McDonald's operating income exceeded interest expense by a comfortable 14 times. The rule of thumb for safety is five times. The company pays a generous dividend and has increased its dividend steadily since 1977. In the most recent quarter, McDonald's paid out 57% of its free cash flow in dividends and currently pays its shareholders 3.1% annually.

China rules for Yum! Brands

Yum! Brands and its franchisees operate well over 40,000 restaurants globally. Yum! Brands seems to be moving beyond the avian flu scare that occurred in China over a year ago. In fact, in China, Yum! Brands increased reported revenue and operating income of 20% and 69%, respectively, in the most recent quarter.

Yum! Brands introduced 15 new products to its KFC menu in China and expanded Pizza Hut's home delivery service in the country. Yum! Brands also saw revenue gains of 13% in India. However, its loss widened 20% during that time due to macroeconomic conditions.

Yum! Brands' China and India divisions brought its overall fundamentals into positive territory in the most recent quarter. With that said, Yum! increased consolidated revenue, net income, and free cash flow 7%, 18%, and 143%, respectively. Operating income gains in its China division contributed to net income gains. Lower capital expenditures contributed to the free cash flow expansion.

Yum! Brands possess a highly leveraged balance sheet. Its long-term debt-to-equity ratio comes in at a high 126%, which is less than the 131% it registered the same time last year. However, its operating income exceeded interest expense by 17 times. Yum! Brands' $734 million in cash equates to 31% of stockholder's equity. In the most recent quarter, the company paid out 41% of its free cash flow in dividends.Currently, Yum! Brands pays shareholders $1.48 per share per year, translating into a yield of 1.9%.

What should investors do?
Both McDonald's and Yum! Brands still belong in your portfolio. They both show plenty of expansion potential in the Chinese markets, as evidenced by the apparent rise of the "consuming class" in the country.

Moreover, both companies also need to address challenges on the domestic front. Yum! Brands recently demonstrated superior ability on this front with new breakfast innovations at Taco Bell and the announcement that Taco Bell's CEO Greg Creed  will take the top job as Yum! Brands' CEO on Jan. 1, 2015. Duplicating Taco Bell's media savvy in other Yum! Brands divisions can only enhance Yum! Brands' potential for capital gains and dividend boosts. By contrast, McDonald's only notable marketing campaign consisted of free coffee for a short time.

In its most recent earnings call, Yum! Brands executives said they desire to be the breakfast leader. Investors can also enjoy generous dividends from these companies while waiting for any initiatives to pay off.