Suppose that 2015 had been a normal year for global quick-service restaurant chain McDonald's Corp (NYSE:MCD). If so, I could say with some confidence that if we had to answer the simple question of whether McDonald's would raise its dividend in 2016, I wouldn't be writing this article, and you wouldn't be reading it. The franchise juggernaut currently in transition to being a "modern, progressive burger company" has reliably raised its dividend every year since 1977, the year after it issued its first checks to common shareholders.
But here we both are. And it hasn't been a normal year for McDonald's, despite the stock's enormous late-year rally:
While investors are clearly endorsing the conclusion that McDonald's is turning its business around, company management has engaged in a good bit of financial engineering both to support the turnaround and keep those shareholders sated.
New leverage, dividend uncertainty
As I discussed a few weeks ago, McDonald's has embarked on a near-term mission to divest itself of all but 5% of global company-operated restaurants. In that article, I described how the move to being 95% franchised will make the company's financial model more inflexible. In addition, management has decided to promise massive shareholder returns through a schedule of dividends and share repurchases -- on the order of $30 billion -- through the end of 2016.
That's quite a bit of cash, even for McDonald's. To keep its commitment to shareholders, the company is leveraging its balance sheet, borrowing $10 billion to fund the scheduled dividends and stock repurchases. So far this year, McDonald's has added $3.2 billion in net debt issuances to its obligations pile. Let's return to that preceding price chart, with an overlay of the trend of McDonald's debt-to-equity ratio:
Investors aren't alone in their discomfort with how fast debt is rising (and is projected to increase next year). As I discussed in the article I referred to earlier, Standard & Poor's rating agency has downgraded McDonald's once spotless credit rating twice this year, from an "A" designation, all the way down to "BBB+." That's still considered investment grade, but just barely, as it sits only three notches above "junk" status.
The debt complicates an already cloudy picture on the company's dividend, which has been an attractive aspect of holding McDonald's stock over the past three years through a revenue slump. Currently, the quick-service giant's dividend yields 3%, even after its recent share-price run-up.
As quarterly earnings have decreased during 2015, McDonald's payout ratio (dividends paid as a percentage of net income) has increased, from an already high 65% through the first nine months of 2014, to 73% during the same period this year.
In normal circumstances, the higher payout ratio wouldn't be a great cause for concern. McDonald's still throws off ample cash from operations. In the first three quarters of 2015, the company has generated $5.2 billion in operating cash flow. That's enough to cover the period's $1.2 billion in capital expenditures, as well as the $2.4 billion bill for dividend payments.
With a cash model like the one described, in which McDonald's still has $1.6 billion left over for long-term debt payments after nine months of operation, we probably could safely project that the company could continue to raise its dividend for some time annually at a rate between 4%-5%, as it did this year.
Yet McDonald's is encumbering itself, not just with debt that will eat into cash flow and earnings (through interest expense), but also with shareholder expectations, having created a perception that it will keep engineering ways to buy back shares. So far this year, the company has spent $4.6 billion on share repurchases -- the largest cash use by far in the organization. And we still have one reportable quarter to go.
What's likely to happen with McDonald's dividend next year
Considering all these factors, will McDonald's raise its dividend for the 49th straight year in 2016? A reasonable guess says it will. The incremental cost of another dividend increase of between 4%-5% next year is $150 million, in very rough numbers.
And although the company's financial condition has deteriorated under the weight of both the turnaround and management's determination to repurchase billions worth of shares, $150 million isn't that daunting of a number for the world's largest burger chain.
But looking past 2016, management may be in for a painful conversation with shareholders who have become spoiled with the amount of stock being repurchased on the open market. McDonald's simply won't have the resources, either on its balance sheet or in the debt markets, to sustain the buyback pace of 2015 and 2016 in the following years.
On the other hand, as the business rights itself, other options to please shareholders will become available. For example, the company could zero in on those dividend payments, and institute more aggressive annual increases as cash improves. That's a rational, plausible alternative to the company's current share-buyback binge.
Asit Sharma has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.