The sheer scale of the McDonald’s shareholder return program is astonishing. In the roughly four-and-a-half years since the beginning of 2015 the company has spent a cumulative total of $42.5 billion returning cash to its shareholders. (For those interested roughly $14.5 billion of that went on cash dividends and the rest on stock repurchases). Total net profit for the period came to a little over $23 billion.
In light of that discrepancy many McDonald’s shareholders will be tempted to channel their inner Jean-Claude Pitrel, a character in the Hollywood film Taken. When challenged by Liam Neeson’s character the corrupt French cop replies something like this: “My salary is X. My expenses are Y. As long as my needs are met I do not care where the difference comes from”.
In McDonald’s case we know full well where the difference comes from: debt. At the start of 2015 McDonald’s had a debt position of just under $13 billion net of company cash. By the end of the first half of 2019 that position had swelled to over $30 billion. On the face of it that trend looks immediately unsustainable, however we do have to take into account the fact that McDonald’s makes a lot more money now than it did even just a few short years ago.
Over the course of its 2015 fiscal year the company made total net profit of $4.5 billion. Last year, and largely thanks to corporate tax cuts in America, the company made nearly $6 billion. Analysts estimate that the company will make around $6.2 billion this year in net profit. In other words as a function of net profit debt has gone from around 2.9x 2015 earnings to 4.8x estimated 2019 earnings. The implication for our debt trend is therefore still firmly in the unsustainable camp. That number can’t keep going up and up forever.
For shareholders worrying that this represents irresponsibility on behalf of management I’d offer three caveats. Firstly, check out how much McDonald’s actually pays to service its debt. Back in 2015 the company paid $640 million in annual interest, equivalent to an effective interest rate of 4% on it year-end debt position. Last year the company paid $980 million, or around 3.2%. Despite net debt more than doubling its interest expense as a proportion of profit is actually pretty much the same.
The second point worth remembering is that buybacks are not wholly cost ‘negative’ for a company. To illustrate what I mean by that just think about the McDonald’s dividend for a moment. This year the company will declare and pay around $4.65 per share to its stock holders. Now, since the start of 2015 the company has spent close to $28 billion eliminating around 200 million shares. If those shares still existed then we would be looking at an extra $930 million in annual outgoing dividend cash. So, in a way McDonald’s is actually saving money even though its interest bill is higher than in 2015. (Note this still holds true even at the 2015 annual dividend rate of $3.44 per share).
Finally it’s worth bearing in mind the nature of McDonald’s debt obligations. The vast-majority, over 90%, is fixed-rate debt, and so there is little interest-rate risk here. Not only that, but well over half (around $19 billion) isn’t due anytime in the next five years. I’d also add that if McDonald’s simply ceased buying back stock it would generate a billion dollars per year in post-dividend free cash flow.
Right now McDonald’ stock trades around the $215 point. That makes for a price-to-earnings ratio of 26.8. Pretty steep. On a debt-adjusted basis things look even richer. If we tack the roughly $40 per share that McDonald’s carries in net debt onto the share price then it makes for a ‘debt-adjusted’ P/E ratio of over 30. As I’ve said previously the biggest risk to buying McDonald’s stock right now comes not from the business, or indeed its debt load, but its valuation.