Between 2014 and 2016, fast food giant McDonald’s (MCD) saw annual revenue decline from $27.5b to $24.5b. Net income actually rose slightly over that period, from $4.7b to $4.9b. Once you take into account the factors that explain the contrasting fortunes of the top and bottom lines – e.g. increasing the proportion of franchised stores versus company managed ones – it all looks, well, pretty much as you’d expect for a mature company.
So, not much to see here, I hear you say. However, when you look at those figures on a per-share basis you suddenly find a whole different story. Revenue actually increased by around 5% on that basis, from $28.50 in FY14 to just over $30.00 in FY16. Profit increased by almost 20% on the same basis.
Obviously there is no magic going on here. The reason for the unusually large degree of divergence is the company’s aggressive stock buyback program. McDonald’s had a grand total of circa 990m shares in existence at the start of 2014, with that figure falling to approximately 820m by the end of 2016. The total bill for wiping out nearly 20% of the shares outstanding in just three years? Roughly $20b.
Now, stock buybacks tend to generate controversy in a way that dividends don’t. Depending on who you ask, they are either a blatant tool for financial engineering or a legitimate way to return cash to shareholders. Indeed, they were actually illegal on insider trading grounds until 1982.
The truth of the matter is probably somewhere in between. I mean, if you’re looking at a mature business generating plenty of excess capital then I don’t see much of an issue. For instance, a chunk of the cash will go towards maintaining and growing the business; the rest can potentially be split between paying down debt, cash dividends, stock buybacks, acquisitions, or even just letting it accumulate on the balance sheet.
In the case of McDonald’s, the level of buybacks has far exceeded the operating realities of the underlying business. If we take the 2014 to 2016 period in isolation, then the total amount spent on stock buybacks was around $20b. McDonald’s generated around $19.5b in cash from operations during that time. If anything, that actually downplays the scale of the buyback program because it ignores all the other uses of cash. For instance, the firm also spent a grand total of around $9.5b on cash dividends in that period. Capital expenditures of over $6b also represented another significant cash outflow line.
To see the net impact of all this then just head over to the company’s balance sheet. In 2010, McDonald’s reported total debt of circa $11.5b. It made the same $4.95b in net profit that year as it did in 2016. On that basis, and after netting out the $1b or so in cash & equivalents it had back then, we get a debt-to-profit ratio of around 2x for 2010. This year, the company will probably earn around $5.35b in net profit, but with total outstanding debt of approximately $28b. Once you back out cash & equivalents, that debt-to-profit ratio jumps to over 5x.
The major concern I have with this trend is that the benefits seem to be disproportionally aimed at shorter-term share holders. I wonder whether that’s such a good idea in a strong bull market. The reason I say that is because the recent average valuation of McDonald’s stock has been around 20x earnings. In the prior decade, the stock typically traded around the 15x annual earnings mark. Or put another way, most of that $20b was spent on buying historically expensive shares. That represents less bang for shareholders’ buck.
The potential downsides are carried by those looking a bit further ahead. At some point, the company will have to align the level of cash sent to shareholders with the performance of the underlying business. When that happens, anyone going down the buy-and-hold route could be left with the awkward combination of slowing growth, a rich valuation multiple and a highly leveraged balance sheet. Time will tell how it plays out, but with management promising to return another $22b to $24b to shareholders before 2020, it doesn’t look like those buybacks will be stopping anytime soon.
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