The Business Of

Fast Food | McDonald’s | What Do They Do With Their Profits?

Morning All!

Yesterday we put together McDonald’s costs with their revenues. And we’ve covered a fair amount this week. So let’s have a quick recap…

• Rent, Royalties, Restaurants: The US fast food giant makes its money in 3 ways - rent, royalties and restaurant sales. With rent bringing in most money!

• Closing Down: Restaurant sales have been decreasing since 2013. With McDonald’s operating less restaurants in favour of a franchised model.

• Margin Mix: And this shift towards having more (higher-margin) franchised restaurants has lead to McDonald’s EBIT margin expanding to 40%!

So, it’s time to take a look at the famous TBO EBIT margin rankings chart! And we can see how our ranking looks when it’s updated to include McDonald’s. And quite astonishingly, the fast food giant slots in at number 2! Only behind the formidable TSMC.

What’s even more amazing, is how high that margin is versus the other fast food companies. We saw yesterday how Starbucks only has an EBIT margin of 14%. And Restaurant Brands International (who own Burger King) have a margin of 29%.

But we need to march on. Because, with ~$23bn in revenues. And a 40% margin. It means McDonald’s made ~$9bn EBIT in 2022. And the question we’ll be answering today is - where does all that profit/cash go?!

Dividends Up For 47 Years In A Row… So What?

Okay, so $9bn EBIT last year. But McDonald’s Corporation has actually made $123bn in cash from operations over the last 20 years. And the waterfall chart below shows us that share buybacks have been the most popular use of cash. With $67bn of that $123bn used to buy back shares. Dividend payments ($51bn) and capex ($42bn) followed close behind!

You’ll also notice that because these 3 cash uses came to more than $123bn. McDonald’s had to issue a total of $27bn in debt to finance these uses!

Okay, so let’s quickly dive into each of the 3 cash uses now. Capex for McDonald’s involves (i) constructing buildings for new restaurants and (ii) reinvesting in existing operated restaurants. That reinvestment can look like upgrading old kitchen equipment. Or building an extension at a restaurant. However, over the last decade, capex spending has fallen considerably because McDonald’s have been selling their operated restaurants to franchisees. And it’s then the franchisees who have the responsibility to reinvest in the restaurants!

Share Buybacks - we talked about quite a bit last week during our ASML newsletters. So, I won’t bore you and we won’t go into detail again now…

But the cash use we will go into more detail with is dividends. McDonald’s have increased their dividends 47 years in a row. Which sounds incredibly impressive. And don’t get me wrong - it is. But how significant is it for an investor of McDonald’s? Let’s quickly dive into that now…

High Dividend Yield = Good or Bad?

Okay, so what investors really care about when they hear dividends is - what’s the dividend yield? Because the dividend yield is a measure of return. It’s the return investors can make through solely dividend payments.

And dividend yield is calculated as dividend / stock price. So, what’s McDonald’s dividend yield? Well, the current stock price is ~$290. And the dividend last year was $5.66. So, the dividend yield is 2.0% ($5.66 dividend / $290 stock price)!

Well, the next thing to ask would be - is 2.0% a good dividend yield? And that’s a great question! Because it’s not entirely straightforward. The chart below shows us what the highest dividend yields are in the S&P500 right now…

Now, 2.0% seems super low vs some of the figures we see above. There are some stocks that have dividend yields over 10%! But be careful with these high dividend yields. Because remember, the dividend yields we see above are based on the dividend the companies paid out LAST YEAR. However, last year’s dividend is gone! It’s no use to us now! This year’s dividend is what’s important.

Let’s take the example of Newell Brands in the chart above. They’re the company behind the famous Yankee Candles. And their dividend yield looks enormous at 10.5%. Which means that an investor could make 10.5% a year from just dividend payments! Right?

Well, not quite (and this little part gets a bit technical, apologies)! Because remember, that 10.5% yield is calculated based on LAST YEAR’S DIVIDEND and TODAY’S SHARE PRICE. This is called the trailing dividend yield. We’re interested in this year’s dividend (called the forward dividend yield)! And this is where it becomes not too straightforward. Because a company that’s going through problems can have an artificially high dividend yield based on LAST YEAR’S DIVIDEND.

What do I mean? Well, sales for Newell Brands have been down 70% over the last year. And as a result, management decided to cut this year’s dividend by 70%. And this then led to a ~60% fall in the share price as investors sold off the shares. But think about what this does to the trailing dividend yield calculation. Because the denominator in the equation is 60% less, the dividend yield looks higher and better! Even though the company is in a much worse off position! So just a warning for anyone who wants to find high dividend yielding stocks through Google. Most likely, they’ll be looking at trailing dividend payments!

McDonald’s Stock Being Driven By Sentiment

Just before we wrap up, let’s take a quick look at how McDonald’s shares have performed over the last 10 years. Because this is fascinating. And to illustrate this, let’s rewind to Netflix. We saw that Netflix’s share price had increased 29% CAGR for the last 10 years. As EBIT had grown 32% CAGR during the same period. So the company’s share price pretty much perfectly reflected EBIT growth.

Do we see the same thing at McDonald’s? Absolutely… not! The table below shows us that from 2012/13 to 2022/23, the company’s EBIT is up 1.1x. But the McDonald’s stock price had increased 3.5x!

How does this work? Why have investors been buying up McDonald’s shares even when operating profit (EBIT) has hardly gone up? Well, there’s 2 reasons:

1. Share buybacks. EBIT is a great measure to look at usually. But when a company has been doing a lot of share buybacks like McDonald’s, we need to look at EPS (earnings per share). Because the share buybacks are reducing the number of shares outstanding at McDonald’s. And hence lifting EPS. So, whilst EBIT has only increased 1.1x, EPS in 2022 has actually increased 1.7x vs 2013.

2. Investors are hopeful for future growth. The strategy to focus more on franchised restaurants rather than operating their own. Has made the business less asset-intensive. What do I mean? Well, because the company needs to invest less capex in their own restaurants. The company can use that cash to buy more land/buildings to fund franchisee growth! Investors like that growth!

And evidence of investors liking that growth is seen below. The chart shows us how investors are now valuing McDonald’s on a P/E ratio of 30.1x vs ~15x back in 2013.

Will the valuation stay this high? Well, that’s probably the topic for another newsletter! But what we’ve been able to see is WHY the stock price has increased 3.5x since 2013. EPS has increased 1.7x. And the P/E ratio has increased 2.0x. What’s 1.7 multiplied by 2… about 3.5!

1st Jun 2023

Nigel Jacob CFA