The Long-Term Risk in McDonald's Turnaround Plan

One of the more fascinating slides presented during McDonald's annual investor meeting held on November 10th. Image source: McDonald's Corporation.

At McDonald's Corporation's annual investor meeting held earlier this month, executives updated shareholders on a number of significant items, including the widely reported decision to forego pursuing a REIT spin-off transaction of company-owned real estate. McDonald's also told shareholders that it now expects to reduce its general and administrative, or G&A, spending by 20%, or approximately $500 million, by the end of 2017.

But two other announcements, while not dominating headlines, nonetheless should give investors pause when taken together, as they have long-term implications for the company's financial course going forward. Let's delve into these decisions below and try to assess their future impact.

Caution No. 1: dispensing with a core strengthDuring the meeting, McDonald's confirmedthat it wants to be a completely franchisee-driven organization, in the mold ofDunkin Brands Group Inc orRestaurant Brands International Inc'sBurger Kingchain. Management disclosedthat it will refranchise, or sell to franchisees, 4,000 company-owned locations through 2018. This will take McDonald's to a 93% franchised position, and the company stated its intention to eventually be 95% franchised.

At present, McDonald's has one of the highest percentages of company-owned stores among its major peers, at roughly 19%, meaning it's only 81% franchised. Both Dunkin' Brands and Burger King are nearly 100% franchised. McDonald's is undoubtedly attracted to the idea of increasing its royalty income without incurring the heavy operational expenses of being its own store owner-operator.

To explain this in terms of margin, the locations McDonald's owns generate a 15.2% operating income margin before any corporate G&A and other expenses are applied. Franchised stores, however, deliver a margin of nearly 82%:

All dollar figures in billions. Author's calculations. Image source: McDonald's Corporation SEC Filings.

The revenue the company derives from its franchisees as royalty and fee income has only one significant cost against it: the occupancy expenses McDonald's incurs as a landlord to the bulk of its restaurants.

As you can infer from the chart, refranchising more restaurants will have a positive impact on McDonald's total margins, as well as its cash flow, since capital expenditure requirements will decrease.

However, despite being lucrative for McDonald's, this arrangement doesn't have the financial flexibility the company enjoys by keeping one-fifth of all restaurants to itself. McDonald's turns out to be pretty good at running its locations. And it books a tremendous amount of revenue from its own outlets -- $12.5 billion through the first three quarters of this year.

As a restaurant operator, McDonald's has the ability to make cost improvements that provide operating leverage to the entire organization.

To illustrate, what would a 3% improvement in operating margin (before G&A expenses) in the first column of the chart mean to the company?

If you could apply an incremental 3% improvement to the first nine months of this year, you'd see a $375 million gain in the company's overall bottom line. That's a huge number, equal to 11%of the total $3.3 billion in net income McDonald's has booked in the first three quarters of 2015.Small expense efficiencies on a massive revenue base can translate into significant earnings power.

In copying its competitors on the road to becoming fully franchised, McDonald's will join them in giving up this one crucial and core strength: the ability to control operating leverage, and thus significantly impact profits. After moving to a fixed model where it simply receives royalties and rent checks from its partners, while providing marketing and corporate services, McDonald's will be left with only one lever to really adjust profits -- expand the revenue coming in from franchisees.

It can do so by helping franchisees boost their sales, bumping up the number of franchisee locations, or both. But this year, for the first time in decades, McDonald's will have a net reduction in total restaurants. Thus, unabated, year-in and year-out store count expansion shouldn't be taken for granted.

Finally, under this new model, McDonald's could theoretically juice profits by more G&A cost cutting (as mentioned in the first paragraph of this article). Personally, I'm skeptical -- those expenses typically increase as the burden of supporting franchisees rises.

Caution No. 2: Adding atypical leverageApparently to give investors plenty of reason to hang around besides its turnaround plan, McDonald's is giving its shareholders a mammoth amount of cash -- $30 billion -- by the end of 2016, in the form of dividends and share repurchases.

Even the company's tremendous cash flow -- to the sum of $4 billion in free cash flow through three quarters of the fiscal year -- isn't enough to supply ready money for this goal,so management has decided to leverage the balance sheet, and it reported to shareholders on November 10th that McDonald's will take on $10 billion in debt to fund the initiative.

The debt by itself is more than a bit worrisome: Standard & Poor's rating agency downgraded McDonald's debt rating in May from an "A" rating to "A-" when the company disclosed its plan to return $8.5 billion to shareholders in 2015 through dividends and share repurchases. On November 10th, when the new borrowings were announced at the investor meeting, Standard & Poor's again downgraded McDonald's debt, this time to "BBB+."

While this rating is still considered investment grade, which is the highest rated category of debt, the triple-B designation is at the threshold of the next category of credit quality: dreaded "BB" status or lower. It would now take only three more downgrades for McDonald's credit to be rated speculative, or "junk."

For a company that takes pride in keeping a pristine balance sheet, this magnitude of borrowing is disconcerting. But more to the point, these two significant changes, a future loss of financial flexibility and added leverage, could together make life difficult for McDonald's should the company suffer another multi-quarter sales retracement a few years from now.

After all, it's difficult to envision that McDonald's will cease its borrowings after 2016. Management has, in the space of a few months, created an expectation that, in addition to an extremely handsome dividend (currently yielding 3.13%), shareholders will also keep benefiting from outsized share buybacks.

Lest we stay too long in positing what might happen to McDonald's under these new conditions, we can look to competitors who've already arrived at this juncture. A quick-service restaurant chain that is nearly 100% franchised, highly leveraged, and attempting growth through new store expansion, can be found in Dunkin' Brands. The popular coffee and doughnuts retailer has watched its stock reverse course abruptly this year as investors begin to question how much earnings growth can be achieved through its business model going forward.

I've written a detailed analysis of the challenges facing Dunkin' Brands, which can also be read as a cautionary tale about McDonald's recent actions, here. Ironically, in this article, published about a month before McDonald's recent investor meeting, I lauded the golden arches for operating roughly 20% of its restaurants and maintaining relatively manageable debt. It's surprising how quickly a promising turnaround has become muddied when you try to envision McDonald's future in the context of two major decisions.

The article The Long-Term Risk in McDonald's Turnaround Plan originally appeared on Fool.com.

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.