Why a REIT Wasn't Right for McDonald's

By Rich DupreyFool.com

Some investors think the cure for McDonald's ills is sitting right underneath its golden arches, but the burger joint has a different idea on how it can return value to shareholders.

Cashing in on the value of its real estate isn't on the menu at McDonald's . Despite calls from numerous investors to spin off its restaurants into a real estate investment trust, the burger chain, which is struggling to turn around sales amid changing consumer tastes, says creating a REIT would be too risky and runs counter to its turnaround efforts. More likely it just doesn't want to give up a good thing.

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Franchisees currently pay McDonald's anywhere from 8.5% to 15% in rent, according to the chain's franchise disclosure documents, as well as royalties, which it admits enables it to generate significant levels of cash flow. But the rents, which totaled $6.1 billion in 2014, were twice the amount it realized from royalties. That's a lot of recurring revenue to give up.

Not always the REIT stuffBut REITs have become a go-to solution for activist investors looking for a quick return on their investment. Darden Restaurants , for example, just completed its own REIT spinoff of 430 Olive Garden restaurants to Four Corners Property Trust (NYSE: FCPT) after activist investors pushed for the move. However, it took private equity firm Starboard Value overthrowing the board of directors to get it done.

Bob Evans Farmshas similarly been under pressure from Sandell Asset Management to form a REIT following the hedge fund's gaining a number of seats on the board.

However, there might not be the same ability to mount a challenge to McDonald's board from outside investors, and the burger chain may just be right anyway in resisting the push, at least for the time being.

The resulting asset sale and influx of cash is only a temporary fix to what could be a deeper problem at a chain. For McDonald's, it first needs to fix its declining traffic and sales before it thinks about separating the restaurants from the company.

The market may be offering some celestial valuations on REITs at the moment, but it tethers the chain to what could be an unattractive arrangement, including higher rents it would have to pay instead of receive, and force it to keep underperforming restaurants in business because of long-term leases.

A shotgun approachWhile there can be differences of opinion over the direction McDonald's is taking in pursuing a strategy that seeks to compete against better-burger chains such as Shake Shack and The Habit, rather than tending to its base of being the destination of choice for a value meal, management is committed to righting a listing ship. It's possible it may be seeing the first fruits of that effort, too.

McDonald's enjoyed its first quarter of higher same-store sales in two years this quarter, as comps inched 0.9% higher in the U.S., and up 5% globally. While it's hard to believe it's really just adding butter to its Egg McMuffins and not a halo effect from launching all-day breakfast that caused the turnaround, it came at a crucial time for the burger joint, and now it needs to prove it's not just a one-off event.

The Golden Arches isn't immune to pleas for enhancing shareholder value, though. In rejecting the push for a REIT, McDonald's did lay out several specific goals for the next few years:

  • The number of restaurants refranchised, or sold to franchisees, would increase to as many as 4,000 through 2018. Earlier this year it had committed to refranchising 3,500 stores and it's now looking to be 95% franchise-operated.
  • It raised its targeted operational savings from $200 million to $500 million a year by the end of 2017.
  • It increased the dividend 5% to $0.89 per share payable on Dec. 15.
  • It plans to return to shareholders some $30 billion in cash for the three-year period ending 2016.

Not that such efforts won't cause problems. Standard & Poor's, for instance, just downgraded McDonald's credit rating to "BBB+" and said the company's credit metrics were "measurably worse."

McDonald's says it is "adding a meaningful amount of additional debt" because debt is cheap right now, but if it can't make that sales growth stick, McDonald's may find that none of its choices are the right one in the future.

The article Why a REIT Wasn't Right for McDonald's originally appeared on Fool.com.

Rich Duprey has no position in any stocks mentioned. The Motley Fool owns shares of Bob Evans Farms and has the following options: short December 2015 $55 puts on Bob Evans Farms. 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.

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