• Shares trading just shy of 52-week highs as company returns cash to shareholders
• Refranchising efforts to help with underlying profitability and reduce risks to the outlook
• Cost cutting has improved the bottom line but the top line shrinkage goes unabated

Fast food giant McDonald’s Corporation (MCD:NYSE) has finally started showing signs of life after a long period of disappointing performances. The company has seen sales drop for several consecutive quarters. A massive turnaround plan and an intense rebranding effort have led the company to the cusp of a breakthrough in 2016. Also, despite the company’s struggles, they have been able to continue increasing dividend payments and stock buybacks, although the sustainability of the company’s efforts might be a concern going forward. All in all, the new turnaround plan could have some unforeseen consequences and could lead to deleterious effects in the medium to long term.  

Turnarounds and New Outlooks

After a string of disappointing quarters and increasingly concerning sales trends, McDonald’s was at a crossroads. CEO Steve Easterbrook has led the company on an aggressive turnaround plan and a rebranding effort that has seen share prices recover from 52-week lows of $87.50 to record highs of $118.90, leading to analysts raising price targets for the company to as high as $130 a share.

A large part of this major turnaround has come from policies centered around improving the service and options provided in store, as well as attempting to change brand perception. So far, the company has pared down their menu offerings, and slightly tweaked their preparation processes in order to improve quality as well as lower wait times for food. Limited-Time offers (LTOs) have also been highly successful, as opposed to previous years’ efforts

The biggest in-store improvement, however, has been the introduction of all-day breakfast. Starting in October, stores in the US began offering the company’s popular breakfast options at all times, and the results were immediately positive. The new policy not only increased sales, but has already contributed to attracting new customers as well as increased sales of non-breakfast items. According to the latest figures, nearly one-third of customers who bought breakfast were new and almost two-thirds of customers who bought breakfast items also bought a non-breakfast item.

It needs be said that despite the current rebranding effort, McDonald’s still faces an uphill battle in changing consumers’ perceptions of the company’s products. As consumers shift to a more health-conscious mentality, McDonald’s has lost a lot of ground to companies that are perceived to be more health-friendly and transparent about their food practices.This is one area the company has yet to show improvement and is likely to weigh on the revenue guidance for quarters to come until it is more fully addressed.

Franchise Restructuring Efforts

On a larger scale, McDonald’s is also attempting to restructure the way it does business vis-à-vis its franchises. Until recently, the company has been an outlier in the industry as it still controlled almost a full fifth of its open locations. The company has been aggressive in closing locations that are not profitable as part of a continued effort to reduce costs. In the US, more stores will be closed this year than opened as McDonald’s works to optimize its operations.

The second front of the company’s franchise-related turnaround is an active move to drastically reduce the number of company-run locations. By 2018, McDonald’s expects to refranchise 4,000 locations, moving the company’s franchised position from 81% to 95%. The refranchising effort is expected to help the company significantly increase its margins by retaining the locations’ revenues while reducing the company’s liability and operating expenses.

Finally, the company has been aggressively attempting to cut costs across all of its segments. Already, McDonald’s has seen its costs drop significantly in restaurant operation and franchise expenses, as well as general operating income. The company has stated the goal of cutting an extra $500 million in general and administrative costs by 2017, which should help improve profitability even while revenues continue to decrease.

Potential Risk Factors

Despite struggling to improve revenues and margins, McDonald’s has developed a reputation as one of the best dividend stocks as a result of its business model that generates generous free cash flow. Historically, the company has been able to increase dividend payouts consistently. Today, McDonald’s pays out a $3.56 annual dividend, and dedicates a large portion of profits to dividends and share repurchases. The strategy has endeared the company to shareholders, but could have a potentially negative impact over the medium-to-long term.

The company has announced that it plans to return approximately $30 billion to investors by the end of 2016. The move, while great news to investors, places McDonald’s in a position to seriously harm its fundamentals and its balance sheet.Even with fantastic cash flow of $4 billion for the first three quarters this year, the company will have to take on approximately $10 billion in debt in order to finance buybacks and dividends. As a result, Standard & Poor’s has downgraded the company twice in 2015 from A to BBB+ which could affect the company’s fundamentals in the long-term as it loses flexibility in its balance sheet and borrowing costs rise.

The Fundamental Perspective

While on a bottom line basis investors and analysts are cheerleading McDonald’s latest efforts, the outlook sees the predominance of downside risks.The blistering 1-year return of 26.25% while reflective of improvements in the company’s operation, hides the fact that revenues contracted 5.00% to $6.62 billion year over year in the latest quarterly report.The accounting gimmicks of buybacks to raise share prices and return cash to investors is not necessarily the wisest course of action considering the company’s existing debt load and rising interest rates.From a valuation perspective, the current price-to-earnings multiple of 25.42 for McDonalds is well above historical averages for broader indices but the middle of the range with respect to comparable companies.

Aside from the concerns about revenues, borrowing additional cash to finance buybacks and dividends is not a sustainable path.Despite strong cash flows and reduced risks thanks to the franchise business, if nothing is done to improve the revenue outlook, buybacks are likely to be scrapped first, followed by the dividend.Although the present dividend yield of 3.02% is enticing for income investors, chances are this will improve especially once concerns about sliding revenues resurface.While trading just below 52-week highs, McDonald’s shares are in for a deeper pullback back towards $110 per share, marking a better entry level for both value and dividend investors seeking to capitalize on a continued trend higher in share prices.

Conclusion

McDonald’s stands at a crossroads heading into 2016. While the company has shown a strong willingness to change and improve the way it does business, some of its practices which have made it a blue chip dividend stock could eventually land the company in a very uncomfortable position as its fundamentals are seriously harmed by quickly taking on large amounts of debt. Despite its pledge to return profits to investors, McDonald’s might be doing itself more harm in the long run. If the company can manage to keep investors satisfied by returning capital and turn around sliding revenues, 2016 could see the fast food giant’s shares soaring to new highs on increased optimism even though the prevailing factors point to a correction in shares before a prolonged rally.