McDonald’s Corporation — Q2 2016 Form 10-Q
Reporting period: Quarter and six months ended June 30, 2016. Financial statements are unaudited; amounts are U.S. dollars unless stated otherwise.
Business context and performance
McDonald’s operated or franchised 36,504 restaurants in 120 countries at June 30, 2016. Of these, 30,367 were franchised or licensed and 6,137 were company-operated. Management’s strategy emphasized refranchising, cost savings, returning capital to shareholders, and improving the customer experience, with a long-term goal of being 95% franchised.
- Global comparable sales increased 3.1% in Q2 and 4.6% for the first half, with positive growth in all segments. U.S. comparables rose 1.8% and 3.5%, respectively; International Lead Markets rose 2.6% and 3.8%; High Growth Markets rose 1.6% and 2.6%.
- Consolidated revenue declined 4% in Q2 and 2% for the first half as reported, but was down 1% and up 1%, respectively, in constant currencies. Refranchising lowered reported revenue by shifting company restaurant sales to franchise royalties and rent.
Financial results and financial position
- Q2: Revenue was $6.265 billion, down 4%; operating income was $1.858 billion, essentially flat as reported and up 3% in constant currencies. Net income was $1.093 billion, down 9%; diluted EPS was $1.25, down 1% as reported and up 1% in constant currencies.
- First half: Revenue was $12.169 billion, down 2%; operating income was $3.638 billion, up 12% as reported and 16% in constant currencies. Net income was $2.218 billion, up 10%; diluted EPS was $2.51, up 20% as reported and 23% in constant currencies. First-half operating margin was 29.9%, versus 26.0% in 2015.
- Margins: Company-operated restaurant margin was 17.1% in Q2 versus 15.6% a year earlier, and 16.3% for the first half versus 15.0%. Lower food and paper costs helped; higher payroll and employee benefits costs, including wage investments, were a partial offset. First-half franchised margin was 81.2%, versus 81.0%.
- Cash flow, first half: Cash provided by operations was $2.994 billion, down from $3.213 billion. Capital expenditures were $744 million; operating cash flow exceeded capital expenditures by $2.3 billion. Investing used $460 million, while financing used $7.116 billion, primarily reflecting share repurchases and dividends. Cash and equivalents fell to $3.128 billion from $7.686 billion at year-end.
- Debt and liquidity: Long-term debt was $26.010 billion at June 30, up from $24.122 billion at December 31, 2015. Current assets were $5.047 billion and current liabilities $2.667 billion. The estimated fair value of debt was $28.6 billion versus a $26.0 billion carrying amount. Management cited substantial operating cash flow, investment-grade credit and continued credit-market access.
- Shareholder returns: The company repurchased 57.0 million shares for $7.1 billion during the first half and paid $1.5 billion in dividends. It declared $0.89 per share for Q2, versus $0.85 a year earlier. The company reported cumulative shareholder returns of about $24 billion toward a $30 billion three-year target ending 2016.
Material changes and unusual items
- Results included approximately $230 million of strategic charges, primarily non-cash impairment charges related to refranchising and G&A initiatives and the headquarters relocation. Prior-year comparison included charges of $45 million in Q2 2015 and $240 million in the first half of 2015. Excluding current- and prior-year charges, diluted EPS increased 13% in constant currencies in Q2, with no significant change for the first half.
- Interest expense rose 50% in Q2 and 49% in the first half, mainly due to higher average debt balances associated with the capital-structure plan.
- Foreign currency translation reduced diluted EPS by $0.02 in Q2 and $0.06 in the first half. The stronger U.S. dollar against the British pound and most currencies weighed on results.
- McDonald’s early-adopted share-based payment accounting guidance in Q2. Excess tax benefits reduced income tax expense by $17.6 million for Q2 and $43.8 million for the first half; the adoption also changed classification of certain cash flows.
- A $2.6 billion accelerated share repurchase agreement begun in Q2 was completed in July; an additional 5.1 million shares were delivered and retired, bringing total deliveries under that agreement to 21.3 million shares.
Outlook, commentary and risks
- The company did not provide specific EPS guidance. For 2016, it expected net restaurant additions to contribute about 1 percentage point to systemwide sales growth in constant currencies; U.S. commodity costs to decline 3.5%–4.5%, with International Lead costs relatively flat; and SG&A to decline 1%–2% in constant currencies, excluding specified incentive compensation and refranchising timing effects.
- Management expected full-year interest expense to increase 40%–45% versus 2015, an effective tax rate of 31%–33%, and capital expenditures of about $2.0 billion. It expected approximately 1,000 restaurant openings and net additions of about 500.
- The company continued to target approximately $30 billion of shareholder returns for the three years ending 2016, with about $6 billion remaining after June 30. Longer-term targets included refranchising about 4,000 restaurants through 2018 and achieving approximately $500 million in annual G&A savings, mostly by the end of 2017. Further strategic charges may occur.
- Management cited the U.S. All-Day Breakfast expansion planned for fall 2016, food-quality and sustainability initiatives, and modernization of restaurants as elements of its turnaround effort. The company noted that execution and results are not assured.
- Key risks include intense competition and changing consumer preferences; execution of refranchising and cost-reduction plans; dependence on franchisee performance; commodity and labor cost volatility; currency and economic exposure; food safety, brand and regulatory risks; litigation; and increased leverage and funding costs. The U.K.’s decision to leave the EU was also identified as a source of currency and economic uncertainty.
- The company expects lease accounting guidance to materially affect its balance sheet, while evaluating its income-statement effect; it expects no cash-position impact. It was also evaluating the impact of the new revenue-recognition standard.
Important facts for investors to verify
- Whether comparable-sales momentum persists and translates into systemwide sales, guest counts and sustainable operating-income growth.
- Whether refranchising improves cash-flow stability and margins while limiting revenue dilution and franchisee-related risks.
- The composition and cash/non-cash nature of the approximately $230 million strategic charges, and the timing and realization of G&A savings.
- Debt growth, interest expense, credit ratings and the company’s capacity to meet shareholder-return targets alongside investment needs.
- Full-year outlook assumptions, especially commodity costs, foreign exchange, tax rate, capital spending and restaurant additions.
- The effects of lease-accounting adoption and the July settlement of the $2.6 billion share repurchase agreement.