Confidence Increases in McDonald's Turnaround

As we've expected since it laid out the initial turnaround plan in May, McDonald's set more-aggressive refranchising and cost-reduction targets, calling for 4,000 refranchised locations by the end of 2018 (versus earlier goals of 3,500) and $500 million in annual net general and administrative cost cuts by the end of 2017 (up from $300 million). While we've said McDonald's could unlock tax savings through a real estate transaction, our conversations with management made it clear that franchisees did not support a REIT spin-off. As franchise cohesion is a critical intangible asset behind our wide moat, we agree with the decision to pass on a REIT transaction. Management also announced plans to take on debt to fund an additional $10 billion in share repurchases and dividends in 2016, which we view as prudent from a shareholder perspective, given current interest rates, as well as move to a more franchised model.

Reaping Rewards of Reorganization CEO Steve Easterbrook passed his first investor day as CEO with high marks. True to the vision laid out shortly after his appointment, there has been a shift in the level of organizational accountability, customer centricity, and process simplification, each of which adds to our conviction in McDonald's longer-term turnaround. It's also clear that Easterbrook's decision to reorganize the company into four segments based on the maturity and competitive position of its different markets is positively affecting results, which has led to rapid improvements in the level of cohesion and communication among executives, franchisees, suppliers, and marketing teams across the globe.

This is most apparent in the international lead segment (Australia, Canada, France, Germany, United Kingdom), where innovations in each country are establishing a blueprint for more sustainable growth across the entire system. We walked away from the investor event more constructive about the "full restaurant" model rolled out in France earlier this year, which is perhaps the best example of a McDonald's format fully integrating ordering flexibility (including counter, kiosks, Web, and mobile ordering), menu customization (including the ability to custom-build burgers, chicken sandwiches, and salads), and customer experience (including a blend of front counter, table service, and curbside kiosks). Innovations like these--which have also been successful to some degree through the Experience of the Future rollouts across each of the other international lead markets--contribute to our comfort with the company's guidance for positive same-store sales across all regions in the fourth quarter, which will probably persist through the first half of 2016, though international lead markets will begin to face more difficult comparisons in the second quarter. Management's initial 2016 outlook--including 3%-5% systemwide sales growth, 5%-7% operating income growth, return on incremental invested capital in the high teens, and capital expenditures of approximately $2.0 billion, split evenly between opening 1,000 new restaurants and reinvesting in existing restaurants--is aligned with our model and strikes us as realistic based on the current turnaround momentum.

Although adapting innovations from international lead markets will take additional time to implement in the United States given the region's size and competitive set, we're becoming more constructive on the longer-term opportunity for the company to return to sustainable comparable sales growth in the low- to mid-single-digit range. Our confidence stems from recipe changes using higher-quality ingredients and changes to and incremental investments in labor and training, driving improved speed of service and order accuracy metrics and helping to boost comparable sales in the U.S. even before the launch of all-day breakfast in early October. While the rollout of all-day breakfast has exceeded management's expectations and is likely to bring U.S. transaction counts to positive territory in the fourth quarter, we still believe the more important takeaway is that the program went from a single test market in May to nationwide rollout in October. This implies that McDonald's is overcoming its recent supply chain execution hurdles while demonstrating a greater level of coordination across the system, which we think portends a more seamless rollout for new products, promotions, and other in-store innovations in the future, including a revamped national value platform emphasizing bundling in 2016 and digital menu boards that automatically adapt using consumer data.

Positive on Refranchising Plans We generally take a positive view regarding refranchising efforts, as we believe these can reduce a restaurant company's operational and financial risks, bolster return on invested capital metrics by lowering a company's invested capital base and transferring capital responsibilities to franchisees, and provide additional cash proceeds that can be used for other shareholder-enhancing activities or debt reduction where prudent. Additionally, we believe current cap rate conditions are conducive for more aggressive refranchising activity. In that vein, we support McDonald's goals to refranchise 4,000 locations through 2018--implying roughly 1,000 locations per year over that time frame, with the majority of the refranchising taking place in the company's high-growth and foundational market segments, but also some activity in the U.S. and international lead segments--and move to a 95% franchised structure over a longer horizon. While we're positive on the company's refranchising plans, we're also encouraged by the selection criteria that management uses to determine in which markets it will keep a company-owned presence--including a strong competitive position, low top-line volatility, large market size, sustainable high teens margins, and strong free cash flow--which we believe can optimize the company's returns on capital over a longer horizon.

Management's goal of reducing annual general and administrative costs by $500 million by the end of 2017 (compared with earlier estimates calling for $300 million) strikes as realistic, given the aforementioned refranchising efforts (even after factoring in restaurant modernization co-investment projects that will also come with the refranchising targets), a streamlined corporate expense structure, and greater efficiencies out of its global business services platform. While this would represent a 20% reduction in total G&A spending compared with the end of 2015, we would be surprised if the company did not ultimately find incremental opportunities for further G&A reductions in the years to come, going even further beyond its stated target of being below an industry G&A average of 2.5% of sales.

REIT Transaction Tabled We appreciated the level of detail that chief administrative officer Pete Bensen went into with respect to the company's analysis regarding a potential real estate transaction and the decision to ultimately not pursue a REIT spin-off. Citing analysis performed on several types of transactions (including a REIT spin-off and sale leaseback) and variables (including the portfolio of properties to be included, market-based rents, operating company structure, tax considerations, and regulatory environment), the company did conclude that a master lease REIT spin-off encapsulating roughly 8,000 full-owned and some franchised locations, representing market-based annual rents of $1.5 billion-$2 billion, would be the optimal real estate transaction to explore. However, management ultimately decided against this route, naming concerns about impediments to the company's operational turnaround efforts; potential disruption to the company's relationship with its franchisees; recent cautionary statements from the Internal Revenue Service regarding real estate spin-offs; and the possibility of longer-term brand impairment. Our follow-up conversations with Bensen revealed that the company also explored possible transaction structures where franchisees would more directly participate in the REIT structure, but ultimately could not garner support among franchisees because of the potential for longer-term changes to current leasing terms. Given this context, we believe management made the right decision not to pursue a real estate transaction, even with the potential tax savings involved.

Although management plans to refine its longer-term strategies and financial targets during the second quarter of 2016, we don't expect major changes to our longer-term discounted cash flow assumptions. These include mid-single-digit consolidated system sales growth (on a constant-currency basis) and low- to mid-single-digit consolidated revenue growth, driven largely by new unit openings from the international lead and high-growth market segments as well as a return to low-single-digit comparable sales growth through new menu innovations, modernized customer experience, and inflationary price increases across each region. From a profitability standpoint, we expect an inflection point for operating margins in 2016; our model already calls for 6% growth in 2016 (in line with management expectations of 5%-7% growth and compared with expectations of a 10% decline in 2015), implying roughly 30% operating margins next year. Over the next 10 years, our model assumes that consolidated operating margins reach the mid-30s, driven by higher franchisee rent and royalties, refranchising activity, increased emerging-market franchise openings (including China), and margin-friendly menu additions, but partly tempered by labor and occupancy cost inflation.

Dividend Increase Disappoints, but We Expect Further Growth Additionally, as McDonald's moves to a less asset-intensive structure via a more heavily franchised structure, we're comfortable with management's decision to return an additional $10 billion to shareholders via share repurchases and (to a lesser extent) dividend increases in 2016, which comes on top of the company's previous 2014-16 cash return target of approximately $20 billion. Given that a cohesive franchisee system is one of the key attributes behind McDonald's intangible asset moat source, we appreciate management's emphasis on maintaining investment-grade ratings--CFO Kevin Ozan noted that the company is targeting a BBB+ rating--which we believe will still allow franchisees to borrow at attractive interest rates for new restaurants or existing restaurant improvements. However, as the company's turnaround plan becomes more visible, we're also comfortable with company taking on additional leverage, as the expected cash flow stemming from refranchising activities should help the company quickly pay down its debt position, which will stand at a little more than 3 times EBITDA after its proposed transactions, still well below the 5-plus times debt/EBITDA ratio for many heavily franchised quick-service peers.

Perhaps the only disappointment among the company's capital-allocation announcements was the 5% increase in the quarterly dividend to $0.89 ($3.56 on an annualized basis, or a 3.2% yield at current prices), below our expectations of a 7% increase in 2016. That said, we view this as conservatism as management continues to implement turnaround plans, and we still expect dividend growth to accelerate in the later years of our longer-term forecast.