McDonald's (MCD) did well in the fourth quarter, and reported a year of earnings growth. The way they're deriving that growth still continues to trouble me. McDonald's has carried out a large initiative of refranchising, thereby cutting down its corporate expenses. It's certainly not a bad strategy to a degree, but over the long term, it doesn't seem like a viable means of growth. As franchising cuts down on corporate expenses, it also cuts down on corporate revenues. Indeed, the company's share of 4.4% global same store sales growth was not what it used to be.
Granted lower revenue business can certainly outpace a high revenue business in terms of earnings, but I don't like what's happening to MCD's operating income. I also don't like what's happening on the balance sheet. McDonald's has taken on a grandiose amount of debt. It's the kind of debt that only a much larger enterprise should have. What happens when McDonald's runs out of stores to franchise? What happens when that earnings trick ends and the company has to derive further earnings from revenue growth? Comp sales experienced growth in the fourth quarter as well as the full year, but MCD's overall operating income still declined. If anything, lower taxes were a big part of this year's profits.
Total revenues declined 3% in the fourth quarter. Corporate store revenue declined 11% to $2.37 billion, while franchise restaurant revenue increased 5% to $2.79 billion. When you compare the trade-off from refranchising, MCD's company business revenue declined $301.9 million, while franchise revenue increased a lesser $124.7 million. When you compare the operating expenses incurred from company locations relative to franchises, you can see why McDonald's opted to cut company owned stores. The company currently derives more revenue from franchises, and pays a fraction of the expenses to keep them in operation. Franchise revenue of $2.79 billion cost McDonald's occupancy expenses of $509.7 million. In contrast, company store revenues of $2.37 billion cost the company $1.95 billion in expenses, a much higher ratio of its sales.
In all, operating income took a 7% hit in the fourth quarter, falling $144.7 million to $1.99 billion. This to me is the problem. I think operating income should be at the very least steady if the efforts of refranchising are to produce full benefits that outweigh the loss of sales revenue potential.
So where did MCD's earnings come from if they had lower overall operating margins? The answer is taxes. Income before taxes decreased 7% in the quarter, while provisions for income taxes decreased 72% to $336.1 million. This allowed McDonald's to report a 103% increase in net income year over year to $1.42 billion. Combined with a lower overall share count from buybacks, the resultant earnings per diluted share increased 109% to $1.82 per share.
For the full year, revenue fell 8% to a little over $21 billion. Operating income declined 8% to $8.82 billion. Income before taxes declined 9%, while provisions for taxes decreased 44%, driving net income up 14% for the year to $5.92 billion. Earnings per share increased 18% to $7.54 per diluted share.
On an earnings basis, it's great for shareholder news. The company beat estimates and bulls will likely lean on the refranchising story as a means for riding the continuation of unlocked value. Higher global sales were also a strong selling point. That's all well and good, but it's not a long term strategy for the business itself. There are a lot of issues in the underlying financials that are not being addressed. McDonald's does not have a pretty balance sheet. U.S. and same store sales underwhelmed at 2.3% vs. 2.4% expected. Those store sales might not seem that bad. And with global same store sales growth of 4.4%, the problem certainly seems mute. But the U.S. is by far McDonald's biggest market in terms of revenue. They can't have their domestic market falter or they'll be suffering a cannibalization of overseas expansion.
Over the past few years, McDonald's has also relied on share buybacks and dividends to keep the stock attractive. This has resulted in a lot of long term debt. At the end of the fourth quarter, McDonald's had $31.08 billion in long term debt. That giant debt load is weighing heavily on the balance sheet, bringing shareholders equity to a deficit of over $6.2 billion. With a little over $800 million in cash, the company most certainly cannot pay it off either.
Played out over the next 10 years, I worry that McDonald's will hit a point where it can no longer derive further earnings value from refranchising. When that happens, the lower revenue streams will limit what the company can do. Let's face it, the market is pretty saturated with McDonald's stores. I don't think there's a huge growth story for further store openings within the U.S. They have to derive store sales growth from their current store base. Rather than putting their full resources into prudent moves, they've spent a lot of money on stock. The debt load seems too high, and they don't have the capital to do anything major.
Simply put, an investment in MCD is a question of short term value potential versus long term liabilities. If you want to try to eke out more earnings gains from further refranchising, perhaps there's a play here. Trading at roughly 24.8x full year earnings, I think the stock is too high for an accelerated run from here. Granted I've been wrong about MCD's performance before. Investors seem to have a high tolerance for the company's liabilities due to its time honored performance. Over the long term, I think I'm going to be proven right.