Profitable Restaurants Reporting Negative Equity: Causes and Implications for Investors

Abstract

While typically characteristic only of insolvent businesses, negative shareholders’ equity has become more common among healthy, profitable businesses. Many are large restaurant chains, including McDonald’s, Starbucks, Yum! Brands, and Papa John’s. Since none of the above reported negative equity a decade ago, a close study of each company’s financial statements over the period 2010-2019 revealed how these deficits came about. Each company was able to pay out, as dividends and share repurchases, well over 100% of its reported earnings during the period. Interestingly, this is not because earnings understated each company’s cash-generating capability; in fact, there is strong evidence that earnings overstated reality for McDonald’s and Yum! Brands. In general, the primary driver was massive debt issuance, followed by refranchising (selling company-operated restaurants to franchisees). Of the four companies, Starbucks has the highest ability to continue distributing over 100% of earnings, while Yum! Brands does not appear to have much more room to do so. Each company was able to push equity negative because of the wide spread between its return on assets and cost of liabilities. Each has negative net working capital, which is essentially a cost-free source of funding, and was able to issue massive amounts of debt at low single digits rates. Meanwhile, return on assets averaged between 15-30% (due to powerful unrecorded intangible assets like brand and supply chain capabilities). The extreme case is Yum! Brands, whose debt at the end of 2019 was around twice the level of total recorded assets, yet their interest coverage ratio was a fairly comfortable 4.0x. There are a few important implications for investors. First, negative equity is characteristic of companies on opposite ends of the business quality spectrum. Secondly, for many companies, metrics involving equity have lost their relevance and should be ignored. Next, issuing debt to repurchase shares can be a great strategy if cost of equity greatly exceeds cost of debt, but it carries substantial risk if done too aggressively (the primary risk being that interest rates are substantially higher in the future). Lastly, businesses that appear overvalued using traditional metrics like price-to-earnings may in fact by greatly undervalued, as is the case for one that can distribute well over 100% of reported earnings for an extended period of time.