The strong growth in McDonald's earnings over the past 20 years it is not a coincidence. Factors such as a strong brand (and also a very huge advertising budget of $788 million in 2012), a franchisee system (that reduces the company's capital requirements) and international expansion (last year the company spent $2.9 billion toward unit openings and modernization) make good profitability numbers. The return on equity (ROE) grew from 13.20% in 2003 to 36.80% in 2012. Also, McDonald's generates excellent free cash flow and returns on invested capital.
A key driver of the company is “Menu Innovation” which also has played a role in its productivity. In 2013 those innovations are based on four key growth categories: chicken, premium beef, breakfast and beverages. For example, a firm's beverage initiatives are the McCafe coffee and real fruit smoothies.
Moreover, the company expects to continue to execute its corporate strategy, "Plan to Win," which was laid out several years ago. The plan has five pillars: People, Products, Place, Price and Promotion. The plan plus financial discipline will deliver cash for its shareholders. It is important for investor to take into consideration that since the inception of its dividend payout policy, the company increased dividends every year. The last dividend increase was in September 2013 when the board of directors approved a 5.2% increase to 81 cents per share. The company pays an annual dividend of $3.24 which, at its current stock price, produces a yield of 3.07%, above both the Hotels, Restaurants & Leisure industry average of almost 3% and the average stock in the S&P 500 Index at 2.1%.
In terms of valuation, the stock sells at a trailing P/E of 17.9x, trading at a discount compared to an average of 23.5x of the industry. Analysts’ expectations imply a forward P/E of 16.07. At that P/E it seems cheaper compared to the industry average.
The company's largest competitors include Burger King, Subway and Yum! Brands Inc. (YUM). Although the China division of the company was very profitable in the recent past (42% of total operating profit in 2012), the subsidiary was in trouble due to allegations regarding the quality of chicken supplied to KFC. This controversy could make a decline in 2013, added to another factor, the fear of avian flu. Furthermore, an overall economic slowdown in China is likely to threaten the company´s growth, because Yum is more sensitive to fluctuations in the region than its peers.
The profitability of the companies is driven by the ability to reach new markets and meet customer needs. As we have seen before, it will take time to restore KFC's reputation in China following negative publicity. On the other hand, McDonald´s aims to register growth by increasing restaurant visits, providing value, innovating new menu items, re-imaging its restaurants and marketing campaigns. The company maintains its long-term financial target of 3% to 5% sales growth and 6% to 7% operating income growth.
By owning quality stocks like McDonald´s, investors would collect dividends each and every year. Hedge fund gurus like Louis Moore Bacon, Joel Greenblatt, Jim Chanos and Jim Simons added this stock to their portfolios, and I would advise fundamental investors to consider adding McDonald´s to their long-term portfolio.
DIsclosure: Damian Illia hollds no position in any stocks mentioned.