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Daniel Seens
Daniel Seens
Articles (92)  | Author's Website |

McDonald's Looks Delicious

McDonald's is an attractive company from a purely dividend perspective

December 22, 2015 | About:

McDonald’s Corporation (NYSE:MCD) is the owner and franchiser of one of the world’s most recognizable brands. Who doesn’t recognize those iconic “Golden Arches?” The arches symbolize the availability of quality food, treats and drinks sold at reasonably affordable prices in more than 100 countries. As of year end 2015, there were approximately 36,000 locations serving approximately 69 million customers in over 115 countries.

Company revenues come from the payment of rent and royalties based upon a percentage of sales, with specified minimum rent payments, along with initial fees paid upon the opening of a new restaurant or granting of a new franchise.

More than 80% of McDonald's restaurants worldwide are owned and operated by independent local business men and women, with about 7,200 operated by the company. The company’s franchise structure enables individuals to own the restaurants and maintain control over personnel, purchasing, marketing and pricing decisions while using the McDonald’s global brand, product lines and operating systems. Under a conventional franchise arrangement, McDonald’s purchases the land and building or secures long-term lease arrangements for the location and the franchisee pays for equipment, signs, seating and décor.

McDonald’s is without question the most dominant firm within the fast food hamburger market with an approximate 45% market share. Burger King (BKW) and Wendy’s (NASDAQ:WEN) remain the next largest competitors with many smaller firms, including Sonic Corp. (NASDAQ:SONC) and Shake Shack Inc. (NYSE:SHAK), gaining share in recent years. In the overall fast food market, McDonald's has been consistently ranked as the most valuable food brand. According to Statista, Starbucks (NASDAQ:SBUX), the second-most valuable brand in the world, had an estimated value of $29 billion. McDonald's easily surpassed this with an estimated brand value of about $81 billion.

As the most recognizable fast food chain in the United States, it is also interesting to note that about two-thirds of its revenues are generated from outside the U.S.

Recent financial highlights

  • U.S. third quarter comparable sales increased 0.9%, the segment's first quarterly comparable sales increase in two years led by new product launches including its Crispy Chicken Deluxe sandwich.
  • Comparable sales for the International Lead Markets segment increased 4.6% for the third quarter led by strong performances in Australia, the U.K. and Canada and positive results in Germany.
  • In the High Growth Markets segment, third quarter comparable sales increased 8.9%, reflecting very strong comparable sales performances in China and positive performances in most other markets.
  • Overall, consolidated revenues decreased 5% due primarily to the significant increase in the U.S. dollar.
  • Consolidated operating income decreased 2% (increase of 10% in constant currencies).
  • Diluted earnings per share were $1.40, an increase of 28% (44% in constant currencies). The market expected EPS of $4.81 for 2015.
  • In addition, the company returned $3.1 billion to shareholders through share repurchases and dividends. This brings the year-to-date return to shareholders to $7.1 billion against its targeted return of $8 billion to $9 billion in 2015.

Purchase considerations

  • One of the biggest reasons for McDonald's success has been its ability to consistently develop new menu offerings. We think this is going to continue long into the future and will provide the necessary margin support to hold company value.
  • We like that management continues to divest and convert corporate-owned stores to franchise arrangements. Company-owned stores are generally less profitable. Franchise rent and royalty fees are a very stable and predictable source of income with lower capital requirements than company-owned stores. We think this will help to support free cash-flows moving forward.
  • We really like the progress the company is making with store renovations and up-fits: new styling and marketing excellence are helping to attract new younger customers and retain older ones.
  • We like that McDonald's strategy remains committed to offering a diversified mix of healthier food items for the more weight/health conscientious consumers.
  • We like management’s strategy to expand store hours in key high volume locations to boost revenues. Customer surveys indicate that clients have responded favorably to this initiative.
  • We like the firm’s international expansion opportunities, particularly in China and other Asian markets where local menus will need to be refined but for which the convenience benefits of fast food are only starting to be realized.

Reasons for caution

  • Fast food restaurants remain, and will likely continue to remain, at the center of the debate regarding the childhood and adult obesity problems in the U.S. Management will have to continue to fight this negative publicity and adopt product lines that are viewed favorably by private and public health organizations.
  • State, provincial and other regional laws requiring food establishments to use menus and signs that post caloric counts could negatively alter consumers' buying behavior. The effect of these changes on the bottom line is yet to be seen, but customer survey results do suggest a shift in purchases away from hamburger items toward more grilled chicken items.
  • We dislike how sensitive the firm is to ingredient price swings and supply/demand imbalances in the potato, chicken and beef markets.
  • The company has enjoyed a long uptrend in the stock price, primarily on account of growing earnings, but the recent slowdown in sales could be an early indication that similar growth in the stock price might be difficult to sustain and could actually fall.

Dividend vitals: McDonald’s offers an attractive yield of 3.1%

We are always on the hunt for dividend-paying businesses with strong and stable operating cash flows. Ultimately, when buying a stock for dividends, we want to invest only in companies that have long histories of rising, stable, uninterrupted dividends that exceed yields on long-term government bonds and that have low payout ratios.

McDonald's has a dominant competitive position in its respective markets, and the company continues to be very shareholder-friendly. McDonald's has paid dividends every year since 2000, and the dividend yield is 3.1%. In 2014, McDonald's increased its annual dividend to $3.28 per share. Dividends increased 19.6% per year since 2004 compounded annually.

The company offers one of the most attractive and stable dividend streams and has not rejected or reduced its dividends during any economic slowdown over the last two decades. We doubt management will do anything to compromise its long-term track record of annual payouts, regardless of the recent slowdown in sales. The company's substantial borrowing power and recapitalization strength speaks to the company's balance sheet health. We estimate conservatively that the firm will at least maintain existing dividend levels for the next couple of years and start to increase dividends more aggressively after 2017.

Figure: Dividend vitals with projections

When assessing companies for dividends, it is important to assess dividends for safety. The best way to do this is to search for companies that pay out a smaller percentage of their earnings and cash flows as dividends. This is because when the economy contracts or the business goes through difficult times, as it currently is, it should have a cushion of earnings and cash flows to continue to meet payments without crippling the operational capacity of the firm.

If not, it will need to cut the dividend to preserve cash to fight the downturn. McDonald's has an earnings-based payout ratio of 68% and a cash-flow based payout ratio of 78%, indicating that the firm has to pay about 68% of earnings and 78% of free cash flows as dividends to shareholders. Ignoring the substantial borrowing capacity of the firm, these are acceptable levels as there is a 22% to 32% cushion in earnings and free cash to withstand a downturn in sales.

Even with the recent slowdown in sales, it is unlikely that earnings could fall by more than 22% to 32% any time soon. And because it is unlikely to occur, the dividend probably won’t need to be cut nor will the firm need to issue debt to support distributions. This is a safe position for dividend investors. With such a stable dividend, the stock price has a base level of support. Furthermore, management has signaled its intentions not to cut the dividend and continue to raise the payout ratio if appropriate.

In addition to paying dividends, McDonald's has been aggressively buying back stock. By doing so, the number of diluted shares outstanding declined, and the remaining shareholders' percentage stake in the company's assets and profits increased. McDonald's diluted shares outstanding decreased by about 20 million shares in 2014. As of 2014 year end, there were about 986 million shares outstanding. This fell by another 32 million over the first three quarters of 2015. Considering total stock repurchases, McDonald's offers a repurchase yield of 3.3%. Combined with a 3.1% dividend yield, McDonald's is offering investors a clean 6.4% return without any price-driven stock gains.

Conclusion

McDonald's is an attractive company from a purely dividend perspective. Unfortunately, the stock has moved up by more than 25% over the last year, and there is a lot of momentum behind the position without a corresponding improvement in earnings. McDonald's is a lucrative business with solid sales, margins, returns, cash flows, and it has a healthy balance sheet. This is a delicious-looking firm. But a word of warning: the market currently expects EPS of $4.81 in 2015, and you need to be prepared for the stock to pull back hard if the company's earnings disappoint.

Disclosure

We do not have any positions in McDonald's.

About the author:

Daniel Seens
SEENSCO, a Canadian Corporation founded by Daniel Seens, CFA, is an investment research firm located in Ottawa, Ontario. Our Safety-First approach to identifying and evaluating companies helps investors to protect their principal and generate exceptional rates of return.

Visit Daniel Seens's Website


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