(Published by Nick McCullum on July 26)
McDonald’s Corp. (MCD, Financial) is a legendary dividend growth stock.
Founded in 1940, the company became popular among consumers because of its food’s consistency and low prices. Today, McDonald’s is the largest restaurant chain in the world with over 37,000 locations in more than 100 countries.
McDonald’s success has translated into exceptional shareholder returns.
The company has increased its dividend for a remarkable 40 years, hiking its payout each and every year since its first dividend payment in 1976.
This exceptional track record qualifies McDonald’s to be a member of the Dividend Aristocrats, a group of elite dividend stocks with at least 25 years of consecutive dividend increases.
Despite its fantastic track record, there are many investors who think the restaurant’s best days are behind it.
This is not the case.
In fact, McDonald’s second-quarter earnings release revealed the company is still growing at a rapid pace, with excellent comparable store sales and double-digit earnings per share growth.
Based on McDonald’s second-quarter earnings release, we will determine whether the company is a buy at today’s price.
Quarterly results overview
There was a lot to like about McDonald’s second-quarter earnings release.
Most notably, global comparable store sales increased 6.6%.
For a large, established player like McDonald’s, which already has a significant restaurant base, comparable store sales are one of the most important metrics to follow because the company’s current restaurant count dwarfs its ability to grow by adding new locations.
The company's comparable sales growth was driven by improved performance in each of its broad operating geographies. CEO Steve Easterbrook commmented on regional sales growth during the conference call:
“Here are just a few highlights from around the world to illustrate this momentum. Italy experienced its best quarter guest count since 2010. In April, the U.K. saw the highest monthly sales volume in its 43-year history. Germany had its strongest quarterly comp sales in nearly 10 years. Canada’s sales growth was the highest in the last five years. And in the Netherlands, a market that’s becoming a more meaningful part of our overall business, we had our best comp sales and guest counts in more than 20 years.”
McDonald’s comparable store sales growth is impressive, and one of the major reasons why the company’s financial performance came in better than expected.
The company’s consolidated revenues still managed to decline, however. This is due to the impact of McDonald’s strategic refranchising initiative.
The company is aiming to transfer most of its restaurants to the franchisee model, where independent businessmen and businesswomen operate the restaurants and pay royalty fees to corporate McDonald’s.
Franchised McDonald’s locations have lower revenues, but much higher margins. They also have other benefits, including less capital intensity. Chief Financial Officer Kevin Ozan commented on the company's refranchising initiatives during the conference call:
“…while these refranchising transactions will have a dilutive impact on our revenue and operating income in the near term, these transactions are immediately accretive to our free cash flow, as we’ll be operating under a less capital intensive model that delivers a more stable and predictable revenue stream. We expect to return to revenue growth and achieve our long-term targets beginning in 2019, as our strategic partners invest and unlock the potential in these markets through unit expansion as well as sales-building initiatives.
Our refranchising strategy has been a key part of transforming McDonald’s into a more purposeful, more stable and more efficient organization focused on delivering more growth. Further details on the impact of these refranchising transactions on our future operating results is provided on our website.”
The higher margins of franchised restaurants can be seen in McDonald’s EPS growth in light of declining revenue.
McDonald’s GAAP diluted EPS of $1.70 was a 36% increase over the same period a year ago. On a constant currency basis, the company’s GAAP per-share profits increased 38%.
These figures were positively impacted by accounting charges related to the strategic refranchising initiative. Excluding the impact of the current quarter and prior year’s charges of three cents and 20 cents per share, adjusted diluted EPS increased 19% (or 21% in constant currencies).
EPS growth of 19% for a company of McDonald’s size is very impressive. It is also above what the company is likely to deliver over long periods of time (though this earnings print was still welcome by the company’s investors).
From a capital allocation perspective, McDonald’s continued to be very shareholder-friendly during the quarter. The company returned $1.8 billion to shareholders through a combination of share repurchases and dividend payments.
Looking ahead
McDonald’s second quarter was phenomenal.
What can investors expect from this restaurant giant moving forward?
McDonald’s released a "New Global Growth Plan"Â in March that contained details on the company’s strategic plan for future growth.
The three pillars McDonald’s is expecting to use to drive further improvements are:
- Retaining existing customers by fortifying and extending areas of strength. Through a renewed focus on areas such as family occasions and food-led breakfast and transforming the experience in its restaurants, McDonald’s will build on the strong foothold it has and grow the core of the business.
- Regaining customers lost to other QSR competitors. As customers’ expectations increased, the company simply did not keep pace with them. Making meaningful improvements in quality, convenience and value will win back some customers.
- Converting casual customers to committed customers by being more present in underdeveloped categories and occasions and competing more aggressively given the untapped demand for McCafé coffee and other snack offerings.
The global growth plan also included financial targets for the period beginning in 2019. Until 2019, the company will likely experience a decline in sales because of its refranchising initiatives. The new financial targets are:
- Systemwide sales growth of 3% to 5%.
- Grow operating margin from the high-20% range to the mid-40% range.
- EPS growth in the high single digits.
- Raise the return on incremental invested capital target from the high-teens to the mid-20% range.
History indicates McDonald’s should be able to achieve these growth targets over time. For context, the company managed to compound its adjusted EPS at a rate of 10% per year between 2001 and 2016.
The company’s full EPS trend is displayed below.
Source: Value Line
All things considered, McDonald’s looks to be a strong investment based on fundamental business performance.
Unfortunately, the stock is overvalued at today’s levels.
We can see this by looking at the company’s price-earnings (P/E) ratio.
McDonald’s is expected to report adjusted EPS of $6.30 in fiscal 2017, and the company is currently trading at $159.07 for a P/E ratio of 25.2.
The following diagram compares McDonald’s current valuation to its long-term historical average.
Source: Value Line
McDonald’s valuation is well above its long-term historical average of 17.2.
This indicates patient investors should wait for McDonald’s stock to return to more normalized levels before initiating a position.
Final thoughts
McDonald’s second-quarter earnings release was fantastic on a number of levels.
The company realized impressive same-store sales growth, driven by improved performance in each of its key operating geographies.
McDonald’s translated this strong performance to its bottom line. After adjusting for one-time accounting charges, the company's EPS increased 19% from the same period a year ago.
However, the company’s stock appears significantly overvalued, trading at a P/E of 25 – a significant premium to its long-term average of 17.
Now is not the time to buy McDonald’s stock. The company remains a strong hold for existing investors.
Disclosure: I am long MCD.
