By Jason Fieber
We keep hearing about the demise of McDonald’s Corporation (NYSE:MCD).
Now, there’s no doubt that the company has faced some challenges lately.
Labor disputes, currency effects, questions over the food quality and nutrition, and changing consumer tastes have all coalesced to put the company – and its stock – in a precarious position.
Same-store sales are down regularly and marketing initiatives haven’t connected well with consumers.
But let’s not forget that this is a $91 billion company that franchises and operates a combined 36,000+ restaurants across 125 countries.
Let’s also not forget that people have to eat. As long as McDonald’s continues to conveniently provide good food at a great value, they’ll very likely continue to sell billions of dollars’ worth of cheeseburgers, fries, and beverages.
So let’s talk about that demise. What does that demise look like for the stock?
Well, first the long-term performance: McDonald’s total return over the last 10 years is an annualized 16.64%. That obviously trounces SPY’s 10-year annualized 7.71%.
Short term? The stock is up 1.46% YTD. The S&P 500 is roughly flat.
So that’s the demise of MCD’s stock. We now see that there’s perhaps just a little hyperbole involved there.
What about the company’s performance? That’s ultimately what matters most. Stock prices go up and down, but long-term business performance is what will ultimately drive returns. And it’s growing earnings that will fuel growing dividends.
Using that same 10-year time frame as above, we can see revenue grew from $20.460 billion to $27.441 billion from fiscal years 2005 to 2014. That’s a compound annual growth rate of 3.32%.
Top-line growth isn’t particularly impressive, though the company is a victim of its own success: It’s somewhat difficult to grow from such a large base, especially at a meaningful rate.
But per-share profit growth is more impressive. earnings-per-share increased from $2.04 to $4.82 over this period, which is a compound annual growth rate of 10.02%. However, growth over the last five years has slowed markedly.
Improving margins and a substantial reduction of the outstanding share count drove a lot of that additional bottom-line growth. Shares outstanding have been reduced by over 20% over the last decade. That means there’s 20% less shares across which to spread out the remaining profit.
S&P Capital IQ anticipates that earnings-per-share will grow at a 7% compound annual rate over the next three years, which, while lower than what we saw over the last decade, is nowhere near a company on the brink of failure. That’s still a pretty solid growth rate.
However, what makes this stock really attractive right now is the 3.6% yield. That’s about 160 basis points higher than the broader market – a significant difference.
Add that 3.58% yield to the 7% expected underlying EPS growth, and you have the recipe for pretty solid returns moving forward.
But what really juices the prospects is the dividend growth: MCD has increased its dividend for the past 39 consecutive years. McDonald’s is the only restaurant stock that is a Dividend Aristocrat.
That’s almost four decades. That time frame includes the massive inflation of the early 80s, the savings and loan crisis, multiple wars, the financial crisis, and the Great Recession. So if you’re looking for durability and consistency, look no further than McDonald’s.
What’s perhaps just as impressive as the length of dividend growth streak is the rate at which the dividend is growing. Over the last decade, the dividend has increased at an annual rate of 19.6%. However, like recent EPS growth, the dividend hasn’t increased as fast over the last five years.
Part of the reason the dividend hasn’t grown much lately – besides the lack of underlying profit growth over the last five years – is the fact that the payout ratio now stands at 76.4%. That means for every $1 in profit the company takes in, they’re sending out a little over 76 cents to shareholders in the form of a dividend. The other ~23 cents is retained by the company to continue growing.
That’s a very high ratio, which limits the potential for future dividend raises because the company is already retaining somewhat little profit to reinvest back into the business. That huge dividend growth we see above has come at the cost of a payout ratio that’s doubled over the last decade, so it’s something to be mindful of in terms of one’s expectations moving forward.
One other area of the company that does concern me a bit is the balance sheet.
While not necessarily worrisome in and of itself, it has deteriorated some over the last decade. This is a somewhat common sight among a lot of companies because cheap debt has made it easy for companies to leverage up and potentially boost returns to shareholders. But McDonald’s balance sheet has deteriorated while growth has simultaneously slowed.
The long-term/debt equity ratio is 1.17 and the interest coverage ratio is approximately 14. Again, not bad numbers, especially relative to the industry, but I think there’s room for improvement there.
However, McDonald’s profitability really shines bright. Over the last five years, the company has averaged net margin of 19.59% and return on equity of 35.58%. Really incredible numbers here, especially the margin. However, both metrics have been slipping as of late. That’s something to keep an eye on.
Fundamentally, the company is in good shape. There has no doubt been some chinks in the armor lately, though. Growth is essentially flat over the last five years, margins are slipping, the balance sheet has deteriorated some, and global comparable sales decreased by 0.3% in May 2015 – another disappointing sales report in a long line of them.
But there are initiatives here to be excited about. Steve Easterbrook, who took over CEO duties earlier this year, has announced that the company is going to eliminate unnecessary bureaucracy through restructuring segments, refranchise 3,500 restaurants which will increase their franchised restaurants to 90% of the company total, improve the food, slim the menu, and also offer the ability to build custom burgers in select markets.
It will take time to turn a behemoth like McDonald’s around, but you’re paid a very attractive 3.58% yield to wait in the meanwhile. And you have to like the odds that people will continue to buy their products. The stores are ubiquitous and the food is still highly convenient and provides a great value proposition.
I’m certainly enjoying being paid – the stock is in my six-figure dividend growth stock portfolio and has long been a favorite of The 8 Rules of Dividend Investing.
Looking at the valuation, however, the stock appears a bit pricey. McDonald’s sports a price-to-earnings ratio of 21.35. Not only is that high in absolute terms, but it also compares unfavorably to the five-year average of 17.3. I always look for a margin of safety, especially with a company that’s involved in a turnaround story.
But the P/E ratio can only tell us so much.
I valued shares using a dividend discount model analysis with a 10% discount rate and a 6% long-term dividend growth rate. That growth rate appears conservative, but the high payout ratio and lack of much growth over the last five years means that’s likely what we’ll see for the foreseeable future, especially with the forecast for EPS growth where it’s at. For perspective, the most recent dividend increase was less than 5%. The dividend discount model analysis gives me a fair value of $90.10.
So the stock doesn’t appear significantly overvalued, but there also isn’t a margin of safety here. As such, I’d be cautious about buying MCD right now.
Overall, I think there’s a lot to like. Ubiquitous stores across the entire world. A product that’s improving. The company’s aware of their issues and aiming to rectify them. Almost 40 straight years of dividend increases, which will likely continue well into the future. And a yield that’s substantially higher than the broader market.
However, shares appear to lack a margin of safety right now. The current valuation doesn’t seem to price in all the risks and potential for permanent lower growth moving forward. Not the best opportunity in the market, but a minor pullback would make this an interesting long-term pick that provides substantial dividend income that’s also likely to grow in excess of inflation.
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