Friday, July 17, 2015

McDonald's (MCD) Dividend Stock Analysis 2015

McDonald's Corporation (NYSE:MCD) franchises and operates McDonald's restaurants in the United States, Europe, the Asia/Pacific, the Middle East, Africa, Canada, and Latin America. As of December 31, 2014, it operated 36,258 restaurants, including 29,544 franchised and 6,714 company-operated restaurants. McDonald's is a dividend champion that has increased distributions for 39 years in a row. McDonald's is one of the 60 companies which could be purchased commission-free using Loyal3, with as little as $10.

The most recent dividend increase was in September 2014, when the Board of Directors approved a 4.90% increase in the quarterly dividend to 85 cents/share. The largest competitors for McDonald's include Restaurant Brands International (QSR), YUM! Brands (NYSE:YUM) and Starbucks (NASDAQ:SBUX).
Over the past decade, this dividend growth stock has delivered an annualized total return of 16.70% to its shareholders. Future returns will be dependent on growth in earnings and dividend yields obtained by shareholders, as well as attractive entry price.

The company has managed to deliver a 10.40% average increase in annual EPS over the past decade. McDonald's is expected to earn $4.73 per share in 2015 and $5.19 per share in 2016. In comparison, the company earned $4.82/share in 2014.

Between 2004 and 2015, McDonald's has been able to reduce the number of shares from 1.274 billion to 965.50 million through consistent share buybacks.

In the past four years, the company's earnings per share have largely stagnated. In addition, earnings per share are expected to remain flat for the foreseeable future. I believe that without rising earnings per share, further dividend growth will be limited. In addition, without growth in profits, intrinsic value will not grow either. The reason why earnings are stagnating is due to a variety of factors, including higher competition and decreased appeal for restaurants such as McDonald’s which are viewed by the public as providing unhealthy food.

McDonald’s has a new CEO this year, who is trying to turn the company around. As part of the initiative, the company will try to simplify operations, refranchise 3,500 restaurants to reach a goal of 90% franchised restaurants, and reduce costs by as much as $300 million/year. The company needs to restore its appeal, which would likely take some time. The nice thing is Mcdonald’s has the scale to maintain low cost of operations, and generate excess returns. However, I would like to see the company make its menu appealing to customers again, improve its image to keep existing clients and gain more to its restaurants, and to start growing revenues and earnings organically again. I would be interested to see if McDonald’s manages to create a separate brand of “fast casual” or healthier restaurants, acquires an existing restaurant chain or redesigns its image.

I like the fact that the company can still generate low revenue growth, and still generate good returns to shareholders. For example, the company can refranchise more of its company owned existing units, which would reduce capital needs for the business. Revenues from franchised locations are more stable and require less resources for the company. This could result in more cash for dividends and share buybacks. In addition, the company could also package its prime real estate locations under the restaurants it owns in a real estate investment trust, and thus lower taxes. A tax-free spin-off like that could immediately unlock more value for shareholders.

Many investors forget that McDonald's is essentially a play on real estate, since it owns land and buildings under a large portion of restaurants. Those are prime heavily trafficked locations, whose value appreciates over time. For example, approximately 65% of revenues generated from franchised restaurants comes in the form of rent, while approximately one-third comes from royalties. The company owns 70% of restaurants and the land behind 45% of restaurants in its consolidated markets. Next time you look at their balance sheet, please remember that land and buildings are there at historical cost.

Now of course, we can also look for the power of share buybacks as well. McDonald's spent $3.20 billion on share repurchases in 2014, $1.81 billion in 2013 and $2.60 billion in 2012. If the company manages to repurchase $2 billion worth of stock each year, this would effectively reduce number of shares outstanding by approximately 2%/year. This automatically increases earnings per share by about 2%, assuming net income is flat. Hence, the intrinsic value per remaining share increases by 2% automatically. If a shareholder now owns a higher stake in the firm, and also earns a dividend yield of 3.50%, they can generate a total return of 5.5% even if net income is flat until the end of time. The yields and amount of shares repurchased can vary from year to year, which is why this is not going to be straightforward growth each year. These numbers of course are wildly pessimistic, and merely shown to illustrate that even a small growth in organic revenues or earnings per share can result in very good dividend growth and total returns for shareholders over time. The real money for shareholders will be made if earnings per share can grow organically, and then any extra cash being returned to shareholders in the form of dividends or buybacks. As I mentioned above, this turnaround plan is still in progress.

The company can still grow through the opening of new restaurants. This would be more difficult in established markets in North America or Europe. However, there is that untapped and growing middle class in emerging markets that is slowly rising out of obscurity, and will be adding hundreds of millions of people in the next 15-20 years. Those people are busy, and will need convenience of quick service restaurants such as McDonald's.

The annual dividend payment has increased by 19.50% per year over the past decade, which is higher than the growth in EPS. Future growth in dividends will be dependent on growth in earnings per share.

A 20% growth in distributions translates into the dividend payment doubling every three and a half years on average. If we check the dividend history going as far back as 1979, we could see that McDonald's has actually managed to double dividends almost every four and a half years on average.

In the past decade, the dividend payout ratio increased from 32.80% in 2005 to 68% in 2014. Given the fact that earnings per share are expected to be flat in the next two years, and given the high dividend payout ratio, I do not expect much in terms of dividend growth in the near term. A lower payout is always a plus, since it leaves room for consistent dividend growth minimizing the impact of short-term fluctuations in earnings.

The return on equity increased from 17.70% in 2004 to 33% in 2014. I generally like seeing a high return on equity, which is also relatively stable over time.

Currently, the stock is slightly overvalued at 20.30 times earnings and has a current yield of 3.50%. I believe that given the high payout ratio, the dividend growth in the near term will be very low.

There is an increasingly negative sentiment toward the company, given the flat revenues and sales since 2011. I believe McDonald's will overcome its problems and reward patient shareholders who have a long-term horizon. However, I would not be purchasing shares in the company at current levels. That being said, I will keep holding to my shares, but allocate dividends elsewhere.

Full Disclosure: Long MCD, YUM

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