Dividend Aristocrats In Focus Part 1: McDonald’s

Updated on November 19th, 2019 by Bob Ciura

Every year, we review each of the 57 Dividend Aristocrats, the group of companies in the S&P 500 Index, with 25+ consecutive years of dividend increases.

In addition to the full downloadable spreadsheet, you can view a preview of the Dividend Aristocrats list in the table below:

For the 2019 Dividend Aristocrats in Focus series, first up is fast food giant McDonald’s (MCD). McDonald’s paid its first dividend in 1976, and has increased it every year since. The company has now increased its dividend for more than four decades.

McDonald’s has implemented a successful turnaround in recent years, through new menu offerings, remodeled restaurants, and an accelerated franchising effort. Put together, these initiatives have done the trick. McDonald’s is a high-quality Dividend Aristocrat feeding shareholders with strong returns.

Business Overview

McDonald’s was founded in 1954, by Ray Kroc and his partners, Dick and Mac McDonald. Together, they formed the McDonald’s System Inc. In 1960, Kroc bought the exclusive rights to the McDonald’s name. With a market cap of $146 billion, McDonald’s is the largest publicly-traded fast food company in the world. It operates over 38,000 locations, in more than 100 countries around the world.

Revenues come primarily from franchise fees. McDonald’s has accelerated its franchising over the past several years. While this effort initially led to lower sales, it allowed McDonald’s to expand its profitability through higher margins. And with the franchising efforts lapped, McDonald’s is back to reporting impressive sales growth in addition to earnings growth.

For example, McDonald’s recently reported strong third-quarter results. For the quarter total revenue came in at $5.43 billion, up 1.1% compared to the same quarter last year. During the quarter a 3.8% decline in revenue from company-owned restaurants was more than offset by 5.4% increase in revenue from franchised restaurants – the latter of which has notably higher margins.

Global comparable sales, which includes results at locations open at least one year, increased 5.9%, marking the 17th straight quarter of positive growth in this metric. Operating income came in at $2.41 billion, a 0.3% decline, while net income declined 1.8% to $1.61 billion. However, earnings-per-share equaled $2.11 compared to $2.10 previously, as a result of a 2% lower share count.

Now that McDonald’s has gotten back on track, its momentum should continue–even in a recession.

Growth Prospects

McDonald’s performance has improved in the past few years, due in large part to the strategic initiatives put in place to restore growth. These initiatives are working well, and put McDonald’s in a good position to continue growth moving forward.

First, McDonald’s announced new menu offerings, including all-day breakfast which provided a big boost to sales. A renewed focus on providing value to customers has also helped restore traffic. International markets have shown even more growth in recent periods. Last quarter, the U.S. posted comparable sales growth of 4.8% year-over-year, while the International Operated segment increased 5.6%, and the International Developmental Licensed segment increased 8.1%.

McDonald’s underwent a new wave of refranchising, which has boosted growth. Just a few years ago, a majority of McDonald’s revenue came from company-owned stores. But McDonald’s has flipped this around in a big way. Over the first nine months of 2019, 55% of McDonald’s revenue came from franchised restaurants. McDonald’s has a target of re-franchising ~95% of its restaurants over the long run.

In addition, investments in store renovations and technology are helping to grow sales and profits. McDonald’s has made a significant commitment to utilizing new technologies in a way that gets food to customers faster. For example, it has partnered with third-party delivery services such as Uber (UBER) Eats and GrubHub (GRUB), while it also recently acquired voice technology firm Apprente. Apprente makes artificial intelligence technology which can provide faster and more accurate fulfillment of drive-through orders.

Lastly, McDonald’s has rolled out mobile ordering as well as kiosks at many of its restaurants to simplify the ordering process even further. All of these initiatives will help differentiate McDonald’s in a highly competitive fast food landscape. Overall, we expect McDonald’s to generate 6% earnings-per-share growth over the next five years.

Competitive Advantages & Recession Performance

McDonald’s enjoys several competitive advantages that separate it from its industry peers. First, it is the largest publicly-traded fast food company in the world. It has enormous scale, which allows it to keep prices low. And, it has one of the most valuable and widely-recognized brands in the world.

One of the big reasons why McDonald’s continues to increase its dividend year in, and year out, is because it has a defensive business model. When the economy takes a downturn, consumers tighten their belts, particularly when it comes to dining. Rather than go to higher-priced sit-down restaurants, consumers will often shift down to fast food during a recession.

From this perspective, McDonald’s actually benefits from recessions. For evidence of this, its earnings-per-share during the Great Recession are shown below:

• 2007 earnings-per-share of $2.91
• 2008 earnings-per-share of $3.67 (26% increase)
• 2009 earnings-per-share of $3.98 (8% increase)
• 2010 earnings-per-share of $4.60 (16% increase)

McDonald’s grew earnings in each year of the recession, at a double-digit compound annual rate. This is highly impressive, and speaks to its recession-resistant business model. Investors can be reasonably assured the company can continue raising the dividend, even if another recession hits.

Valuation & Expected Returns

McDonald’s stock has generated huge returns in recent years. For example, in the past five years McDonald’s stock generated total annualized returns of 18.3%. The only downside from this outstanding performance is that the stock now appears to be overvalued. Using the current share price of ~$194 and expected earnings-per-share for 2019 of $7.90, the stock has a price-to-earnings ratio of 24.6.

Over the past decade, shares of McDonald’s have held an average P/E ratio of 18-19. We consider 18 times earnings as a reasonable fair value estimate. If shares were to revert to a P/E valuation of 18, annual returns would be reduced by 6.1% through 2023.

Therefore, McDonald’s appears to be slightly overvalued, based on relative comparisons to the broader market, as well as to its own historical average. Fortunately, the impact of overvaluation will be offset by earnings-per-share growth and dividends. In addition to expected EPS growth of 6% per year through 2024, the stock also offers a current dividend yield of 2.6%.

Still, overall McDonald’s is expected to generate total returns of just 2.5% per year, a weak projected rate of return. The relatively low expected return is due entirely to McDonald’s stock valuation, which is abnormally high at the present time.

Final Thoughts

McDonald’s has paid a rising dividend for over 40 years in a row. Over those four decades, it has had to reinvent itself from time to time, to stay on top of changing consumer trends. But it has consistently succeeded in its various turnarounds, a testament to the strength of its brand and business model.

It recently had to do this once again, but the results have been very encouraging. Same-store-sales and earnings are growing again, which is powering McDonald’s rising share price and dividend growth.

That being said, investors aren’t likely to see sizable gains with the high valuation of the stock. As a result, we believe investors should avoid the stock and wait for a pullback before buying McDonald’s.