Published October 27th, 2016 by Bob Ciura
McDonald’s Corporation (MCD) is one of the biggest corporate success stories in American history. The company traces its beginnings all the way back to 1954, when Ray Kroc partnered with brothers Dick and Mac McDonald to form the McDonald’s System Inc.
In 1960, Kroc bought the exclusive rights to the McDonald’s name, and the rest is history.
Today, McDonald’s has more than 36,000 locations in more than 100 countries around the world. The stock has a $95 billion market capitalization.
McDonald’s is the single largest restaurant in the world – the only restaurant (if you can call it that) in the same hemisphere in terms of size is Starbucks (SBUX). McDonald’s is highly profitable, and returns a great deal of cash each year to investors.
Case-in-point: McDonald’s has raised its dividend each year for the past 40 years.
This makes the company a member of the exclusive Dividend Aristocrats Index. It is made up of stocks with 25+ years of consecutive dividend increases in the S&P 500… And the performance of the Dividend Aristocrats Index has been exceptional:
Source: S&P Fact Sheet
You can download the full list of Dividend Aristocrats here. McDondald’s performance over the last decade is shown below:
As you can see, McDonald’s has been an excellent investment over the last 10 years. That’s the power of compounding at work. McDonald’s has managed to increase its value per share over time – while paying out hefty dividends.
McDonald’s has been a Sure Dividend favorite at certain price points – as this case study demonstrates. McDonald’s stock currently has a 3.4% yield.
Keep reading this article to learn more about the investment prospects of McDonald’s stock today.
McDonald’s has an incredibly impressive history as a company, but it has encountered significant headwinds over the past several years. First is the changing U.S. market.
The domestic consumer landscape is shifting; consumers are looking for healthier eating options with better ingredients. As the largest fast food company in the world, McDonald’s is often viewed as the poster boy for the obesity epidemic in the U.S.
This is why McDonald’s took the very unusual step of closing more U.S. restaurants than it opened last year. That was the first time McDonald’s took that step in more than 40 years.
If that weren’t bad enough, the company is struggling overseas. The economic slowdown in the emerging markets like China has suppressed McDonald’s international growth. And, McDonald’s is also grappling with the strong U.S. dollar, which makes goods more expensive abroad. Approximately two-thirds of the company’s sales are derived outside the U.S.
From a long-term perspective, McDonald’s financial performance looks very good. In the 10-year period spanning 2006-2015, the company grew earnings-per-share by 8% per year.
However, this performance masks the difficulties McDonald’s has encountered more recently. For example, earnings per share declined 9% in the past five years. McDonald’s earnings-per-share have taken a concerning trajectory since 2011:
- 2011 earnings-per-share of $5.27
- 2012 earnings-per-share of $5.36
- 2013 earnings-per-share of $5.55
- 2014 earnings-per-share of $4.82
- 2015 earnings-per-share of $4.80
The good news is that business conditions have improved somewhat this year. In the first nine months of 2016, earnings-per-share increased 17% in constant currency. This is great news for the company, although it should be noted that McDonald’s declining earnings in recent years made for easy comparisons.
Two significant growth catalysts that McDonald’s has are new menu offerings and accelerating franchising activity. In the past year, McDonald’s has launched a number of new menu initiatives, including All Day Breakfast and the McPick 2 promotion.
This was a good decision on McDonald’s part. The fast food industry is highly competitive, and new menu promotions are an important driver of customer retention.
With regard to franchising, this has been one of McDonald’s most important strategic initiatives over the past several years. Approximately 82% of McDonald’s restaurants are franchise-owned. The company decided to move away from owning restaurants, because franchising generates a steady stream of royalties for the company. In addition, franchisees are responsible for most of the maintenance and renovation expenses.
There is still room to expand on this initiative. McDonald’s intends to move to 90% franchised restaurants.
That being said, McDonald’s is not without its headwinds. Moving forward, it will still have to contend with a difficult climate in the U.S., and the strong U.S. dollar. In an effort to return to growth in the U.S., McDonald’s is investing more to restructure its menu and raise its employee wages.
Competitive Advantages & Recession Performance
McDonald’s has two critical competitive advantages, which are its brand and its massive scale. McDonald’s is one of the most valuable brands in the world. Its famous golden arches are widely recognized across the globe. In fact, according to Forbes, McDonald’s has the 9th most valuable brand in the world, worth $39.1 billion.
Another major competitive advantage is McDonald’s massive size, which lends itself to significant economies of scale. McDonald’s can purchase supplies at attractive prices, and it passes this on to customers in the form of low prices. It also allows McDonald’s to pour significant financial resources into advertising to maintain its brand image with consumers.
Moreover, McDonald’s has a very strong balance sheet. It had $22.8 billion of property and equipment on its balance sheet at the end of the second quarter. It also had $48 billion of treasury stock, which represents shares repurchased by the company. McDonald’s has immense financial resources that provide a low cost of capital, and allow the company the flexibility to invest in new growth initiatives.
One of the best reasons to own McDonald’s stock is for its recession performance. As the largest publicly-traded fast food stock, McDonald’s has a highly recession-resistant business model. It could be argued that recessions actually improve its performance. When the economy enters recession, consumers typically scale down their dining out. Instead of going to higher-priced casual or sit-down restaurants, consumers often opt for fast food.
This is exactly what happened during the Great Recession.
- 2007 earnings-per-share of $2.91
- 2008 earnings-per-share of $3.67
- 2009 earnings-per-share of $3.98
The fact that McDonald’s grew earnings-per-share by 37% in the two years encompassing the Great Recession is very impressive. For this reason, McDonald’s was only one of two component stocks in the Dow Jones Industrial Average to increase in value in 2008.
Valuation & Expected Total Returns
McDonald’s stock trades for a price-to-earnings ratio of 21.4. This is above its historical average. Since 2000, McDonald’s stock has held an average price-to-earnings ratio of 16.5. McDonald’s is currently trading approximately 27% above its average valuation over the past 16 years.
There could be reason to believe McDonald’s is slightly overvalued, given its stagnating financial performance over the past several years. Investors typically pay higher valuation multiples for companies exhibiting strong growth. Buying McDonald’s stock at this price could result in lower-than-average share price returns moving forward.
As a result, investors will rely on earnings growth and dividends for future returns. McDonald’s expected total returns will come from the following sources:
- 3.5% from dividends
- 2.0% to 7.0% from earnings-per-share growth
A reasonable set of expectations would be for McDonald’s investors buying today to earn 5.5% to 10.5% annualized returns moving forward, less any compression of the price-to-earnings multiple.
The company’s total returns are difficult to pin town because there are questions as to the company’s ability to navigate the changing dining climate in the United States while also dealing with slower international growth. The single most important number to watch at McDonald’s is same store sales growth. As this goes, so too will the company go.
Dividend growth investors have plenty of reason to hold McDonald’s stock over the long term. The company is highly profitable and has several competitive advantages that protect its earnings power. It should have no trouble maintaining and raising its dividend for years to come.
With that said, the company is not a bargain at current prices. Investors looking to initiate a position in McDonald’s should likely wait for a better entry point. A caveat to this is that McDonald’s tends to do very well during recessions – if you are preparing your portfolio for a recession, McDonald’s is certainly wworth considering.
People switch from more expensive restaurants to the inexpensive McDoanld’s during recessions. This makes McDonald’s one of the most recession resistant stocks around.