Published on October 18th, 2019 by Josh Arnold
It would not be an exaggeration to say that in just about every country in the world today, McDonald’s (MCD) is a household name. The company that is famous for its Happy Meals and Big Mac has found a way to grow around the world, in part by tailoring its offerings to its local customers.
McDonald’s is undoubtedly a growth success story over its company history, and in turn shareholders have been rewarded with rising dividends since 1976. For the past 43 years, McDonald’s has managed to grow its dividend payment to shareholders, despite varying economic conditions around the world.
Because of its impressive dividend history, we view McDonald’s as a blue chip stock, which we consider to be the safest dividend stocks in the market today due to their consistent growth and durable competitive advantages.
You can download the complete list of all 271 blue chip stocks below:
McDonald’s is one of just 57 Dividend Aristocrats, a group of S&P 500 stocks that have increased their dividends for at least 25 consecutive years.
This track record of dividend excellence is certainly attractive to shareholders, and McDonald’s continues to be a favorite for growth investors, as well as those seeking a meaningful, growing dividend payment.
McDonald’s is the largest fast food operator in the world with 38,000 locations in more than 100 countries worldwide. The size and scale the company operates on is unparalleled in terms of physical presence. Only about 7% of the company’s locations are owned by McDonald’s; the remaining 93% are franchised.
McDonald’s has about 5,000 unique global franchisees, as most franchisees own more than one location. McDonald’s has undergone a years-long transition from a more heavily company-owned store mix, to franchising nearly all of its locations as part of its growth and capital return strategy, and it owns fewer than 3,000 locations today.
Revenue topped out at $28 billion in 2013 before the refranchising effort began, and today, McDonald’s produces around $21 billion in annual revenue. Shares have performed extremely well in recent years, and as a result, the company’s market capitalization is up to $157 billion.
McDonald’s has invested in menu innovation in recent years, such as premium coffee through its McCafe platform, more upscale desserts, as well as premium burgers that have helped drive traffic and higher average ticket prices over time.
McDonald’s is positioning itself in the market as everything to everyone, from breakfast items and premium coffee drinks, to the lunch hour with its chicken sandwiches, premium burgers, as well as its long-time favorites. The formula has worked quite well in recent years, as McDonald’s has generated strong earnings growth.
McDonald’s history of growth has been somewhat lumpy in the past decade, but more recently, the company’s asset-light, franchisee-heavy strategy has boosted earnings growth. Earnings-per-share grew at an average rate of 8% annually since 2008, which is quite impressive for a company the size of McDonald’s. Growth stagnated in 2013, followed by declining earnings-per-share in 2014 as it struggled with a stale menu and a group of outdated restaurants. This combination drove traffic lower, and with it, profits as well.
McDonald’s growth plan, which has been in place for a few years now, has fixed those issues. The “new” McDonald’s is much more efficient, has updated thousands of stores globally, and its menu innovation rivals any other fast food operator. These factors have driven comparable sales up in recent years, which has provided the company with leverage on its costs, driving margins and profits higher.
Indeed, from 2015 to 2018, McDonald’s grew its earnings-per-share at an average annual rate of nearly 17%. That is a highly impressive growth rate for such a large company with ~40,000 locations globally, and is the product of prudent planning and execution. While we see double-digit earnings-per-share growth as unsustainable over the long-term, simply given how far the company has come already, we think 6% annual EPS growth is a realistic expectation in the years to come.
McDonald’s has seen growth in recent years through its all-day breakfast menu, as well as some of the menu innovation discussed above. The all-day breakfast menu capitalized on the company’s dominant position in fast food breakfast, and extended that advantage throughout the entire day. This initiative alone has driven traffic growth for years now, and its willingness to step outside the box and take a risk is part of what has allowed the company to produce such strong growth numbers.
The advantage to the refranchising effort, wherein the company sold many of its restaurants to franchisees, is that it requires much lower capex and operating costs. While it obviously reduces revenue at the same time, the franchise fee revenue that is received is very high-margin, much more so than company-owned store revenue. This has afforded the company outstanding profitability growth, albeit on lower total revenue, since the refranchising effort began. As an example, McDonald’s produced operating margins of 28.9% of revenue in 2015. This year, McDonald’s is on pace to produce ~42% operating margins thanks to its asset-light operating model.
Looking forward, we see 6% average annual earnings-per-share growth, driven by rising revenues, margin growth, and share repurchases. Revenue should continue to rise given that the company’s comparable sales are moving in the right direction, and that revenue growth provides leverage on the company’s operating costs, improving margins. McDonald’s has also committed to strong shareholder returns of capital, so we expect a small tailwind to materialize from a lower float each year.
Many restaurant chains do not perform particularly well during recessions. Consumers tend to pull back discretionary spending when times are tight, which includes eating at restaurants, and the weaker ones suffer as a result. McDonald’s, by contrast, actually grew its earnings-per-share every year during the Great Recession. Arguably, McDonald’s is a rare company that could grow earnings if another recession occurs, as consumers scale down their dining budgets to fast food.
Earnings-per-share grew 27% in 2007, 26% in 2008, and another 8% in 2009. This outstanding recession performance track record is another reason why McDonald’s is an attractive dividend stock. When a company is able to maintain (or increase) its dividend during tough economic times, it gives shareholders peace of mind. McDonald’s has been able to do that during every recession since it began paying dividends 43 years ago.
We see the company’s dividend as very safe, even during recessions, because consumers flock to value during recessions. As McDonald’s offers significant value to consumers with its budget offerings, we don’t see the next recession as a particularly large risk to the company’s earnings or dividend. McDonald’s is a defensive stock in a sector where investors do not find many defensive stocks, highlighting the exemplary operating history this company possesses.
Given its very long history of dividend increases, McDonald’s has been a favorite for income investors for decades. McDonald’s is a Dividend Aristocrat, and is only seven years of increases away from being a Dividend King, which is the most prestigious title a dividend stock can achieve. For much of the past decade, the company’s dividend yield was in excess of 3%. However, the recent rally in shares has sent the yield down to 2.4% at present, so it isn’t quite offering as high of a yield as it once did.
However, McDonald’s continues to boost its payout at strong rates, including the most recent dividend increase of 8%, put into place in September. The new annual payout is $5 per share, which is only about 63% of our earnings-per-share estimate of $7.95 for this year. McDonald’s has gradually increased its payout ratio in recent years as it has become more serious about returning excess cash to shareholders.
Free cash flow per share has risen from $3.48 in 2009 to a projected ~$7.00 this year, so despite the operating challenges that persisted during the past decade, McDonald’s has been able to generate plenty of excess cash. This growth in cash generation not only makes it easier to maintain the dividend payment, but also to grow it each year. As earnings continue to climb, cash generation will as well, aided by the company’s franchise-heavy model that doesn’t require huge investments in new stores. Franchisees shoulder that burden, meaning the benefit of the new model is stronger cash generation, which helps McDonald’s raise the dividend over time.
Given this, as well as the relatively low payout ratio, we see McDonald’s dividend safety as outstanding. Not only will the payout almost certainly continue to grow for the foreseeable future, but we don’t see a recession as a material risk to the company’s dividend growth streak.
The following video discusses our view of McDonald’s dividend safety in greater detail:
McDonald’s does have a significant long-term debt load on its balance sheet, totaling nearly $33 billion as of the end of the most recent quarter. That is in excess of five times its annual net income of ~$6 billion, so it is certainly meaningful. In addition, servicing that debt has become more expensive over time as the amount of liabilities has grown, and this year, interest expense is expected to top a billion dollars. Despite this, we don’t see debt as hampering the company’s ability to return capital to shareholders as interest expense is just ~12% of operating income.
Long-term debt grew quickly beginning in 2015 and was used for a variety of purposes, including buying back shares to reduce the float. However, growth in the company’s long-term debt has slowed significantly of late, and we see modest long-term debt growth on the horizon. This should help stabilize interest expense, and thereby gradually decrease the percentage of operating income that is consumed by interest expense.
McDonald’s, over time, has been the model for restaurant chains in terms of operating excellence. The company’s vast global scale and recent innovation have given it renewed growth. This means its dividend will almost certainly continue to grow for many years to come, and we see the company reaching Dividend King status in seven years’ time.
While McDonald’s has faced its fair share of challenges over the years – some of which were self-inflicted – it has always come out the other side stronger than before. We see recession risk as very low in terms of earnings and the dividend, so McDonald’s remains one of the best stocks in our coverage universe in terms of safety and growth potential. Its defensive nature and strong growth outlook make it attractive for investors who want a strong and growing payout over time.