Published on May 3rd, 2018 by Bob Ciura
When it comes to dividend stocks, the Dividend Aristocrats are the tried-and-true. These are a group of stocks in the S&P 500 Index with 25+ consecutive years of dividend increases. You can see all 53 Dividend Aristocrats here.
McDonald’s (MCD) is a Dividend Aristocrat, with over 40+ consecutive years of dividend increases. McDonald’s is the largest publicly-traded fast food company in the world, with more than 37,000 locations, in 100+ countries.
One of McDonald’s fiercest competitors in the fast food industry, Yum! Brands (YUM), is not a Dividend Aristocrat. But it has a dividend yield of 1.7%, and typically raises its dividend at a higher rate than McDonald’s. Yum has already delivered a 20% dividend increase in 2018.
Both companies recently reported quarterly earnings results. McDonald’s reported quarterly financial results that beat expectations on both revenue and earnings-per-share. The strong earnings report sent McDonald’s stock up ~5% in early trading. Yum stock, on the other hand, fell 5% after its own quarterly report.
This article will compare-and-contrast these two dividend-paying fast food giants.
For the 2018 first quarter, McDonald’s had earnings-per-share of $1.79 on revenue of $5.14 billion. Both figures handily exceeded analyst expectations; consensus estimates called for earnings-per-share of $1.67 on revenue of $4.97 billion.
System-wide sales increased 7% in constant currencies, driven by growth of comparable-store sales, which measures sales at locations open at least one year. Comparable sales increased 5.5% in the first quarter, a very strong result that was far ahead of the 3.8% growth expected by analysts.
In the U.S., McDonald’s largest segment, comparable sales were up 2.9% year over year, and also beat analyst expectations of 2.7% growth. Across McDonald’s other geographic segments, comparable sales for the International Lead segment increased 7.8% for the quarter, primarily driven by the U.K. and Germany.
In the High Growth segment, first quarter comparable sales increased 4.7%, led by strong performance in China and Italy. In the Foundational markets, first quarter comparable sales rose 8.7%. Overall, global comparable guest count was up 0.8%. Menu price increases and favorable product mix also contributed to growth.
Earnings-per-share increased 16% in constant currency. The double-digit earnings growth reflects the company’s successful refranchising strategy, as well as other growth initiatives.
Meanwhile, Yum owns the KFC, Pizza Hut, and Taco Bell brands. It competes directly with McDonald’s, in all geographic markets in which it operates.
Yum’s system-wide sales (excluding foreign currency translation) grew 4%, led by KFC’s 6% growth. Taco Bell and Pizza Hut grew sales by 4% and 2%, respectively.
For its first quarter, Yum reported revenue of $1.37 billion (down 3.5% year-over-year) and earnings-per-share of $0.90 (up 38%). Both figures exceeded analyst expectations. Consensus estimates called for revenue of $1.09 billion and earnings-per-share of $0.68.
Same-store sales rose across all of Yum’s brands. Same-store sales rose 2% at KFC, and 1% at Pizza Hut and Taco Bell.
Yum’s earnings growth was boosted by share repurchases. Last quarter, Yum repurchased 6.5 million shares totaling $528 million.
McDonald’s growth catalysts include refranchising and new menu offerings. As a major part of its turnaround strategy, McDonald’s significantly accelerated the refranchising of its restaurants. Refranchising lowers overall revenue, with fewer stores owned by the company, but it increases profitability.
Franchising provides a steady stream of cash flow while placing greater expense on the franchisee. When McDonald’s unveiled its global growth plan last year, the company expected to have over 90% of its global restaurants franchised by the end of 2018.
In addition, McDonald’s has revamped its menu offerings, to better serve its customers’ demands. As the company mentioned on the analyst call, the pricier Signature Recipe Burgers provide higher margins, while the new $1/$2/$3 Dollar Menu offerings drove transaction growth.
The strategy has clearly paid off—McDonald’s has now racked up 11 consecutive quarters of positive comparable sales, and five consecutive quarters of rising guest traffic.
Yum is also growing through refranchising. Last quarter, Yum refranchised 144 restaurants, including 52 KFC, 43 Pizza Hut and 49 Taco Bell units. At the end of the quarter, its global franchise ownership mix was 97%.
An additional growth catalyst for Yum is new restaurant openings. Yum is being much more aggressive than McDonald’s right now in opening new locations. Last quarter alone, Yum opened 239 net new units for 3% new unit growth.
The emerging markets are a major growth priority for Yum, particularly in the core KFC brand. For example, China, rest of Asia, Russia & Eastern Europe, and Latin America collectively comprise 51% of KFC’s total sales. These markets hold fast-growing economies with large populations.
China, rest of Asia, Russia & Eastern Europe, and Latin America grew same-store sales by 9%, 3%, 20%, and 15%, respectively, last quarter.
Valuation & Expected Returns
For 2018, ValueLine analysts expect McDonald’s to generate earnings-per-share of $7.60. McDonald’s stock trades for a price-to-earnings ratio of approximately 22.0, after the ~5% post-earnings rally. This is a fairly lofty forward-looking valuation for McDonald’s, particularly in the context of its 10-year average.
In the past 10 years, McDonald’s traded for a price-to-earnings ratio of 18.0, meaning McDonald’s currently trades at a premium of over 20% to its 10-year average. McDonald’s valuation has expanded considerably in recent years, as its share price has climbed.
A fair value estimate for McDonald’s is a price-to-earnings ratio of 20, which is reasonable given McDonald’s strong brand and earnings growth. This is higher than the 10-year average, but McDonald’s still appears overvalued by 10%. Therefore, McDonald’s does not appear to be an attractive stock based on valuation.
Investors cannot rely on continued expansion of the price-to-earnings ratio to drive shareholder returns. However, McDonald’s stock will still generate returns from earnings growth and dividends. According to ValueLine, in the past 10 years McDonald’s grew earnings-per-share by 7% compounded annually. With its turnaround underway, this could be a reasonable baseline of expectations going forward. Therefore, a potential breakdown of future returns is below:
- 3%-5% revenue growth
- 1% margin expansion
- 2%-3% share repurchases
- 2.4% dividend yield
Based on this, total returns would reach 8% to 11% per year, not including changes in the valuation multiple, which could be a future headwind for the stock. If McDonald’s is approximately 10% overvalued, and it takes five years to reach fair value, the decline in the valuation would reduce total returns by 2% per year. As a result, total annual returns would be 6% to 9%, which is a decent, albeit modest, rate of return.
Yum also appears to be overvalued. Analysts expect Yum to generate earnings-per-share of $3.25 in 2018. As a result, the stock currently trades for a price-to-earnings ratio of 25.1.
In the past 10 years, Yum stock traded for a price-to-earnings ratio of 21.8. Using the 10-year average valuation as a current fair value estimate, Yum is overvalued by approximately 15%. Over the next five years, this could weigh on Yum’s total returns to the tune of ~3% per year.
That said, while Yum is slightly more expensive than McDonald’s, on the other hand Yum also grows earnings at a higher rate. A reasonable breakdown of total returns is as follows:
- 5%-7% revenue growth
- 1% margin expansion
- 2%-3% share repurchases
- 1.6% dividend yield
Based on this, Yum would deliver annual returns of 10% to 13% per year, before valuation multiple changes. Including the impact of a declining price-to-earnings ratio, Yum’s total returns would be 7% to 10% annually.
The other downside of McDonald’s rising share price and valuation, is that the dividend yield continues to fall. McDonald’s dividend yield is down to 2.4%.
However, McDonald’s continues to increase its dividend each year, meaning investors’ dividend income will surely rise over time. McDonald’s is a Dividend Aristocrat, and it has increased its dividend each year since its first dividend payment in 1976. Its most recent increase was a 7.4% hike on September 21st, 2017. The dividend is highly secure.
Using 2018 earnings forecasts, McDonald’s is likely to hold a dividend payout ratio of 53% for 2018. This is a relatively low payout ratio, and leaves plenty of room for future increases. Investors are likely to see mid-to-high single-digit dividend increases on an annual basis.
Yum has a lower dividend yield (1.6%), but typically grows its dividend at a higher rate than McDonald’s. Yum has already increased its dividend by 20% this year. It could continue to beat McDonald’s in terms of dividend growth, as Yum has a dividend payout ratio of 44%, using 2018 earnings estimates.
And, due to its higher earnings growth rate, it would also have greater flexibility to raise dividends by 10%+ per year moving forward.
McDonald’s and Yum have had great runs over the past few years. But at this point, both stocks appear to be overvalued.
McDonald’s and Yum are likely to continue growing earnings, and paying dividends. While investors may not see the valuations of each stock continue to expand, McDonald’s and Yum both have a positive total return profile moving forward.
If investors attempted to choose between the two, McDonald’s appears to be the better pick for risk-averse investors. It is a larger company, and it is a Dividend Aristocrat. It also has a higher dividend yield. Yum would be the better pick for investors looking for faster growth, albeit with a higher valuation and lower dividend yield.