Time to Love the Golden Arches? (MCD)

Quick Background:

Come on, people, you don’t really need me to tell you who McDonald’s is, do you? The 6th most valuable brand in the world? The one we’ve been exposed to since childhood, and the focus of several quasi-legendary movies? In case you’ve been living in a cave for the past century, let me break it down quick for you: McDonald’s (MCD) serves McFood. Boom, done, call it a day. Burgers (like the Big Mac), fries, chicken (McNuggets), salads, and ice cream (McFlurries). Quick and convenient, MCD serves 69 million people a day with 36,000 locations in over 100 countries. Over 80% of restaurants are franchised.

MCD operates in an intensely competitive industry. Everywhere you look, there’s a fast food restaurant. On every street corner, in every major mall. Hell, I probably have one in my apartment complex at this point. I’m sure you can name 5 off of the top of your head by the time you finish reading this sentence. For the sake of convenience, we’ll say that the two main competitors in the restaurants sub-industry are Yum! Brands (YUM) and Cracker Barrel Old Country Stores (CBRL), two other dividend growth investor favorites.

For more basic information, check out the company’s website and the 2014 annual report. Definitely keep a copy of the annual report handy, we’ll be needing that a lot here.

An investment of $10,000 in December 1995 would be worth $63,517.33 today, all dividends reinvested. This yields an annual rate of return of 9.9%, slightly beating the S&P 500 (8.4%) during this time frame. (Source: FAST Graphs)

Sparknotes Analysis:

So we have our company. But how do we determine if it’s a good investment? Why, with our handy-dandy screening criteria, of course!

• Pays a dividend: Yes
• Has 5+ years of dividend increases: Yes (39 years)
• Has not frozen dividend for over 8 quarters: Yes
• Has a Chowder number of 10 or more: Yes (13.4)
• Has am EPS payout ratio of less than 70%: No (70.39%)
• Pays a dividend monthly or quarterly: Yes (Quarterly; March, June, September, December)

• Has an S&P Quality Ranking of ‘A-‘ or better: Yes (A)
• Has generally increasing earnings over the past 10+ years: Yes
• Is fairly valued/undervalued according to the Normal P/E ratio (blue line): No
• Is fairly valued/undervalued according to the Intrinsic P/E ratio (orange line): No

Other Ratings:

• S&P Capital IQ: 2-star sell
  • Scale is 1-5, 1 being ‘strong sell’, 5 being ‘strong buy’
• Thompson Reuters StockReport: 6 (optimized score of 9)
  • Scale is 1-10, 10 being best, 1 being worst
  • Optimized scores weight insider trading and price momentum heavier than other criteria
• Value Line: 1 for safety; 4 for timeliness
  • Scale is 1-5, 1 being best, 5 being worst
• Morningstar:
  • Moat: Wide
  • Stewardship: Standard

Financial Overview:

MCD has a very respectable dividend yield of 3.48%; the company pays out $3.40 per share annually. Only problem is, with normalized 2014 earnings per share of $4.45, that yields a payout ratio of 70.39%. That just barely fails my payout ratio criterion, which is my first warning that the dividend growth rate will be reduced to the rate of earnings growth, at best. Considering that earnings have been not been looking good these past few years (+4% in 2013, -8% in 2014, and an estimated -8% in 2015), MCD’s dividend looks in danger of not growing in excess of inflation.

Thankfully, free cash flow (FCF) per share was $6.12 in 2014, which yields a much more comfortable free cash flow payout ratio of 55.56%. While still high, FCF doesn’t seem to be dropping, so this is a more satisfying number. But oh wait, we ain’t done yet. FCF has been bouncing around the same range since at least 2010: $6.34 billion in 2010, $6.73 billion in 2014. This is a compound annual growth rate (CAGR) of 1.20%, much less than the 9.9% dividend growth rate in that time. Well, shit. This can go down either of two ways: EPS can start to increase, or the dividend growth rate can start to decrease, significantly. And looking at the earnings trend since 2010 in the FAST Graph above, I think the latter is more likely. Definitely not a positive outlook, in my opinion.

Now let’s look at debt. Total debt is $14.99 billion, while total shareholder’s equity is $12.853 billion. This yields a debt/equity ratio of 1.16; any number over 1.0 is bad on face value. Even worse, this ratio has been increasing steadily over the past few years. However, interest expense is only $570 million, which with total earnings of $4.758 billion, gives us an interest coverage ratio of 11.97x (interest expense of $0.58 per share), which is reasonable.

The company has slowly and steadily been buying back shares, going from 1.057 billion in 2010 to 958.51 million today. The company has split regularly, 10 times since going public. However, the last split was a 2:1 split in 1999, so they haven’t been recent.

MCD’s current P/E ratio is 22.1. Morningstar has a one year forward P/E ratio of 19.1, which, given current trends, is another hint that MCD’s share price isn’t done falling yet.

Now let’s look at margins. I’ll display them as MCD vs Peer Group.

• Gross margins: 37.98% vs 31.04%
• Operating margins: 27.71% vs 11.06%
• Net profit margins: 16.35% vs 7.07%

To MCD’s credit, what they can do is exercise solid margins, much better than the peer group. Hopefully this keeps up.

If we look at the historical CAGR, we can try to draw some conclusions about how MCD will perform in the coming years. If we assume analysts’ estimates actually mean something, we can assume that by 2018, MCD will have grown earnings by 4.7%. That, plus the dividend and share repurchases, tells us to expect an annual rate of return (AROR) of 1.94%. Pretty terrible, if you ask me. YUM will grow earnings by 14.2% and have a AROR of -8.21%. This, however, is the result of massive overvaluation (according to FAST Graphs). CBRL will grow earnings by 10.67% and have a CAGR of 2.26% (again, the result of overvaluation). So considering the better earnings growth of MCD’s competitors and the better chance of total return (overvaluation accounted for), MCD doesn’t seem like the best place to park money.

Valuation:

Morningstar’s fair value estimate is $102.00. S&P Capital IQ has a fair value of $83.80. FAST Graphs has a fair value between $71.10 and $90.37. Hm. Well, with a range like that, how about we try to calculate MCD’s fair value ourselves?

We’ll use the dividend discount model to determine this:

• Discount rate (DR): 7.425%
  • FAST Graphs‘ historical annual rate of return with dividends reinvested, multiplied by 0.75
• Dividend growth rate (DGR): 3.1%
  • Given the last raise and what we noticed above, I’m expecting a DGR that will end up basically equaling inflation
• Next Year’s Dividend Guess (NYD): $3.59
  • Calculated as [this year’s annual dividend] * (1 + DGR), rounded to the nearest penny
• Dividend discount model calculation:
  • Fair Value = NYD / (DR – DGR)
  • = 3.59 / (1.07425 – 1.031)
  • = $83.01

Given today’s closing price of $98.78, MCD is 16% overvalued.

Risk Factors:

Most of you know what issues MCD faces. Rather than rehash the same old shit, here’s Morningstar’s take on them. Read and enjoy.

Final Conclusion:

MCD is not a buy at this time. It fails the valuation criteria, being solidly overvalued. And more importantly, it fails the payout ratio criterion, telling me not to expect much in dividend growth. The company is pretty heavily in debt, and although FCF looks good, the declining EPS hints that the current pace of share buybacks and dividend increases isn’t sustainable. Frankly, I see little to like with the company, besides better margins than peers.

While I clearly won’t be adding MCD at least until it drops to my fair value target, I won’t be selling yet. MCD is in the midst of a turnaround, recently hiring a new CEO and presenting a new plan to reinvigorate growth. And who knows what they’ll do with the real estate; MCD owns some of the most valuable property in the world. I think it’s best to wait and see. However, if MCD’s DGR falls below inflation, or FCF and earnings continue to deteriorate heavily, I guarantee you I’ll be the first out the door. Good luck.

Does MCD make the cut for your portfolio? How can I improve future analyses?

Disclosure: Long MCD, YUM

All data is accurate as of market close, 07/14/2015. My stock analysis archive page has been updated accordingly. Please read my disclaimer here before choosing to invest. Company logo is IP of the above company. Data source is FAST Graphs, Scottrade Research, David Fish’s US Dividend Champions List, or company materials, unless otherwise indicated.

Tags: dividend-stock-analysis, MCD, McDonald's Corp