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By: Ahmed Ishtiaq

McDonald's (NYSE:MCD) is the world's number one fast-food company by sales, with more than 33,500 restaurants serving burgers and fries in 119 countries. (There are more than 14,000 Golden Arches locations in the US.) The popular chain is well-known for its Big Macs, Quarter Pounders, and Chicken McNuggets. Most of the outlets are free-standing units offering dine-in and drive-through service, but McDonald's also has many eateries located in airports, retail areas, and other high-traffic locations. About 80% of the restaurants are run by franchisees or affiliates.

Dividend Profile

McDonald's first paid a dividend in 1976, since then, the company has been increasing dividend each year. Since 1977, average dividend rate has been 24.66%, and the biggest dividend increase of 126.36% came in 1977. At the moment, the company pays an annual dividend of $3.08 per share, yielding 3.25%. Payout ratio based on free cash flows stands at about 73%, slightly higher than the optimal payout ratio of about 60% for a mature company. McDonald's paid $2.8 billion in cash dividends over the past twelve months and generated $3.9 billion in free cash flows. I decided to go little deeper and evaluated the free cash flows trend over the past three years for the company. Let's take a look at the free cash flows and some important metrics.

Free Cash Flows

  
 

2012

2011

2010

Net Income

$5,445

$5,503

$4,946

Depreciation and other noncash charges

$1,470

$1,415

$1,276

Funds from Operations (FFO)

$6,915

$6,918

$6,222

change in noncash current assets

$165

$150

$84

change in noncash current liabilities

$179

$82

$36

Operating Cash flows

$6,901

$7,150

$6,342

Capital Expenditures

$2,992

$2,730

$2,135

Free Operating Cash Flow

$3,909

$4,420

$4,207

Source: SEC Filings

Over the past three years, net income of the company has demonstrated a mixed trend. At the end of 2010, net income stood at $4.9 billion, which went up to $5.5 billion in 2011. However, the company had slightly weaker operations in 2012, and net income went down to $5.4 billion. McDonald's funds from operations have followed the trend in net income over the past three years while depreciation expense has increased.

Furthermore, operating cash flows have also shown a slight decline over the last twelve months, after recording an increase of about $800 million in 2011. At the end of 2011, cash flows from operations stood at just above $7 billion as compared to $6.3 billion at the end of 2010. Capital expenditures are a significant element on the books of the company, and in each of the previous three years, the company has spent over $2 billion. Over the past twelve months, McDonald's spent $2.9 billion in capital expenditures, highest in the previous three years. As a result of solid cash flows from operations, the company has impressive free cash flows. Free cash flows of the company have shown a varied trend over the past three years. Free cash flows in the last twelve months have gone down by almost $500 million due to an increase in capital expenditures.

Important Metrics

  
 

2012

2011

2010

Funds from Operations(FFO)/Total Debt

0.57

0.60

0.59

FFO/Capital spending requirements

2.31

2.53

2.91

Free Operating Cash Flow + interest expense/ Interest expense

8.61

9.97

10.33

Debt Service coverage

5.02

9.81

9.93

First ratio shows that coverage provided to debt by FFO has remained fairly stable over the past three years. The ratio for MCD has deteriorated slightly to 0.57 at the end of 2012, compared to 0.59 in 2010. FFO to total debt ratio indicates that the firm generates enough funds from operations to cover its total debt. However, due to a fall in FFO during the past twelve months, the ratio has come down to 0.57. The second metric in the table (FFO to capital spending requirements) shows that the capital spending requirements of the company has been appropriately covered through internally generated funds. However, the ratio has deteriorated over the three years, mainly due to an increase in the capital expenditures of the company over the past three years. McDonald's capital expenditures have been increasing over the past three years while operating cash flows have remained stable.

McDonald's free operating cash flows have shown a mixed trend during the last three years, and interest expense has been increasing. As a result, interest coverage ratio has shown a decline over the period of evaluation. Nonetheless, interest coverage ratio is incredibly strong for the company, and it should not face any trouble meeting its interest obligations. Finally, the debt service coverage ratio for the company is solid, despite a declining trend. McDonald's should not face any trouble meeting its debt servicing needs. Overall, the metrics indicate the firm is in excellent financial position.

Summary

There are a few companies in the market that can match the dividend growth demonstrated by McDonald's. My free cash flows model shows that the company has enough free cash flows to cover its interest, debt and dividend obligations. I would have liked a lower payout ratio, but it is not dangerously high for a mature company. I believe the company will carry on its impressive history of increasing dividends every year, and investors will be able to enjoy steady income source for the foreseeable future.

Source: Strong Cash Flows Back McDonald's Dividends