What Is McDonald's Thinking?

When I read McDonald's (MCD) had increased their dividend, I almost fell out of my chair. The company has done a good job of increasing earnings over the years; about 10.72% between 1999 and 2009. The dividend has grown over 25% during the same period. It also has great international exposure, which is a driver of future growth.

The payout ratio is over 58% which compares with historic payout ratios of 28% at median levels over the past decade. What this means is that a lower multiple must be applied - if value is returned via dividends, the value delivered via capital appreciation must fall. The rate hike puts a lid on future dividend increases.

But gosh; how do they have the nerve to pay, let alone hike the dividend? Their balance sheet is so terrible; their net debt to net debt plus equity is up over 73%. What this means is any impairment of its assets will cause shareholder equity serious damage - and consider that 2.18 of its book value of $3.02 comes from Goodwill. In a rising rate environment this stock could suffer serious damage.

Their operating cash flow is decent and their ability to create free cash flow is good, so that's a positive; but because of its terrible balance sheet I would rate the stock a buy only at the very low $30's.

On valuation, I would not pay more 12X for a company with a dividend payout of over 58% with long term growth rates of 15%. I suspect MCD long term growth is closer to 7%/8% at which level I would refuse to pay more than 11.25X. And these are multiples where the company has a healthy balance sheet. With a highly leveraged balance sheet, I would not look at paying anything more that 8X-10X EPS estimates for 2009 (mine is $3.85).

Please visit The Quant Report and select the link to MCD at the bottom of the page for details on the numbers used in this post.

Disclosure: No holdings

Comments

[imc:]

"The payout ratio is over 58% which compares with historic payout ratios of 28% at median levels over the past decade. What this means is that a lower multiple must be applied - if value is returned via dividends, the value delivered via capital appreciation must fall."

I don't understand your rationale. Why must a lower multiple be applied, surely you would value the company based on the income together with the capital appreciation you get from holding the stock. A multiple should be based on earnings and likely growth of those earnings, MCD has shown consistently that it outperforms its competitors in this fashion.

A number of your other arguments regarding the balance sheet may or may not hold water to influence your thoughts on discounting the multiple but the rate of dividend surely shouldn't as it's not a business that requires large reinvestment of its earnings to maintain or develop its growth.

Sep 25 06:20 AM

[sanchezman:]

Many of your numbers are incorrect, rendering your analysis irrelevant.

Sep 25 06:37 AM

[wobatus:]

If something has a 58% payout ratio and long term growth rate of 15%, well, it depends on the interest rate environment, but I don't see how that isn't worth a lot more than 12x earnings. And then to slash the growth rate in half (and 7-8% seems like a more sober assessment of the growth rate) only takes you down less than 1 on the multiple? Perhaps if you fleshed out your dcf analysis and why those ae the multples. But thanks for the input.

Sep 25 07:32 AM

[reluctantQuant:]

MCD seems to have no problem covering the interest on its debt.
2008, after cap-ex, EBITDA was 10 times interest expense.
Q2 this year, 12.7 times.

Ah, if only more folks in the world could cover their monthly mortgage expense with that level of take-home pay.

Keep those quant models humming along. But understand what they're kicking out, sil vous plait.

--rq

Sep 25 08:33 AM

[algo41:]

Net debt (debt minus cash) is 8.8 billion. Tangible equity is 10.9 billion, and they have lots of real estate bought long ago, and so undervalued on their books. Many companies with "steady" cash flow have much higher debt to tangible equity ratios

Sep 25 09:24 AM

[Brad Castro:]

"Their operating cash flow is decent and their ability to create free cash flow is good, so that's a positive; but because of its terrible balance sheet I would rate the stock a buy only at the very low $30's."

Yeah, I'd buy in the low 30s as well - as much as I possibly could. I'll take this "terrible balance sheet" any day of the week.

Sep 25 10:26 AM

[sticktoitiv...:]

"What this means is that a lower multiple must be applied - if value is returned via dividends, the value delivered via capital appreciation must fall."

Take a good look at their business model. Other people put up most of the money to expand. Besides it's a mature business, not a tiny nanocap growth jobby. It should pay a nice dividend.

Sep 25 11:42 AM

[David Van K...:]

"[I]f value is returned via dividends, the value delivered via capital appreciation must fall."
-----
That's putting the cart before the horse. The company (any company) makes hundreds of decisions about what to do with earnings. It can invest in expansion, internal efficiency projects, R&D, make acquisitions, build up a cash hoard, buy back shares...the possibilities are endless. A good management team (and MCD's is really good) tried to optimize its use of available money. They have a great track record. I am willing to trust that they have retained enough for necessary projects and to fund expansion at a rate that makes sense for their business.

So if they've got enough money to do that, then deciding to return some of the rest directly to shareholders via dividends becomes the optimum use of that money. So it's not that the dividend payout cuts into the value delivered by capital appreciation. It's that after plowing an optimum amount back into the business to fund expansion (leading to capital appreciation), there's enough left over to pay a dividend. MCD's record in finding the right uses for their money--allocating capital--is stellar.

Sep 25 07:03 PM

[THofler:]

I presume the long term percentages in the first paragraph are annualized percentages? Please be clear!

The great Peter Lynch was/is a fan of PEG ratio style analysis, but he preferred to add the dividend yield to the annual EPS growth rate before dividing into the P/E value. I call it the LPEG in his honor.

Assuming a conservative 10% annual EPS growth rate I get an LPEG just under 1.1. Not dirt cheap but pretty good for what I consider to be one of the few genuine blue chips.

Sep 25 11:20 PM

[Dividend Di...:]

Interesting McDonald's factoid: Apparently, the farthest you can get from a McDonald's restaurant is 107 miles in the lower 48 states. 145 by car.

media.weathersealed.co...

Sep 26 09:38 AM

[Alaska:]

You didn't almost fall out of your chair. You did, hit your head, you can't remember it but it seriously impacted the rational part of your brain. In the last three years they have returned 25% of their EV to their shareholders via dividends and buybacks. What are they thinking indeed!? Enriching their shareholders! Dastardly them! A tangible book value of around $1? They own all the real estate under their franchises, carried at cost, not market value. Prime business RE worth much more than book value states. A stable recurring business, little debt, a great world brand, useing cash flow to give back to shareholders plus expanding quickly in China, South America, and other high growth areas...this is a great growth and value company.

Sep 27 02:30 AM

[Suren The Man:]

I think this is a feeble attempt to discredit the company to keep the stock price low. Your analysis is like a "spin-zone" talk. You leave out so many critical inputs in your analysis. I balked at your analysis and then realized that such an outcome can only have one motive.

Lemme ask you - Did you miss buying this stock when it fell to $53.88 waiting for $52 or lower? Now, you are panicking and want in. Wow, you can keep waiting for less than 12 times earning to buy and i am sure you will spend your entire lifetime waiting for this to happen. McDonalds will keep expanding and building their brand and buying back shares and increasing the dividend each year and your posts/analysis will become more despearate and then your receding hairline will completely dsintegrate (you will become bald and old). Keep waiting. While you are at it, based on your analysis, you should be waiting for 7 - 8 times earnings. Why do you want to cough up a premium of 50% (12 times earnings) if you expect the growth rate to be meagre??

ROFL!!

Sep 27 10:20 AM

[borisb:]

The company seems to have a better industry positioned global footprint and might be staging a chart reversal. 3 brokerage houses have made favorable comments in the past week.... Goldman, Sanford, Wedbush. Also this coming Tuesday cousins Darden, Nike, and Walgreens report quarterly earnings giving some needed color to strength and weakness of this consumer category.

Sep 27 08:58 PM

[No Moss:]

"Their balance sheet is so terrible; their net debt to net debt plus equity is up over 73%. What this means is any impairment of its assets will cause shareholder equity serious damage - and consider that 2.18 of its book value of $3.02 comes from Goodwill. In a rising rate environment this stock could suffer serious damage."

Sorry, I had to laugh at this analysis. Their "net equity" includes a huge debit (reduction of equity) for treasury stock. For those unacquainted with the term, treasury stock is stock that has been repurchased by the company. While this nominally reduces equity, it is actually a huge plus. The company could pay off all of its long-term debt by either sellling half of its treasury stock, or alternatively pay off its debt in a few years by ceasing to buy back stock for that period.

Goodwill arises when you pay more for an investment than the book (historical) value of that investment. The net difference is booked as goodwill. To give you an example of how that works, if you bought McDonald's today, you would pay far more than its book value--hugely more. Just on the basis of real estate, they have $21 billion in net book value (asset historical cost minus accumulated depreciation) which is actually worth, I would guess, at least three times that amount. Do you think McDonald's would actually sell an urban corner lot purchased 20 years ago for what it paid for it, much less its net book value? Then you would have to pay for the value of McDonald's as an incredibly successful business (the term goodwill actually stems from the reputation of a business and the value of its brand).

MickeyD is a formidable cash machine. It generated about $6 billion in cash flow from operations in 2008, and used about $4 billion of that to repurchase stock. The real question is whether MCD's shareholders are better served by paying off debt or by repurchasing stock and receiving dividends.

The mistake that most people make in analyzing MCD is to think of it as a restaurant company. It is a huge REIT, a franchisor, and a restaurant company. As a REIT, it collects increasing rent revenue even as the net book value of the rented properties decreases. This accounting anomaly gives rise to the use of FFO, or funds from operations, as a method of computing the real return (and the source of dividends) for REITs.

What it is also becoming is an investment company, it business plan being to actually invest in companies that purchase land and property for new restaurants. This allows them to increase their return on assets.

Sep 29 10:52 PM

[Shiv Kapoor:]

AH - I would never consider buying MCD at $53. I do not like the stock now and believe there are far superior defensive plays available. Well each to his/her own.

On Sep 27 10:20 AM Suren The Man wrote:

> I think this is a feeble attempt to discredit the company to keep
> the stock price low. Your analysis is like a "spin-zone" talk. You
> leave out so many critical inputs in your analysis. I balked at your
> analysis and then realized that such an outcome can only have one
> motive.
>
> Lemme ask you - Did you miss buying this stock when it fell to $53.88
> waiting for $52 or lower? Now, you are panicking and want in. Wow,
> you can keep waiting for less than 12 times earning to buy and i
> am sure you will spend your entire lifetime waiting for this to happen.
> McDonalds will keep expanding and building their brand and buying
> back shares and increasing the dividend each year and your posts/analysis
> will become more despearate and then your receding hairline will
> completely dsintegrate (you will become bald and old). Keep waiting.
> While you are at it, based on your analysis, you should be waiting
> for 7 - 8 times earnings. Why do you want to cough up a premium of
> 50% (12 times earnings) if you expect the growth rate to be meagre??
>
>
> ROFL!!

Oct 02 02:10 PM

[Shiv Kapoor:]

FYI sale of treasury stock to pay down debt would be dilutive to future earnings. This would have a significant impact on valuations - it is probably one of the main reasons I do not like MCD. I think there are better defensive plays with sounder capital structures.


On Sep 29 10:52 PM No Moss wrote:

> "Their balance sheet is so terrible; their net debt to net debt plus
> equity is up over 73%. What this means is any impairment of its assets
> will cause shareholder equity serious damage - and consider that
> 2.18 of its book value of $3.02 comes from Goodwill. In a rising
> rate environment this stock could suffer serious damage."
>
> Sorry, I had to laugh at this analysis. Their "net equity" includes
> a huge debit (reduction of equity) for treasury stock. For those
> unacquainted with the term, treasury stock is stock that has been
> repurchased by the company. While this nominally reduces equity,
> it is actually a huge plus. The company could pay off all of its
> long-term debt by either sellling half of its treasury stock, or
> alternatively pay off its debt in a few years by ceasing to buy back
> stock for that period.
>
> Goodwill arises when you pay more for an investment than the book
> (historical) value of that investment. The net difference is booked
> as goodwill. To give you an example of how that works, if you bought
> McDonald's today, you would pay far more than its book value--hugely
> more. Just on the basis of real estate, they have $21 billion in
> net book value (asset historical cost minus accumulated depreciation)
> which is actually worth, I would guess, at least three times that
> amount. Do you think McDonald's would actually sell an urban corner
> lot purchased 20 years ago for what it paid for it, much less its
> net book value? Then you would have to pay for the value of McDonald's
> as an incredibly successful business (the term goodwill actually
> stems from the reputation of a business and the value of its brand).
>
>
> MickeyD is a formidable cash machine. It generated about $6 billion
> in cash flow from operations in 2008, and used about $4 billion of
> that to repurchase stock. The real question is whether MCD's shareholders
> are better served by paying off debt or by repurchasing stock and
> receiving dividends.
>
> The mistake that most people make in analyzing MCD is to think of
> it as a restaurant company. It is a huge REIT, a franchisor, and
> a restaurant company. As a REIT, it collects increasing rent revenue
> even as the net book value of the rented properties decreases. This
> accounting anomaly gives rise to the use of FFO, or funds from operations,
> as a method of computing the real return (and the source of dividends)
> for REITs.
>
> What it is also becoming is an investment company, it business plan
> being to actually invest in companies that purchase land and property
> for new restaurants. This allows them to increase their return on
> assets.

Oct 02 02:13 PM

[Shiv Kapoor:]

When payout ratio's rise and the rise is expected to be long term, multiples shift downwards with a time lag. Investors who buy before the time lag can get hurt because while they gain via the dividend, they lose on account of lower capital growth. If interested have a look at maxkapital.blogspot.co....


On Sep 25 06:20 AM imc wrote:

> "The payout ratio is over 58% which compares with historic payout
> ratios of 28% at median levels over the past decade. What this means
> is that a lower multiple must be applied - if value is returned via
> dividends, the value delivered via capital appreciation must fall."
>
>
> I don't understand your rationale. Why must a lower multiple be applied,
> surely you would value the company based on the income together with
> the capital appreciation you get from holding the stock. A multiple
> should be based on earnings and likely growth of those earnings,
> MCD has shown consistently that it outperforms its competitors in
> this fashion.
>
> A number of your other arguments regarding the balance sheet may
> or may not hold water to influence your thoughts on discounting the
> multiple but the rate of dividend surely shouldn't as it's not a
> business that requires large reinvestment of its earnings to maintain
> or develop its growth.

Oct 02 02:19 PM