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Introduction

Using my portfolio fundamental rules (here), I used the CCC list (here) to select a champion to research. McDonald's (NYSE:MCD) is a long-term, dividend investor favorite. The quick service restaurant has provided both dividend growth as well as capital appreciation for years. Looking at MCD over the past 3 months, the stock is down about 2.5% and is up only 6% on the year. This is compared to the broader S&P 500 growth of 24% for the year. Below is an analysis of recent information from the company as well as its financial performance over the past 10 years.

Quick Facts from Google Finance

Price (12/12/2013)

$94.72

P/E Ratio

17.09

Dividend Payout

Quarterly

Prev. Year Dividend

$3.08

Yield

3.4%

Prev. Year EPS

$5.54

Payout Ratio

50%

5 Year Beta

0.4

Recent Quarterly Report Overview

One of the great things about Seeking Alpha is the opportunity to look at historic company report transcripts. You can find the Q3 2013 report here.

The company highlighted a three-pronged approach to moving the company forward. Specifically, MCD CEO Don Thompson wants to, "optimize the menu, modernize the customer experience and broaden customer's access to the brand."

US Sales were up 0.7% with operating income up 5%. Europe sales were up 0.2% with income up 8% (on constant currency). Asia sales were down 1.4% with a decrease in earnings 4% (on constant currency). The company highlighted challenging macroeconomic conditions as to the decline in Asia. Both China and Japan were down which highlight the long-term growth markets for the company. As a potential new position investor this is slightly concerning, but not too much. To give an idea of the scale of Asia growth, the CFO highlighted the openings by region as follows:

2013 Openings

US - 225

Europe - 300

Asia - 750

The CFO also made a statement that highlights my overview of the financial performance below. He said, "Despite modest comparable sales growth, McDonald's was able to achieve solid growth in revenue and income." The mechanisms here are obvious: cost and share repurchase.

On the cost front, the G&A expense was lower by 11%. Lowering incentive compensation as well as a higher comparison to a year ago when the company was spending heavily on Olympics promotions drove the cost results. Also the company highlighted a slowing of opening new stores. With the majority of McDonald's stores franchised, the company earns money as franchise margins improve. Because of this the company wanted to focus on stronger openings as opposed to more frequent expansion of store fronts.

Financial Performance

12/03

12/04

12/05

12/06

12/07

12/08

12/09

12/10

12/11

12/12

TTM

Revenue / Share

13.4

14.6

15.0

16.7

18.8

20.5

20.5

22.3

25.9

27.0

27.7

EBITA / Share

2.2

2.8

3.1

3.5

3.2

5.6

6.2

6.9

8.2

8.4

8.7

EPS (Diluted)

1.2

1.8

2.0

2.8

2.0

3.8

4.1

4.6

5.3

5.4

5.5

FCF / Share

1.2

2.0

2.1

2.1

2.4

3.3

3.4

3.9

4.2

3.8

4.2

Share Price

24.8

32.1

33.7

44.3

58.9

62.2

62.4

76.8

100.3

88.2

95.3

Dividend / Share

0.4

0.6

0.7

1.0

1.5

1.6

2.1

2.3

2.5

2.9

3.1

Debt to Equity

0.8

0.7

0.7

0.5

0.6

0.8

0.8

0.8

0.9

0.9

0.9

Payout Ratio

0.4

0.3

0.3

0.4

0.7

0.4

0.5

0.5

0.5

0.5

0.5

Shares Outstanding

1,277

1,274

1,274

1,252

1,212

1,146

1,107

1,080

1,045

1,020

1,004

P/E

21.6

17.9

16.5

15.7

29.8

16.5

15.2

16.8

19.0

16.5

17.2

Looking at the important metrics, MCD is a powerhouse. The past 10 years have shown consistent growth in EBITDA, FCF, and dividends. Also, the company has done well in buying back shares. Shares are down over 20% in the past 10 years. While things are great in terms of these top lines there are some concerns. The share repurchase highlights some issues with revenue growth over the years. Also, there is a slow increase in the payout ratio. Starting around 35% in 2003 it has climbed to 50% today. That 42% increase in payout ratio over 10 years is somewhat concerning. There is also a small downward bump in EPS during 2007 and the debt to equity is slightly up over the years.

Price Calculation

TTM Earnings

$5.54

Year 1-5 Growth

8.5%

Year 6-20 Growth

4.3%

Discount Rate

12%

Current Price

$94.72

DCV

$61.85

Year 5 Earnings

$7.68

5 Year Avg P/E

16.9

Price @ 5 Year

$129.97

Intrinsic Value

$41.85

Future Intrinsic Value

$45.41

Looking at a couple of price calculation shows that MCD is currently overpriced. Using the current earnings of $5.54 with a combined analyst estimate growth of 8.5% as a base, I perform a discount price of $61.85. This is compared to the current price of $94. I also calculated the current and future intrinsic values. The formula can be found here. I used the AAA Corp Bond rate of 5.05%. This leads to values of current and future in the $40s. While these calculations show that the current price is high, the historic values have always been high relative to these metrics. The current P/E (17.1) is just above the 5-year average (16.9). Based on next year earnings, the P/E is sitting at 15.8.

Dividends

Year

Dividend Payment

CAGR

2013

3.08

2012

2.87

7%

2011

2.53

10%

2010

2.26

11%

2009

2.05

11%

2008

1.63

14%

2007

1.50

13%

2006

1

17%

2005

0.67

21%

2004

0.55

21%

2003

0.40

23%

One of the highlights to MCD is the string of strong dividend growth. The past 10 years have shown a decline in the CAGR. 10 years ago MCD was about 20%, 5 years ago MCD was about 10% and most recently it has declined to 7%. This trend is concerning especially with the note above that the payout ratio has increased 42% over the same time. While the payout ratio is still safe, it does continue to highlight questions on revenue-generating potential going forward.

Scoring / Conclusion

Category

Performance

Goal

Pass / Fail

Yield

3.3%

2.9%

Pass

Chowder Rule

12.4%

12.0%

Pass

Modified Chowder Rule

16.8%

12.0%

Pass

5 Year EBITA Growth

9.1%

0.1%

Pass

Trailing P/E

17.09

16.93

Fail

Debt to Equity

89.0%

50.0%

Fail

Dividend Payout

50%

60%

Pass

Price Protection

Low

Modest

Fail

Min. Share Price

$94.72

$5.00

Pass

Do I know the Business Model

Yes

Yes

Pass

Total Pass

7

MCD posted a respectable 7 of 10 passes. The Fails are related to things that I commented on above. The first is the trailing P/E ratio is currently above its 5-year average. That being said, the forward P/E is a respectable 15.8. The second is the high debt to equity. This value has continued to climb over the past 10 years and poses some concerns. It is not too high to be a problem, but it is inching closer and closer to limiting the company's flexibility should the company need financing. The last value is price protection. As a rare MCD customer, I only go for the dollar menu. As food costs change, I do not know that MCD has the flexibility in the competitive environment to increase prices equal to their costs. The dollar and more menu concept is something the company has tried before. It doesn't fool me and I assume it won't fool many others.

If the valuation is done off historic perspective, MCD is not a buy. If you look towards the future, the company is positioned well, has a fantastic brand and will continue to provide value to those who purchased at a more respectable rate years ago. Should I hold off buying? I look forward to the comments.

Source: Should McDonald's Be Added To My Dividend Growth Portfolio?