A No-Brainer Dividend Growth Investment

| About: McDonald's Corporation (MCD)

Here are two quotes from an article on McDonald's (NYSE:MCD) in Fortune magazine titled "Can McDonald's Cook Again? The great American icon ain't what it use to be."

"McDonald's missteps seem to have eroded its position, at least in the U.S., as an American icon. For a number of reasons--from increased fast-food competition to a lack of innovation to poor marketing--McDonald's seems to have lost a sense of itself."

"McDonald's identifies the words "rude," "slow," "inaccurate," and "unprofessional" as the top four customer-service complaints, according to Mark Kalinowski, who covers restaurants at Salomon Smith Barney. Ouch. High employee turnover--at nearly 300% industrywide--is a huge contributor to poor service, especially for the monkey wrench it throws into training. And veteran analysts say that turnover at McDonald's tends to be higher than that of its nearest rivals. At the drive-thru, where McDonald's (and almost every other fast-food company) takes in about 60% of sales, a QSR Magazine study (short for Quick Service Restaurant, as they are known in the industry) shows McDonald's average per-order time to be 35 seconds behind Wendy's. (NYSE:WEN)"

What may surprise you about those quotes is that they are from 2003. Throughout the long history of McDonald's, issues concerning service, menu, food quality, etc. have cropped up from time to time and have always been successfully dealt with. Anyone who bought and held the stock in 2003 is certainly very happy as it has climbed from around $15.00 to the $94.00 it is today, a six-bagger. In addition, using David Fish's excellent Drip Investing Resource Center, we see that MCD has raised its dividend an average of 23% annually over the last 10 years.

Improving the Operation

Similar to 2003, McDonald's again faces questions over service, future growth, and menu. Just like in 2003, I am confident McDonald's is aware of these issues and is working to correct them. At the 2013 Analyst Meeting, McDonald's CEO Don Thompson stated that management was aware of the issues facing MCD and they were taking action to resolve the issues. Below are some of the actions MCD is taking to improve service, menu quality, and most importantly, profits.

  • Continue re-imaging restaurants to maintain a current and fresh look to them. In 2014, MCD expects to re-image 1,000 restaurants. Re-imaged restaurants show 6-7% increase in sales.
  • Continue opening new restaurants, which typically provides excellent and growing sales. MCD intends to open between 1,500 and 1,600 restaurants. The highest percentage will be in Asia.
  • Install dual drive-through lanes to speed the ordering process.
  • Install a 3rd drive-through window to allow large complicated orders to wait at the 3rd window, while quicker orders move through the 1st and 2nd window.
  • Expand drive-throughs in foreign markets where MCD is the only operator offering drive-through.
  • Considering opening up McCafe kiosks in stores.
  • Continue to expand the beverage lines to grab more market share in beverages. Beverages are currently 5-8% of sales.
  • Promote breakfast in foreign markets where breakfast is not as popular as it is in the United States. Breakfast is 25% of U.S. sales, but only 12% in Asia and 5% in Europe.
  • Working with Kraft (KRFT) to sell packaged McCafe branded coffee.
  • Rolling out new kitchens in U.S. restaurants, which will speed-up the food preparation process.

Correcting the operational issues, opening new stores, selling more beverages, improving international breakfast sales, and creating new popular menu items will lead to increased sales.

Expansion Keeps the Profits Growing

At the end of 2012, MCD had approximately 35,000 restaurants. In 2013, it opened approximately 1,500 restaurants and expects to open a similar number in 2014 and 2015. That is a more than 12% increase in restaurants over a three-year period. In China alone, MCD believes it can open 300 restaurants a year for many years to come. More restaurants equal more sales, more cash flow, and more profit.

Sharing the Cash

Over the last five-years MCD has been returning between $5 billion to $6 billion annually to shareholders. The cash returned to shareholders is equally split between share buybacks and dividends. The share count has fallen from 1.185 billion in 2007 to just under one-billion today, a decrease of 18% during that period. As share count goes down, the earnings per share goes up.

From the McDonald's website, we see the company bought back the following shares from 2007 through 2011.

Year # Shares in millions $ Amount in billions
2011 41.9 $3.3
2010 37.8 $2.6
2009 50.3 $2.8
2008 69.7 $3.9
2007 77.1 $3.9

If MCD were to keep buying approximately 40 million shares a year, it could conceivably buy back every share in approximately 25 years. I found one source that stated the company bought back 28.1 million shares in 2012, but I could not verify it, and so I did not want to include it in the chart.

MCD yields 3.4%, with a very safe payout ratio of 56%. Again, using David Fish's DRIP Investing Resource Center, we see MCD has raised the dividend an average of 13.9% over the last 5 years and 5% in 2013. An attractive yield of 3.4% and annual dividend increases between 5% and 10% makes for solid income growth for long-term share owners.

Earnings Continue to Grow

In 2012, MCD grew sales by 3.1% and earnings by 5%. In the 3rd quarter of 2013, it grew earnings by 6% over 2012. McDonald's continues to grow its sales and earnings. Its goals are 3-5% annual sales growth, 6-7% annual operating income growth and Return on Invested Capital in the high teens.

When I look at large companies, I often like to look at how they can leverage their size to increase earnings. MCD serves 69 million people a day. Imagine if they increased the check size by 10 cents a customer. Those 10 cents would generate an additional $6.9 million a day and $2.5 billion a year. The size and scale of the company can be used to generate earnings in many ways. Whether it is reducing costs, increasing prices, or selling a higher margined product, a large company like MCD has many tools it can use to generate a little more profit.

McDonald's is Cheap!

Comparing MCD to other restaurants, we see that it is the cheapest of the bunch and has the best yield.

Company P/E Yield
McDonald's 17.4 3.4%


95.5 2.2%
Burger King (BKW 37.7 1.2%
Red Robin (NASDAQ:RRGB) 29.38 0
Yum! (NYSE:YUM) 30.2 2.1%

McDonald's is the largest of the restaurants chains, and as such can be expected to grow the slowest. However, MCD is significantly cheaper than its competitors and has for years outperformed all of them. Burger King and Wendy's have suffered through various management shake-ups and periods of poor performance.

Not only is MCD cheap as compared to other restaurant chains, it is also cheap compared to other Dividend-Growth stalwarts. For this chart, I have included the 5-year dividend growth rate (DGR).

Company P/E Yield 5-Year DGR
McDonald's 17.4 3.4% 13.9%
Coca-Cola (NYSE:KO) 20.3 2.9% 8.1%
Pepsi (NYSE:PEP) 19.8 2.8% 7%
Johnson & Johnson (NYSE:JNJ) 21.2 2.8% 7.6%
Procter & Gamble (NYSE:PG) 20.3 3.0% 8.8%
Kimberly-Clark (NYSE:KMB) 21.9 3.1% 6.9%

Real Estate - The Margin of Safety

Whenever I consider an investment, I always ask myself, what is the downside? With MCD, I see little downside. The stock is, currently, relatively cheap. The company continues to expand restaurants, increase hours of operations, and grow sales. It also continues a long history of buying back stock, reducing the float, and thus, increasing earnings per share. However, even if everything related to the business went bad, MCD would have one advantage almost no other company has - real estate. MCD owns some of the best real estate in the world. The company currently owns about 45 per cent of the land and 70 per cent of the buildings for its more than 30,000 restaurants around the world. The value of this real estate is enormous, and some investors believe MCD should spin-off the properties to create value for shareholders. Back in 2005, Bill Ackman, the Pershing Capital hedge-fund manager, suggested spinning-off the real estate could drive up MCD's price by 50% in 6 months. Ackman suggested, at the time, that MCD's real estate was worth $46 billion.

MCD management, at the 2013 analyst meeting, stated they have looked at spinning-off the real estate, but believe continuing the business as it has been run for years will create the most value for shareholders. That said, for me, it is comforting to know that underneath the day-to-day restaurant business, a substantial portfolio of prime real estate supports the company. Real estate that continues to grow in value.


McDonald's business creates significant cash flow, which the company uses to invest back in the business, buy back shares, and pay dividends. The share count has fallen for years and will continue to fall. The dividend has been raised for years and will continue to be raised. The stores count has grown for years and will continue to grow. As the world's middle class grows, the number of people who can afford a meal at MCD will continue to grow. As more of the world's population moves to urban areas, more customers will be within reach of a McDonald's. Underneath all of the restaurant operations is real estate worth billions, which if needed, could always be spun-off to create value. McDonald's has everything I look for in an investment - a growing business, strong cash flow, methodical share buyback, and healthy dividend that is increased every year. I believe McDonald's has a lot of cooking left to do.

Disclosure: I am long MCD, KO. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.