My aim is to develop a passive income stream, which will eventually support the expenses of my family. I expect dividend income will make up the bulk of this passive income. Last year, the portfolio managed to generate $27,000 in dividends. McDonald's Corporation (NYSE:MCD) was an addition to the portfolio in 2013.
McDonald's is one of the most well-recognized fast food franchises in the world. The company specifically operates and franchises McDonald's restaurants in more than 110 countries around the world. The brand recognition of the company's flagship products such as the Big Mac or French Fries is global and universal in nature. McDonald's has also increasingly been offering premium, higher margin items such as the McCafe line of products and introducing a variety of healthier options to respond to an increasingly health-conscious consumer.
McDonald's Corporation has a market capitalization of $93.3B, with revenues of $28B and a gross margin close to 40%. McDonald's generates a net income of almost $5.5B. McDonald's currently trades at a forward PE of 14.7 and a dividend yield of close to 3.3%.
There are some compelling arguments to support the investment case in McDonald's.
Global distribution strength and wide moat
McDonald's is a recognizable and global presence in an industry that tends to be highly fragmented, with many local, regional and national brands. McDonald's vast network of franchised restaurants provides the company with a high level of cost-efficiency in product sourcing and marketing, enabling the company to deliver a standardized product across the globe for a very low cost. The ability to outspend national and regional chains in marketing reinforces brand recognition with customers and further deepens the company's wide moat, enabling it to further increase sales and marketing.
The strength of McDonald's operating efficiency can be seen in the strong numbers that McDonald's has put up over the last decade. Operating margins almost doubled over the last decade, from 16% in 2003 to just over 30% in 2013. This indicates an expanding moat for production and distribution.
Finally, take one look at McDonald's Return on Equity and you realize why McDonald's investors are a happy bunch. Return on Equity has increased from 13% to 37% over the last decade. The company has gotten significantly better at conversion of revenue to cash leveraging shareholder equity.
Longevity and consistency of performance
McDonald's has been in business since 1940. The company has survived a range of different economic conditions. The operating performance of the company has been so good over a consistently long period of time that it has managed to pay increasing dividends annually to shareholders for the last 37 years without missing a beat.
McDonald's performance in more recent times has also been pretty exemplary. The company has increased revenues from $17.1B in 2003 to just under $27.5B in 2013. Further, net income has strongly risen from $1.4B in 2003 to $5.46B in 2013. Revenue and net income have grown at annualized growth rates of near 6% and 20% respectively for the last decade. The net income performance in particular is a strong for a company that has been around for more than half a century.
An investor who invested $10,000 in the S&P 500 basket of stocks in 2004 would have almost $20,000 today. Certainly not a bad return. However, consider that same investor who invested $10,000 in McDonald's stock. They would have an investment worth almost $50,000 today. That's almost 2.5 times what a comparable investment in the S&P would have delivered.
Product and country diversity
While McDonald's is best known for its burgers and fries, the reality is that the company has been growing its range of beverages and healthy choice options and breakfast items. Coffee sales now account for close to 6% of McDonald's revenues or more than $1.5B annually, where the company is going head-to-head with the likes of Starbucks (NASDAQ:SBUX). McDonald's breakfast items such as Egg McMuffins are also a big earner now for the company and account for close to 25% of revenues, or well north of $6.5B.
McDonald's also has a significant global presence. While the company is known for having a dominant US market share, the company earns the majority of its revenues and cash flows in overseas markets. In fact, greater than 65% of McDonald's revenues come from international markets. Of course, while this means that the company is exposed to fluctuations in value in the USD, it also helps insulate McDonald's from negative trends in the US markets.
Stability of stock price
The operating consistency of McDonald's business model over the years has led to a stock which tends to have minimal price volatility. That is particularly attractive to me, because I maintain a portfolio that tends to skew higher-to-more volatile small cap dividend-paying stocks. While I consider these stocks the gems of my portfolio, the stock prices of these companies still tend to move around like a yo-yo.
McDonald's, for example, has a beta of only 0.38, meaning it moves less than half as much in price as a general move in the market. Thus, when the market takes a precipitous dip McDonald's doesn't dip as much, in general.
This level of stock stability can be very important to new investors and young investors in particular. Frankly, there are very few of us that will be happy seeing thousands of dollars wiped off a portfolio of stocks. I think this is particularly important for newer investors in the stock market or younger investors who may not be so established in the market to understand the fluctuations in price that they need to ride out.
Thus, having stocks like McDonald's as part of a core holding can be a quite valuable for helping minimize portfolio volatility. In my view, stable consistent dividend growth stocks have a strong role in any portfolio, whether more growth or income-oriented.
In 2008, for example, as the S&P 500 went into a nosedive and dropped 37%, McDonald's actually finished the year up 8%!
There are a few arguments that run counter to an investment in McDonald's.
Changing US consumer preferences
McDonald's same store sales in North America have been sluggish in recent years, driven largely by health and wellness concerns around fatty fast food consumption. Consumer activist groups advocating healthy eating could further pressure foot traffic into stores. McDonald's has been fairly active in seeing these trends and taking decisive action. In addition to introducing a range of healthy choices in kids' menus, McDonald's has been experimenting with healthy choice additions in its general menu targeted at all consumers. The company looks to be well-positioned to at least position healthier options on its menu and respond to such changing preferences going forward.
McDonald's is currently in the median of its recent valuation range. Over the last 5 years, McDonald's PE ratio has averaged approximately 17 times earnings, a level at which it is currently trading at today. McDonald's is slightly higher than its average 5-year dividend yield of 3%, offering close to 3.3% today. It trades close to 5-year averages on a range of other valuation measures including price to book, price to sales and price to cash flow.
McDonald's is facing sluggish US same store sales growth. The range of enhancements that are being made to its core offerings with healthy choices are things that should continue to keep the company in good stead with consumers. McDonald's has managed to keep itself relevant with consumers for more than 50 years, and I believe there is every reason to believe this should continue going forward.
While I don't expect McDonald's to have the same improvements in operating margins over the coming decade like it did in the last 10 years, I still believe it should provided healthy increases in net income in the medium term. McDonald's is a quality business that has provided earnings growth and consistency with minimal volatility.
I established a position in McDonald's of 75 shares at $94.