Fast-Food Fistfight: Whose Dividends Are The Strongest: McDonald's Or Yum Brands?

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Includes: MCD, YUM
by: David Schauber, Jr.

When determining whether or not to buy an ownership interest in a certain company, there are a number of things that are often considered. Such things include the durability of the company's business model, the company's balance sheet, valuation, and historical earnings growth.

Another important consideration for many investors is the strength and sustainability of the dividend that the company pays out. Dividends are very important, as they accounted for about 42% of the total return of the S&P 500 from 1930 to 2012. The portfolios of many dividend-oriented investors are composed of dozens of dividend-paying stocks from a wide variety of sectors.

In today's article, I will delve into the quick-service restaurant sector with a look at the dividends from two of the biggest companies in that space. They are McDonald's (NYSE:MCD) and YUM! Brands (NYSE:YUM) (referred to as Yum Brands throughout). I will examine the important aspects of each company's dividend, such as the dividend's history, whether or not the dividend can be covered by the company's earnings, and look for clues as to whether the company can continue paying out and growing their dividends going forward.

Many seasoned investors will look at the two companies mentioned above and say that this article is akin to determining whether Michael Jordan was a great basketball player. There may be some truth to that, but the main idea of this article is to provide a framework by which an investor can determine what company in a given sector has the strongest and most sustainable dividend in the event that the investor can only choose one from the group.

Dividend Yield

Usually, the first and most obvious consideration when analyzing a company's dividend is the dividend yield, which represents the percentage of your original investment that you will get back over the next 12 months, provided that the dividend does not change during that period. Let's compare the dividend yields of the two companies.

McDonald's

3.4%

Yum Brands

2.0%

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Table 1: Dividend Yields Of McDonald's and Yum Brands

Many investors will use a company's historical dividend yield, along with other metrics like historical P/E ratios, as a way to help determine if the stock is cheap or expensive. According to data from YCharts, the last time the dividend yield of McDonald's was this high was in December 2009, four years ago. When it comes to dividend yield, McDonald's clearly comes out the winner here, with its current 3.4% yield, along with the fact that the yield is at its highest point in quite some time.

Dividend Growth

When evaluating the quality of a company's dividend, there is more to it than just the yield. Sometimes, a company's stock may have a high yield due to poor fundamentals that have caused the price of the stock to fall relative to its dividend payout. These poor fundamentals could then lead to dividend cuts, which can then lead to a drop in your net worth.

Dividend growth is another very important factor. For one, dividend growth helps to preserve the purchasing power of your income stream by protecting it against inflation. Secondly, when a company increases its dividend, that is a sign of confidence by management when it comes to the company's fundamentals and future outlook. And third, growing dividends allow investors to share in the benefits of growing earnings. It should also be mentioned that dividend growth can supercharge an investor's yield on cost over the years. For instance, Warren Buffett and Berkshire Hathaway (NYSE:BRK.A) received a whopping 40% yield on cost in 2012 on shares of Coca-Cola (NYSE:KO) that were purchased back in 1988. This is due to the dividends that grew almost fourteen-fold since the purchase.

Let's take a look at the dividend growth rates over the last 5 years of our two fast-food stocks. The numbers in the table represent the average dividend growth rate over the last five years.

McDonald's

10.2%

Yum Brands

14.3%

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Table 2: Five-Year Dividend Growth Rates of McDonald's and Yum Brands

While the dividend growth rates of both of these companies are impressive, easily outpacing inflation, Yum Brands has the higher rate of dividend growth, north of 14%. Yum Brands has increased its dividend every year for the last 10 years. McDonald's isn't too shabby either, with a 5-year dividend growth rate of 10.2%. This company has increased its dividend for 38 years in a row.

It's worth noting that while the 5-year dividend growth rate of McDonald's is above 10%, its most recent dividend increase was just 5.2%. This compares with a 10.4% increase from Yum Brands.

Overall, these are impressive numbers and serve as testaments to the strong business models and long-term earnings growth of these two companies. When looking at dividend growth over the last five years, Yum Brands wins out here.

Dividend Payout Ratio

In many cases, it's not enough to only look at the dividend yield and the historical dividend growth rates of the stock in question. We need to make sure that the company is making enough money to support these dividend payments. This is where the dividend payout ratio comes into play. It represents the percentage of profits that the company has been allocating toward dividend payments, as opposed to being used for buying back stock or reinvesting into the company's operations. Generally speaking, the lower the payout ratio, the better. This is because lower payout ratios often indicate that there is plenty of room left for dividend increases in the future. Payout ratios that approach or even exceed 100% may indicate dividend freezes or cuts in the future.

Table 3 shows the trailing twelve-month payout ratios, as well as the average payout ratios over the last four years for McDonald's and Yum Brands. These percentages are based on core earnings (non-GAAP).

Company

TTM

4-Year Average

McDonald's

56%

52%

Yum Brands

45%

37%

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Table 3: Dividend Payout Ratios of McDonald's and Yum Brands

From looking at Table 3, neither of the dividend payments of our two companies appear to be in any sort of danger. The payout ratios over the last twelve months have expanded a little bit relative to what we have seen over the last several years. While these payout ratios are very good, the payout ratio of Yum Brands is significantly lower than that of McDonald's, implying more room for future dividend increases. However, it is worth noting that Yum Brands mentioned in their most recent 10-K filing that they aim for a dividend payout ratio of 35-40% of their net income, leaving more cash to plow back into its business.

But What About Free Cash Flow?

What we just did above was analyze the safety of the dividends relative to the company's earnings. However, earnings don't pay dividends, cash does. And, earnings often include a lot of non-cash items (like depreciation, amortization of patents, asset writedowns, actuarial gains on pension plans, etc.) that can distort one's perception as to the safety of a company's dividend. For this reason, a more accurate measure of determining a company's ability to pay its dividends is the payout ratio based on free cash flow. In other words, what percentage of actual cash that comes in over the course of a 12-month period gets paid out to shareholders?

Table 4 shows the free cash flow payout ratios of our two companies over the last 12 months, as well as the four-year averages. Note that free cash flow is calculated as operating cash flow minus capital expenditures.

Company

TTM

4-Year Average

McDonald's

72%

66%

Yum Brands

56%

44%

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Table 4: Free Cash Flow Payout Ratios of McDonald's and Yum Brands

Table 4, like Table 3, shows that the current dividends of each company are well-supported. Right now, McDonald's is in the 70% range, which indicates that dividend growth may continue to moderate unless we see substantial increases in free cash flow. Yum Brands has a significantly lower free cash flow payout ratio, which shows more potential for dividend growth going forward.

Other Tools To Predict Dividend Sustainability Going Forward

Many investors would stop at this point and vote yea or nay as to whether or not the dividends of the company in question are of good enough quality. And that's fair enough. However, what we have done so far is look at past dividend and cash flow data. Aside from what we have done so far, there are some other tools that we can employ in order to evaluate the ability of our four companies to pay out increasing dividends in the future.

Interest Coverage Ratio

The interest coverage ratio is simply the company's earnings before interest and taxes (EBIT) divided by the company's interest payments during the time period in question. This ratio shows whether a company can generate enough money to cover its interest payments, which must be made before any dividends can be paid out. The higher this ratio, the better. If the company is paying an exorbitant amount of interest relative to its pre-tax profits (a low interest coverage ratio), then that doesn't leave much room for dividends, which may be indicative of dividend cuts in the future. For this reason, dividend investors like to see high interest coverage ratios.

Table 5 shows the interest coverage ratios of McDonald's and Yum Brands over the last 12 months.

McDonald's

16.8

Yum Brands

7.29

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Table 5: Interest Coverage Ratios of McDonald's and Yum Brands

From Table 5, we see that the interest coverage ratio of Yum Brands is pretty good, where it covered its interest payments more than 7 times. But, McDonald's steals the show here, as they covered their interest obligations almost 17 times with pre-tax earnings.

Net Debt To Equity Ratio

The net debt to equity ratio is also very important. The amount of debt not only influences the amount of interest that must be paid, but also, the amount of debt that at some point will need to be repaid. Right now, a lot of companies are choosing to refinance their debt due to the presence of very low interest rates, as opposed to paying it off. However, if and when interest rates go higher, refinancing may be a less attractive option. As a result, extinguishing debt may have an effect on future dividend payments.

The net debt to equity ratio is calculated by dividing the net debt by the company's equity position. Net debt is simply the combination of short and long-term debt minus the company's cash position. The lower this ratio, the better. Ratios typically below one are considered to be good. Table 6 shows the values of these ratios for our two companies.

McDonald's

0.71

Yum Brands

1.07

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Table 6: Net Debt To Equity Ratios of McDonald's and Yum Brands

From Table 6, we see that McDonald's wins out here, with a significantly lower net debt to equity ratio.

Earnings Per Share Growth Forecasts

While dividend growth can be achieved to some extent through the expansion of the payout ratio, ultimately there must be free cash flow growth in order for there to be long-term dividend growth. And, free cash flow growth stems largely from earnings growth. In order to get a better idea as to whether the company can sustain growing dividends going forward, you may want to consider analyst projections for earnings growth over the next couple of years. Table 7 shows earnings per share growth estimates for both companies from the analysts at S&P Capital IQ. The estimates are for fiscal 2014 and 2015.

Company

2014

2015

McDonald's

6%

8%

Yum Brands

22%

15%

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Table 7: Earnings Per Share Growth Forecasts for McDonald's and Yum Brands

While both companies have decent earnings forecasts for the next couple of years, Yum Brands is expected to grow its earnings at a much faster rate. This bodes very well for strong dividend increases in the future for Yum. If the forecasts hold true for McDonald's, then we should expect to see more dividend increases similar to the 5% bump that we saw in the latter part of last year, as opposed to the double-digit increases that we were seeing before then. Keep in mind that earnings per share growth can be fueled by stock buybacks as well as by cost cuts and revenue increases. When shares are repurchased, the same amount of money that's allocated for dividends will be divided among fewer shares, resulting in per-share dividend increases, without actually having spent more money on dividends.

Conclusion

In this article, we have analyzed the dividend strength of McDonald's and Yum Brands by looking at a number of factors, including the dividend yield, dividend growth rates, payout ratios, interest coverage ratios, net debt to equity ratios, and analyst estimates for earnings per share growth. From looking at all of these items, it can be said that none of the dividends from these two companies appear to be in any kind of danger at this point in time.

Yum Brands has the lowest payout ratios based both on earnings and free cash flow, the highest dividend growth rate, as well as much stronger expected earnings per share growth. These items all indicate that investors in Yum Brands should continue to expect excellent dividend growth going forward.

McDonald's has a significantly higher yield and a better balance sheet. However, with a free cash flow payout ratio at around 70% and 6-8% expected earnings per share growth going forward, we should continue to see mid single-digit dividend increases in the future, as opposed to the double-digit increases that we had been seeing.

In spite of Yum Brands having a stronger dividend growth rate, lower payout ratios, and better earnings per share growth forecasts, I'm going to say that McDonald's still looks the best.

The reason for this is the fact that the starting yield of Yum Brands is so low that if you extended the one-year dividend growth rates of both companies out indefinitely, it would take about 12 years before the yield on cost of an investment in Yum Brands surpasses the yield on cost of an investment in McDonald's. Not only that, but it will take even longer than that for the cumulative dividends from Yum Brands to surpass those from McDonald's. And then, if Yum Brands dials back its dividend growth rate at some point, it could take longer still.

For that reason, if your primary focus is on dividends, I give the edge to McDonald's.

And, of course, before making a final investment decision, you need to consider other things such as valuation, business models, and geographic footprint to name a few.

For more information on how I analyze financial statements and dividend strength, please check out my website at this link. It's a website I created just for fun, as well as to help fellow investors make intelligent financial decisions. Thanks for reading and I look forward to your comments.

Disclosure: I am long MCD. 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.