Share price of McDonald's (NYSE:MCD) has again exceeded $100 and now is trading at ~$102. Prior to this run-up, the price surpassed the $100 level twice in the past 3 years but both times were followed by a notable pullback. In my view, MCD would be able to hold up at above $100 this time as the current uptrend is likely to persist while downside risk is limited.
MCD recently reported same-store results for April 2014, which generally meet market expectations. Management held an investor conference two weeks ago. The discussion was focused on Europe as well as Asia Pacific, Middle East and Africa segments, which management believes still have notable growth opportunities such as revamping operating models in a few key markets. As opposed to market's expectation, management did not provide details of a possible refranchising plan for these markets. Given this plan will likely bring additional growth opportunity, I expect future announcement of the details will be a positive price catalyst.
Owing to an almost 6% gain year to date, which outperforms a 4% return for S&P 500, MCD's forward 2015 EV/EBITDA and P/E multiples have expanded to 10.1x and 16.3x, respectively. Both multiples now trades at around 20% discount over MCD's peer averages owing to the fact that MCD's consensus long-term EPS growth estimate of 8% is notable below peer average at 16%. However, given that 1) MCD has above-average profitability and capital return performance; 2) the company's leverage level is below par; and 3) the stock's dividend yield of 3.2% is 2 times of peer average at just 1.6%, I believe that a smaller valuation discount is warranted (see chart below).
MCD's forward P/E now trades at 9% premium over the same multiple of S&P 500 (see chart below). Provided that 1) MCD's valuation premium relative to the index averaged at 8% in the past 12 months; 2) the company's long-term EPS growth potential (8%) is fairly close to the average estimate of 9% for S&P 500 companies; 3) the stock's dividend yield is much higher than S&P 500's average at 1.9%; and 4) MCD has a dominant position in global fast-food industry, I view the current MCD/S&P 500 relative valuation to be very reasonable.
Based on MCD's current annualized dividend of $3.24 per share and 8% cost of equity (the CAPM model would result in about 6% cost of equity based on 3% risk-free rate, 6% equity risk premium, and MCD's low 5-year beta of 0.5), the Gordon Growth Dividend Discount Model suggests that MCD's current price of ~$102 implies a dividend growth rate in between 4.5% and 5.0%, which is close to the most recent dividend hike (5.2%) and but much lower than a CAGR of 10.1% since 2009 (see chart below).
Now the question is whether the implied 4.5%-5% annual dividend growth is sustainable. To address that, I have performed a free cash flow analysis to gauge MCD's capacity for future dividend growth. As MCD has been able to achieve a very steady operating cash flow margin in between 25% and 26% over the past 5 years, my projections were based on consensus revenue estimates, which predict the top line to reach $32.1B by 2016. I assumed the operating cash flow margin to gradually increase from 25.0% in 2014 to 26.0% in 2016 according to consensus estimates that call for an EBITDA margin expansion from 36.4% to 37.3% over the same period. For capex, I assumed the figure to steadily rise to $3.3B by 2016. Based on these assumption, free cash flow was forecasted to grow from $4.2B in 2014 to $5.0B in 2016, representing an almost 9% CAGR. Given these projections, I estimated that a dividend growth of 9% per annum over the coming 3 years is achievable as MCD is able to maintain a stable free cash flow payout ratio at 80% with my estimated annual dividend payment. In this scenario, the company would have $0.8B-$1.0B of excess free cash flow per annum, which can be returned to shareholders through share buybacks (see chart below).
From a dividend yield perspective, I believe MCD has a price floor at ~$95 given the current state. In the past 10 years, MCD's dividend yield rarely exceeded 3.6% except in 2009 when the share price was under pressure thanks to global financial crisis (see chart below). In addition, given that the average dividend yield from North American fast-food peers is only 1.6% (see peer table above), a 3.6% or above yield for MCD would look very attractive and will draw significant buying demand. As such, assuming a dividend growth of just 5% in the annual cycle and a 3.6% dividend yield ceiling, the resulted share price of ~$95 only represents a 4% price downside from the current level after factoring in the dividend income (3.2%), implying a solid margin of safety on MCD's current valuation. Moreover, the fact that MCD's share price range bounded between $94 and $98 in 2013 also suggests a technical price floor at around $95 (see chart below).
In conclusion, management's plan to improve performance in Europe and pursue growth opportunities in emerging markets will continue to drive robust free cash flows and thus healthy dividend growth. As MCD still trades at an inexpensive valuation with very limited downside potential, investors are recommended to buy the stock.
All charts are created by the author, and data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.
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.