McDonald's (NYSE:MCD) recently announced a plan to return $18B to $20B capital to shareholders through dividend and share repurchase between 2014 and 2016. What would be the implication on future dividend growth? In this article, I will provide readers some perspectives on the company's future cash flow and dividend trends.
I have performed free cash flow projections to gauge MCD's dividend capacity. Given that the company has managed to maintain a very stable operating cash flow margin over the past 5 years, my analysis was based on consensus revenue estimates which predict the top line to grow by 2.5% CAGR from $28.9B in 2014 to $30.4B in 2016. I assumed a flat 25.7% operating cash flow margin through 2016, which is consistent with its 5-year historical average. It is noted that consensus view expects about 200 bps EBITDA margin expansion over the next 3 years, meaning that my operating cash flow margin assumption could be conservative if MCD's EBITDA to cash flow conversion remains steady. I then assumed a flat capex of $3.0B through 2016, which is in line with management's guidance for 2014. Based on those fair assumptions, free cash flow was forecasted to grow by 4.2% from $4.4B in 2014 to $4.8B in 2016 (see chart below).
Due to the reasons discussed later in the article, I assumed dividend spending to increase by 4.0%-4.5% per annum through 2016. In this scenario, MCD's free cash flow dividend payout ratio will remain steady at 73% from 2014 to 2016, which is in line with the actual level in previous 2 years. After paying out dividend, the company would have about $1.2B-$1.3B excess free cash flow per annum which can be used to fund management's share repurchase plan (see chart above).
Given management's plan to return $18B-$20B capital to shareholders and my dividend payment forecasts, I assumed the company to spend about $2.0B in 2014 and $3.5B in 2015 and 2016 on share buybacks (as total buyback value is higher than my forecasted excess free cash flow, remaining funding will come from additional debt borrowing and/or existing cash). In total, my assumption predicts a $19B capital return between 2014 and 2016. Based on $100 buyback price and 7.5% annual price growth, I estimated that average share count will be reduced to 921M by 2016. Hence, dividend per share was projected to grow by 7.5% CAGR from $3.31 in 2014 to $3.82 in 2016. Comparing with consensus EPS estimates, my dividend forecasts imply that earnings dividend payout ratio will decline slightly from 57% in 2014 to 56% in 2016, which is in line with historical level (see chart below).
I believe my dividend per share forecasts are within a sustainable range because 1) both free cash flow and earnings payout ratios are projected to trend steadily over the forecast period and 2) my projected dividend per share CAGR of 7.5% from 2014 to 2016 is below MCD's consensus long-term EPS growth rate of 8.2%, meaning that earnings payout ratio may continue to trend lower in a long run.
The chart below shows a quarterly breakdown of my annual dividend per share forecasts. From 2014 to 2016, I expect 3 dividend hikes in Q4 of each year and that the quarterly dividend could reach ~$1.0 by Q4 2016, implying a dividend yield on cost of 4.0%. I consider my forecasted yield on cost trend to a strong price support because MCD's dividend yield has never exceeded 4% in history (see chart below).
Based on 10% cost of equity and current annualized dividend of $3.24 per share, the Gordon Growth Dividend Discount Model suggests that current share price of ~$101 has priced in a dividend growth rate of just slightly above 6.5%, meaning that the current share valuation has not yet fully reflected the healthy dividend growth potential. Hence, income investors are recommended to buy the shares at the current price level.
All charts are created by the author, and historical data used in the article and the charts is sourced from S&P Capital IQ, unless otherwise specified.
Disclosure: The author is long MCD. The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.