McDonald's 2nd Quarter Results Create Excellent Buying Opportunity

Jul.22.14 | About: McDonald's Corporation (MCD)

Summary

McDonald's constant currency revenue increased 1% for the 2nd quarter of 2014.

McDonald's is almost 3x the size of its largest publicly traded competitor.

The company has increased its dividend each year for 37 consecutive years.

McDonald's will return between $18 billion and $20 billion to shareholders over the next 3 years.

The company is growing its store count by about 3% a year.

McDonald's (NYSE:MCD) is arguably the most recognizable restaurant brand in the world. It is certainly the largest publicly traded restaurant, with a market cap of $96 billion. Its closest competitor (NYSE:YUM) has a market cap of $33 billion, almost 3x as small as McDonald's. McDonald's operates or franchises nearly 35,000 restaurants throughout the globe.

2nd Quarter Results

McDonald's grew constant currency revenues 1% for the second quarter of 2014 compared to the 2nd quarter of 2013. The company's same store sales were flat. Revenue growth was driven entirely by increasing store count. These results are in line with the minimum level of growth McDonald's share holders can expect to see. Ideally, the company would grow same store sales 1% or more a year in addition to growing store count 3% per year.

McDonald's comparable store sales decreased 1.5% in the US. The company plans to turn negative US sales growth around by enhancing customer service, and focusing the menu on its core offerings. The McDonald's menu has substantial room for improvement; its current layout is overly cluttered.

McDonald's European restaurants saw comparable store sales decrease 1%. On a country by country basis, the U.K. and France delivered strong results, while German McDonald's stores fared poorly. The company rolled out blended ice beverages in Europe for the quarter which lessened the impact of unfavorable results in Germany.

Sales in McDonald's Asia/Pacific, Middle East, and Africa (APMEA hereafter) region were the company's bright spot. Comparable store sales increased 1.1% due to strong growth in China. The APMEA region posted positive same store sales growth despite weakness in Japan.

Geographically, McDonald's is seeing its comparable store sales fall in the developed world. The US, Europe, and Japan all saw negative comparable store sales growth. McDonald's is performing much better in the developing world. Comparable store sales are increasing in less developed markets. Developed market weakness is most likely temporary. McDonald's managed to grow same store sales significantly over much of the last decade. The business has the opportunity to test new concepts at a small portion of its stores and roll out beneficial changes to the bulk of its stores.

McDonald's announced plans to return between $18 billion and $20 billion to shareholders over the next three years. This is about a 6% annualized return over the next 3 years. Even if McDonald's sees no organic growth for 3 years, and its valuation multiple does not change, shareholders will receive around 6% a year. The company's shareholder friendly attitude makes McDonald's a low risk investment over the next several years.

McDonald's 2nd quarter results were not fantastic, but they are not cause for alarm either. The company needs to find a way to fix weakness in the developed world. When it does, it will be able to grow revenue faster than the ~3% a year it is currently generating from store expansion. All in all, shareholders of McDonald's can expect near double digit returns without same store improvements from dividends, share repurchases, and new store openings.

Source: McDonald's 2nd Quarter Earnings Results

Consecutive Years of Dividend Increases

McDonald's has increased its dividend for 37 consecutive years. The company's long history of increasing dividends shows it has the ability to grow profitably through a variety of economic conditions. McDonald's consistency is testament to its strong competitive advantage.

Why it matters: The Dividend Aristocrats (stocks with 25-plus years of rising dividends) have outperformed the S&P 500 over the last 10 years by 2.88 percentage points per year.
Source: S&P 500 Dividend Aristocrats Factsheet, February 28 2014, page 2

Dividend Yield

McDonald's has a dividend yield of 3.40%, which is the 24th highest out of 128 businesses with 25+ years of dividend payments without a reduction. The company's relatively high dividend yield gives investors seeking current income a strong inventive to own McDonald's stock.

Why it Matters: Stocks with higher dividend yields have historically outperformed stocks with lower dividend yields. The highest-yielding quintile of stocks outperformed the lowest-yielding quintile by 1.76 percentage points per year from 1928 to 2013.
Source: Dividends: A Review of Historical Returns

Payout Ratio

McDonald's has a payout ratio of 58.84%. This is the 84th lowest out of 128 businesses with 25+ years of dividend payments without a reduction. The company's fairly high payout ratio means McDonald's will not be able to increase its dividend faster than overall company growth for the foreseeable future.

Why it Matters: High-yield, low-payout ratio stocks outperformed high-yield, high-payout ratio stocks by 8.2 percentage points per year from 1990 to 2006.
Source: High Yield, Low Payout by Barefoot, Patel, & Yao, page 3

Long-Term Growth Rate

McDonald's has managed to grow revenue per share by about 7% a year over the last decade. The company regularly repurchases about 3% of sales per year, and grows its store count be approximately 3% a year. For McDonald's to continue growing revenue per share at 7% a year, it will have to increase same store sales about 1% a year. The company compares favorably to other businesses with 25+ years of dividend payments without a reduction based on revenue per share growth, ranking as the 29th highest out of 128.

Why it Matters: Growing dividend stocks have outperformed stocks with unchanging dividends by 2.4 percentage points per year from 1972 to 2013.
Source: Rising Dividends Fund, Oppenheimer, page 4

Long-Term Volatility

McDonald's has a long-term standard deviation of only about 20%. The company's low volatility comes from its low priced food options and strong brand name which provide strong cash flow in both prosperous times and recessions. McDonald's has the 17th lowest standard deviation out of 128 businesses with 25+ years of dividend payments without a reduction.

Why it Matters: The S&P Low Volatility index outperformed the S&P 500 by 2 percentage points per year for the 20-year period ending September 30th, 2011.
Source: Low & Slow Could Win the Race, page 3

Conclusion

McDonald's is an industry leading business; nearly 3x the size of its closest publicly traded competitor by market capitalization. The company is extremely share holder friendly, and plans to repurchase about 3% of outstanding shares each year, along with paying a dividend in excess of 3% at current prices. McDonald's also grows its store count by about 3% a year. The company can generate additional growth by increasing same store sales, which it failed to do in the 2nd quarter of 2014. The stocks current weakness presents an excellent buying opportunity. McDonald's appears undervalued relative to the overall market; the company has a P/E ratio under 18 while the S&P 500 as a whole has a P/E ratio over 19.

McDonald's ranks as a Top 10 stock based on the 8 Rules of Dividend Investing. The company has a low standard deviation, fairly high growth rate, strong dividend yield, and a long history of rewarding shareholders. McDonald's recent weakness presents a buying opportunity for long term investors.

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.