Seeking Alpha
What is your profession? ×
Long/short equity, research analyst
Profile| Send Message|
( followers)


Recent selloff on China supplier concern presents a buying opportunity due to more attractive valuation.

Shares are priced based on a dividend growth assumption at about 4.5%, which is considerably below its potential.

Shares also trade at notable discount relative to comps despite the company's better profitability, more pristine balance sheet, and higher dividend yield.

Share price of McDonald's (NYSE:MCD) has fallen by about 10% since reaching its 52-week high of $103.78 in May 2014, which was primarily driven by the supplier concern in China. I believe the selloff is overdone and would like to share my thoughts and analyses in this article.

Thanks to the selloff, MCD's dividend yield has climbed to 3.4%, which presents a great opportunity for long-term income investors to build positions. Future dividend growth is the most influential factor in dividend investing, and thus my analysis here focuses on forecasting MCD's dividend growth potential.

I firstly created a free cash flow model. My analysis is based on current consensus revenue estimates which predict the top line to grow by 1.7% CAGR from $28.4B in 2014 to $29.4B in 2016. Over the past 5 years, MCD has been able to maintain a very steady operating cash flow margin, which averaged at 25.7%. To be conservative, I assumed the margin to be 25.0% for 2014, which is below the historical average and trailing 12-month level at 25.9%. As current consensus view expects an EBITDA margin expansion of more than 200 bps between 2014 and 2016, I assumed a 100 bps expansion in the operating cash flow margin during the period to reflect the higher profitability. In terms of capital expenditure, management announced a guidance range of $2.9B-$3.0B for 2014, the high end of which was used in my analysis. Based on those assumptions, free cash flow is projected to grow by 6.3% from $4.1B in 2014 to $4.6B in 2016, largely driven by improved profitability and flat capital spending (see chart below).

(click to enlarge)

Based on MCD's current quarterly dividend of $0.81 per share and a 6.3% growth rate for Q4 2014 dividend (discussed later), I forecasted total dividend payment in 2014 to be $3.2B. Assuming an annual dividend growth of 4.0%-4.5% over the next 2 years, the total dividend spending will reach $3.5B by 2016. Given my free cash flow projections, free cash flow dividend payout ratio will rise to 78% in 2014 but then gradually decline to 75% by 2016. In this scenario, MCD's cash surplus will rise from $893M in 2014 to $1.1B in 2016 (see chart above).

For continued value creation, management has announced a plan to return $18B-$20B capital to shareholders between 2014 and 2016 through a combination of dividend and share repurchase. The company expects to fund the capital plan through internal cash flow, proceeds from refranchising, and modest debt borrowings. To be conservative, I incorporated the low end of the range (i.e. $18B) in the model. Given that the sum of my forecasted dividends between 2014 and 2016 amounts to about $10.1B, the total value of share buybacks is $7.9B during the period, which was split equally in each forecast year. As my projected cash surplus after dividend payments totals about $3.1B between 2014 and 2016, MCD will need to fund the remaining $4.8B buyback (i.e. $7.9B minus $3.1B) through refranchising and debt financing. Even without refranchising, MCD can secure the funding through debt issuance because this incremental leverage will increase the company's debt to EBITDA ratio from current 1.5x to just 1.8x by 2016 (based on current total debt of $15.4B, incremental borrowing of $4.9B, and 2016 consensus estimated EBITDA of $11.3B), which is still way below current peer average at 2.3x (see comps table below).

Based on average buyback price assumption of $100 in 2014 and an annual step-up rate of 8%, average share count is projected to reduce by 59M between 2014 and 2016. To account for dilution impact from equity issuance, an 80% haircut was applied on the share count reduction. Based on the previous dividend payment forecasts, dividend per share is projected to grow by 6.5% from $3.29 in 2014 to $3.73 in 2016. Comparing with current consensus EPS estimates, implied earnings payout ratio will drop from 59% in 2014 to 57% in 2016 (see chart below).

(click to enlarge)

As both the free cash flow and earnings dividend payout ratios are expected to decline over the forecast years and are fairly comparable to their levels in recent years, I believe my dividend per share growth is completely achievable. My forecast is also supported by current consensus view which suggests an 8% long-term EPS growth potential for the company.

The chart below shows a quarterly breakdown of my calendar year dividend per share projections. The quarterly dividend is expected to reach $0.98 per share by Q3 2016, meaning that yield on cost (at the current price of ~$93) will rise to 4.2% by then.

(click to enlarge)

From a relative value perspective, MCD is now trading at notable discount relative to its peers in the quick service restaurant segment. The shares trade at 9.7x 2015 forward EBITDA and 15.5x 2015 forward EPS, compared to peer averages at 12.4x and 22.1x, respectively. Although MCD's consensus long-term EPS growth estimate is below par, its various profitability metrics (e.g. margins and capital return), leverage ratios, and dividend yield are superior to peer averages (see chart below).

(click to enlarge)

The stock also looks inexpensive on absolute value basis. Based on Gordon Growth Dividend Discount Model with 8.0% cost of equity, which is less than a 5.4% cost of equity predicted by CAPM model with 3% risk-free rate, 6% equity risk premium, and MCD's 5-year beta of 0.4, the current share price of ~$93 implies a dividend growth rate of just 4.5%, which is lower than the company's historical growth level and my forecasted potential (see chart below).

In conclusion, from an income investing perspective, MCD shares are somewhat undervalued now as their relative valuation compares favorably to peer level and the stock is now priced on a dividend growth assumption that is notably below its potential. A buy rating is therefore warranted.

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.