My aim is to develop a passive income stream, which will eventually support the expenses of my family. I expect dividend income will make up the bulk of this passive income. Last year, the portfolio managed to generate $27,000 in dividends. McDonald's Corporation (NYSE:MCD) was an addition to the my dividend portfolio in 2013.
McDonald's is one of the most well-recognized fast food franchises in the world. The company specifically operates and franchises McDonald's restaurants in more than 110 countries around the world. The brand recognition of the company's flagship products such as the Big Mac or French Fries is global and universal in nature. McDonald's has also increasingly been offering premium, higher-margin items such as the McCafe line of products and introducing a variety of healthier options to respond to an increasingly health-conscious consumer.
McDonald's Corporation has a market capitalization of $92.5B, with revenues of $28B and a gross margin close to 40%. McDonald's generates net income of almost $5.5B. McDonald's currently trades at a forward P/E of 15.4, with a dividend yield of close to 3.4%.
McDonald's recently reported a disappointing Q2 2014 that caused its stock price fall from over $101 to just over $94 within the last couple of months. The company reported adjusted earnings of $1.40 per share in the second quarter of 2014, which missed analyst expectations. Significantly, North American operations have not been able to post same store sales growth since October 2013, with US same store sales down 1.5% in Q2 2014. For the long-term investor, current weakness could present an opportunity to accumulate at reasonable prices. In fact, I believe McDonald's could make an excellent addition to a portfolio for a young dividend investor at current levels.
The case for McDonald' s investment
McDonald's is a recognizable and global presence in an industry that tends to be highly fragmented, with many local, regional and national brands. McDonald's vast network of franchised restaurants provides the company with a high level of cost efficiency in product sourcing and marketing, enabling it to deliver a standardized product across the globe for a very low cost. The ability to outspend national and regional chains in marketing reinforces brand recognition with customers and further deepens the company's wide moat, enabling it to further increase sales and marketing.
While McDonald's is best known for its burgers and fries, the reality is that the company has been growing its range of beverages and healthy choice options and breakfast items. Coffee sales now account for close to 6% of McDonald's revenue or more than $1.5B annually, where the company is going head to head with the likes of Starbucks (NASDAQ:SBUX). McDonald's breakfast items such as Egg McMuffins are also a big earner now for the company and account for close to 25% of revenues, or well north of $6.5B.
McDonald's also has a significant global presence. While the company is known for having a dominant US market share, the company earns the majority of its revenues and cash flows in overseas markets. In fact, greater than 65% of McDonald's revenues come from international markets. Of course, while this means that the company is exposed to fluctuations in value of the USD, it also helps insulate McDonald's from negative trends in the US markets.
Finally, take one look at McDonald's return on equity and you realize why long-term McDonald's investors are a happy bunch. Return on equity has increased from 13% to 35% over the last decade. The company has gotten significantly better at the conversion of revenue to cash leveraging shareholder equity.
The Case Against
There are nevertheless some concerns regarding the investment case in McDonald's.
Operating efficiency gains can't continue
One of the large drivers of McDonald's solid profitability was a sustained increase in operating efficiency that the company experienced from 2003 through till about 2009. Operating margins almost doubled over this period, from 16% in 2003 to just over 30% in 2009. Just how large a driver of profitability this was is clear when one contrasts revenue growth from 2003 to 2009 and profitability growth over the same period. Revenue increased from $17.14B in 2003 to $22.74B in 2009, an annual growth rate of 5%. Operating income over the same period was up from $2.83B in 2003 to $6.84B in 2009. That's annual growth of 16% over the same period. Incredibly, this was achieved in an environment of declining gross margins, which gives you some indication of the kinds of supply chain efficiencies McDonald's was able to pull through.
It's highly likely McDonald's won't be able to repeat this kind of operational efficiency to drive profit increases (at least not at this kind of scale) going forward. In fact, since 2009, operating margins have been fairly static at 30%-31%.
The North America problem
It's fairly well known that McDonald's same store sales in North America have been sluggish in recent years. This has been attributed to supposed health and wellness concerns around fatty fast food consumption. McDonald's, for its part, has been fairly active in seeing these trends and taking decisive action. The company has been experimenting with a range of healthy choice additions for all consumer segments.
However, truth be told, it's not entirely clear that these health and wellness concerns are solely responsible for McDonald's problems in North America. Rather, what seems to be happening is that McDonald's is having a particular problem with the teen demographic, who are gravitating to fast food options that are a little more fashionable with a slightly edgier taste.
Chipotle (NYSE:CMG), in which McDonald's was a major investor just prior to the Chipotle IPO, is having no problems selling its own brand of fast food to consumers. Revenue at Chipotle is up from $475M in 2004 to almost $3.2B in 2013. So arguably, it's not that all fast food is perceived as bad, rather that certain types of offerings are resonating better with a given customer than others.
Digging another layer deeper, it appears that McDonald's is having specific problems with millennials and consumers under 35, the same target demographic that Chipotle appeals to. The good news is that McDonald's appears to be responding to the concerns by taking proactive steps to get back in tune with this demographic. McDonald's is beginning to experiment with digital ordering technology, allowing users to remote order and pick up in store and access special deals and music and video downloads while in store through an app that will be made available on the iPhone.
While this is a good first level of engagement with the millennial demographic, McDonald's may ultimately need to do more with its menu to broaden offerings to appeal to changing preferences. The key message from Chipotle's success appears not so much that fast food is under attack, but rather fast food that doesn't meet consumers' changing tastes and preferences is not being favored. This is good news for McDonald's, because it suggests that if McDonald's can get millennial foot traffic through the door, there is some hope that it can keep them interested by making the needed tweaks in menu items on offer.
To this end, McDonald's needs to consider broadening menu choice options to cater to changing tastes. A focus on product development and internal innovation around menu items will be helpful here. Additionally, McDonald's should consider a more focused investment approach in emerging retail plays to stay abreast of market trends. The company's investment program was responsible for allowing McDonald's to get an early look at Chipotle. McDonald's ultimately acquired a significant ownership in Chipotle, which it sold off through an IPO. A continued focus on these types of investments will allow McDonald's to stay abreast of changing market trends and benefit accordingly.
Conclusions and Takeaways
Continued declines in North American same store sales have caused investors to sell McDonald's stock, with the stock declining almost 7% over the few months. McDonald's is unlikely to have the benefit of operational efficiencies to drive profits to the same extent as occurred from 2003-2009. However recent moves to better engage with millennials are encouraging. Broader industry trends suggest consumers not so much moving away from fast food as embracing different categories of fast food, which McDonald's should be able to respond to. Declines in McDonald's stock price present an opportunity for the long-term investor to accumulate.
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.