McDonald's (NYSE:MCD) has put together quite an impressive record of consistently rising dividends. It is included among the S&P 500 Dividend Aristocrats for increasing its dividend every year for at least the last 25 years. But, McDonald's has not only consistently increased its dividend, it has done so at a rate that few other companies could match. The average dividend increase since 1990 has been about 17%. That's a 20+ year record of serious dividend increases. Not just token increases to appease shareholders and maintain its status as a dividend aristocrat.
This contrasts with other dividend stalwarts that have consistently raised their dividends, but often only nominally so. For example, look at AT&T's (NYSE:T) track record. It has raised its dividend by only a penny each of the last few years. That's enough of an increase to qualify it for the Dividend Aristocrats with McDonald's, but it's clearly anemic in comparison to McDonald's robust dividend increases. Since 1990, AT&T has raised its dividend at a rate of only about 4% per year.
Although McDonald's dividend growth is something to be desired, it does come at a price. Currently, it yields about 3.08% while AT&T yields 5.25%. Is the higher rate of growth worth the sacrifice to current yield? How long will it take for McDonald's yield to overcome AT&T's? Assuming the growth rates of the past 20+ years continue, it would only take about 5 years until the yield on cost basis of McDonald's surpasses that of AT&T. Under these assumptions, McDonald's is the clear choice for a long term investor looking to maximize future income streams.
The next logical question becomes: Will McDonald's be able to continue this performance in the future? Past performance is great (especially if you have been a shareholder), but future performance is what matters now. When analyzing future dividend prospects I look at two main factors: The sustainability of the current yield and the earnings growth prospects for the future (the driver of future dividend increases).
The following chart shows McDonald's payout ratio over the past 6 years:
Source: McDonald's 2011 Annual Report.
The average payout over the period is 49%. This is a good ratio. Its high enough to provide a strong yield, yet low enough to ensure stability in the event of unforeseen challenges. This was the case in 2007. In order to improve its longer term profitability, McDonald's shifted a large number of restaurants from company-operated to franchise-operated. Expenses related to this shift caused a large drop in earnings. Despite the lower earnings, McDonald's still increased its dividend, and although the payout ratio jumped in 2007, it came right back down the following year. This ability to sustain dividend increases in difficult business conditions is promising for the future sustainability of the McDonald's dividend.
At first glance, McDonald's growth prospects may not look all that exceptional. Over the past 5 years, revenues have grown at an annual rate of only 5.3%. But, this neglects a key factor in McDonald's success: improving margins. In 2006, McDonald's profit margin was 17% while in 2011 it was 20%. Much of this increase was due to the relative increase in franchise-operated restaurants relative to company-operated ones. Franchised restaurants provide about an 80% segment margin whereas company operated segment margins are around 20%.
With such an enormous difference in segment margins, one might ask why have company-operated restaurants at all? But, company-operated restaurants are an important aspect of the McDonald's business model. When developing new markets, the company tends to open company-operated restaurants and then shifts towards more franchises as they hone their model to local conditions. As McDonald's overseas markets continue to develop, I would expect the ratio of franchised restaurants to continue to increase, resulting in higher profit margins. It is these higher profit margins that have allowed McDonald's to grown its net income by 9.2% per year over the last 5 years despite growing revenue by only 5.3%.
Improving profit margins are only half of the McDonald's growth story. The other half is the company's aggressive share buyback program. Over the past 5 years, McDonald's has bought back over 15% of the outstanding shares. While net income has grown by 9.2% per year, earnings per share has grown by 18% per year. If this type of performance continues, it seems quite plausible that they could continue to grow their dividend at a similar rate.
McDonald's strong dividend growth over the past 20+ years make it a standout company, even when compared with other companies with long track records of increasing dividends. Additionally, due to its conservatively-aggressive payout ratio, growth in margins, and share buyback programs, McDonald's is well situated to continue its dividend growth performance.