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McDonald’s: The Not-So-Obvious Inflation Hedge?

|Includes:McDonald's Corporation (MCD)

With the backdrop of a complete economic meltdown avoided for now, it appears as though investors have begun to pile into the inflationary camp, as evidenced by the recent rally in gold, 52% above its 52 low low, as of 12/4/09.  Yet much of the investment world continues to debate whether or not the economy is in for a prolonged period of inflation or deflation. 

Investors need not take sides to make handsome returns in the coming decade.  My Paid-To-WaitTM investment strategy embraces corporations with the following attributes:

1.     competitive advantages

2.     healthy balance sheets

3.     and above average (but more importantly, growing) dividend yields

Companies that possess the above attractive characteristics should reward shareholders in either inflationary or deflationary periods. 

McDonald’s Is One Such Holding

Excuse the pun, but as recently as mid-September, McDonald’s (MCD) yield offered a mouthwatering 4%.  The world no longer seems to care about its economic resilience.  As of 12/4/09, (MCD) has underperformed the S&P by 24 percentage points this year.  Instead, the massive rally since March ’09 has been led by low quality companies.

Many people know that McDonald’s possesses one of the world’s most valuable brands (6th according to Interbrand). (MCD) possesses one of the best inflation hedges around and trades at a healthy discount to the market’s P/E multiple as measured by forward earnings estimates.

What Makes (MCD) So Attractive AT This Time?


1.     Franchise Agreements.  In addition to featuring an attractive dividend yield (at 3.6%, 70% more than the market), the real secret lies in the company’s relationships with the franchisees who operate over 80% of the chain’s locations.  More than two thirds of the company’s operating profits arise from an annuity-like stream of rent and royalties based upon franchisee revenue, which is based on dollar volume.

2.     Land Baron.  By owning 45% of the land and 70% of the buildings it occupies (or securing long-term leases on both), McDonald’s has contractually entitled itself to more than $23 billion of cash flows through future minimum rent payments under its existing franchise agreements alone.  The result is free cash flow that can be used to increase the dividend, repurchase shares, pay down debt, and reinvest in the business to the extent profitable growth opportunities arise.

3.     International Exposure.  McDonalds has the most globally diversified restaurant operation on the planet relative to its closest competitors, with more than two-thirds of its revenue and over half of its operating profit coming from locations outside the US.  Thus a weaker dollar results in higher reported sales when international revenue is translated back into US dollars, helping investors offset debasement in the US currency.  

4.     Remaining Inflation Protection.  Unlike many business models, McDonalds also benefits from rapid inventory turnover, ability to adjust menu prices and cost controls, and substantial property holdings (many of which are fixed costs and party financed by debt made less expensive by inflation).


In addition to serving as an attractive inflation hedge, we demonstrate below why longer-term investors can reasonably expect to earn a double-digit annual return owning McDonald’s, in sharp contrast to the uncertain return from owning gold.  Gold possesses a severe opportunity cost, as gold doesn’t throw off income or grow like stocks while tying up your money.

We derive our minimum 10% return estimate as a function of (1) dividend and (2) earnings per share growth without counting on any (3) P/E multiple expansion.


McDonald’s has paid a dividend for 33 consecutive years since 1976.  At $2.20 per share this represents at 3.6% yield.  McDonald’s payout ratio is 52%, leaving room for future growth.  It offers the highest yield of its publicly traded competitors. (MCD) boasts the highest restaurant credit rating (cash flow from operations covered an amazing 59% of its debt load last year).


Revenue Growth. According to NPD Group, Inc., fast food hamburger restaurant sales should grow 4% over the next five years.  For those who believe (MCD) can continue to capture share, Technomic estimates each 0.1% gain of share in the QSR industry is worth $56.3 million of annual sales.  Substantial growth opportunities remain outside the established major markets.  Within China, for instance, there are more than four times as many people as in the US, yet only two restaurants for every million people (versus 60 in the US).

Margin Expansion.  Factoring in lower food and packaging raw material costs, the move to refranchise more company-owned restaurants, and lower interest expense, there should be a modest amount of margin expansion resulting in operating profit growth at least 1-2% faster than its 4% revenue growth.  Hence we assume 5-6% operating profit growth, conservative even against management’s own 6-7% estimate. 

Buybacks.  Factoring in share repurchases of 2% (below actual sharecount reductions of 4% in 2008 and 3% in 2007) on top of its 5-6% operating profit growth would result in EPS growth of 7-8%. 

(3) VALUATION           

We are not betting on P/E expansion – if realized, that would certainly be gravy!  But we want to make sure that our 10-12% fundamental economic return (7-8% EPS growth plus 3.6% dividend) is achievable, which means we must not expect multiple expansion (or be hurt by contraction).

Today’s valuation appears reasonable.  The stock’s P/E of 15.9X trailing earnings is less than the S&P at 16.1X and is the lowest for (MCD) in over a decade.  Its forward earnings yield of 7.2% is well above the S&P yield (6.4%) and the 10-year treasury yield (3.48)%.

Investing lesson:

Taking the unpopular view is how to make money.  In fact, a contrarian style of investing is the ONLY method that has proven, over time, to reduce risk and take advantage of mispriced investment opportunities.

Disclosure: Wade Financial Group, Inc. and the WADEX mutual fund hold a position in McDonald’s (NYSE:MCD).
Stocks: MCD