What To Make Of That 5% McDonald's Dividend Hike

| About: McDonald's Corporation (MCD)


With same-store sales growing at less than 1%, it is fair to wonder what will propel McDonald's future dividend growth.

The current dividend payout ratio of 55% indicates that future growth must come from profit growth rather than increases in the payout ratio.

In a worst-case scenario, McDonald's shareholders may have to tolerate an extended period of 5-6% dividend hikes.

For most of the 2000s, the McDonald's Corporation (NYSE:MCD) has been a delight to own for long-term income investors. Because of a rapidly expanding dividend payout ratio, in addition to growing profits, the restaurant giant was able to put the growth in dividend growth by increasing its dividend payout from 15% in 2000 (when the company was paying $0.22 in annual dividends, while making $1.46 in profits) to 56% by the end of 2013 (when the company paid out $3.12 in annual dividends, while making $5.55 in profits). That's what happens when you grow dividends at an annual rate north of 20% for thirteen years.

The 2014 year, of course, is marking a departure from the status quo on the growth side of the company's dividend. The Board approved a quarterly hike from $0.77 per share to $0.81 per share, for an increase of 5.19%. As we look out, the question becomes: Is this a short-term blip, or the beginning of a new trend to which investors must grow accustomed?

To answer that question, there are four factors we should take into consideration:

First of all, it is entirely plausible that the McDonald's Board chose to give some of this year's dividend increase to its shareowners in the previous year. Although it is almost a forgotten memory now, there was a legitimate concern that dividend taxes in the United States were going to increase sharply last year, and the previous hike may have been a response to that potential risk. The previous dividend hike was a 10% dividend increase that raised the quarterly payout from $0.70 to $0.77 per share, but it was not supported by the underlying profits (at the time, the company had only raised its profits from $5.27 per share to $5.36 per share, not even 2% profit growth, which means last year's dividend hike was almost entirely an increase in the dividend payout ratio). The current 5% growth rate could be the Board's way of allowing profit growth to play catch up with the dividend growth rate that has been noticeably higher than the company's profit.

That leads to our second point: there is not a whole lot more room for the company to increase its dividend payout ratio. When the company was only paying out twenty cents on the dollar in dividends, it was easy to see how the company could enjoy a super-long run of dividend increases that outpaced profit growth. Now that we are approaching a dividend payout that accounts for sixty cents of each dollar in profit the company generates, there is not going to be that much more room for dividend hikes in excess of profit growth, because the company has two other commitments beyond the dividend: a stock buyback program and a desire to roll out more stores. Specifically, the company is currently retiring about 2-3% of the stock per year (for historical reference of the company's buyback effectiveness, note that the share count has declined from 1.26 billion in 2004 to 988 million now). And furthermore, the company is committed to rolling out more fast food stores in Japan, Australia, and Western European countries.

That said, the company does have near-term challenges. Last quarter, the company did not manage to grow same-store figures even one percent. It raises the question of whether, in the near term, earnings per share growth will be driven by stock buybacks and the creation of new stores. The problem with the company's same-store sales figure is that the company chose to raise its prices on its lunch menu in the United States, driving down current volumes a bit. And it may have been resting on its laurels with its breakfast menu in recent years, as the company now has to wake up to a strong commercial challenge from Taco Bell, of all places. And then there's the fact that well over a third of the company's revenues come from Europe, where same-store growth has been hard to come by. In terms of realistic worst-case scenarios, you could picture a world in which McDonald's limps along with growth of 5-6% annually, sustaining shareowners with a rising store count and stock buybacks.

For the good news, the company seems to be handling rising input costs (ingredients are up almost 2%) and the lack of same-store growth quite well. The net profit margin is at 19.6%, the operating margin is at 35.6%, and the company has very low-interest costs associated with its debt load (the company carries $14 billion on the books, but is only set to pay over $600 in interest costs). In other words, the profitability at the core businesses is doing quite well; shareowners are drowning in cash, with net profits of over $5.5 billion generated in the past year. As a matter of dividend valuation, McDonald's stock never offered a starting dividend yield of over 3% for any twelve-month consecutive period of time in the three decades prior to the financial crisis. Even if the dividend growth rate slows down a bit, you're starting from a higher initial yield base.

The take-home lesson with McDonald's dividend is this: the future growth of the dividend will mirror overall profit growth. In a realistic worst-case scenario, you could be looking at 5% or so annual growth for the next couple of years. The days of 20% annual dividend growth for an extended period of time are over, as the payout ratio no longer permits those kinds of increases. However, in a realistic best-case scenario, we could see store count increase around 3%, buybacks reduce the share count by around 3%, and same-store growth revert to its usual 4-5% level, so that profits per share could increase 10-11% (giving dividend investors a growth rate similar to that). Given the fact that you'd still be receiving a dividend growth rate that outpaces inflation even in a realistic worst-case scenario, these shares probably still make sense for long-term investors.

Disclosure: I am long MCD. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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