Is McDonald's Getting Back Into The Buy Zone?

Summary

• McDonald's re-franchising activities are paying off.
• McDonald's is poised to grow further, thanks to strong comps and new measures such as McDelivery.
• Investors get an attractive dividend and potential for solid total returns.

By the Sure Dividend staff

McDonald's (NYSE:MCD) is one of the Dividend Aristocrats, a group of stocks in the S&P 500 that have their dividends for at least 25 years in a row. This has made the company a well-followed dividend growth stock over many decades. You can see all 53 Dividend Aristocrats here.

McDonald's growth has accelerated over the last couple of quarters, and it continues to return a lot of cash to shareholders. Recently, the valuation has come down as well.

At this price, McDonald's valuation is getting more attractive, while investors will also benefit from a solid 2.6% dividend yield.

Company Overview And Growth Outlook

McDonald's is, in terms of total market capitalization, the biggest restaurant company in the world. The company, which was founded more than 70 years ago, has grown into a company with operations in more than 100 countries.

MCD Total Return Price data by YCharts

Since the beginning of the current century, McDonald's total returns have trounced the broad market's total returns, as investors have seen a 10.4% annual gain. This is despite the huge bear markets we have seen over that time frame after the dot.com bubble burst and during the last financial crisis.

Over the last couple of years, McDonald's has undergone big changes. Management found that it would be beneficial for the company to re-franchise the majority of its restaurants. This strategic shift had a big impact on McDonald's results:

MCD Revenue (TTM) data by YCharts

Revenues are down substantially over the last three years, but at the same time, operating earnings jumped up significantly. When we take a closer look at the re-franchising activities, it becomes clear why that happened: McDonald's used to recognize all of the sales at restaurants the company owned as revenues, but that is not true any longer. As many of those restaurants have been re-franchised, McDonald's is now only recognizing the franchise fees as revenues.

This is why the company's top line figure went down substantially over the last couple of years, despite strong comps sales and the opening of new restaurants. Restaurants being franchised have a big impact on McDonald's costs as well, though:

(10-K filing)

McDonald's revenues from franchised restaurants have gone up by $1.2 billion over the last two years, but costs for those franchised restaurants increased by just $140 million. The net impact is a positive $1 billion impact on the company's operating earnings.

Due to the re-franchising activities, costs at company-operated restaurants have declined by $3.5 billion over the last two years as well. On top of that, McDonald's managed to cut some SG&A expenses. The combination of these factors allowed for compelling earnings growth, despite lower revenues.

The re-franchising activities also have freed up a significant amount of cash. As the company is now operating a smaller number of restaurants, its asset base doesn't have to be so big any longer, and capital expenditures have gone down as well. According to the most recent 10-K filing, annual capital expenditures have declined from $3 billion in 2012 to $1.9 billion in 2017.

Lower capital expenditures have allowed McDonald's to accelerate its share repurchases over the past few years:

MCD Average Diluted Shares Outstanding (Quarterly) data by YCharts

In the last five years alone, McDonald's managed to lower the share count by more than 20%. This alone would have made its EPS jump up by 27%, all else being equal.

Operating earnings growth, a less capital-intensive business model, and high cash flows which can be returned to the company's owners are an attractive combination. This is especially true since the growth outlook at McDonald's is still positive. The company has managed to record very strong comps sales over the last couple of quarters.

In Q4, McDonald's global comparable restaurant sales grew by 5.5%. The comps sales performance in the U.S., McDonald's most important market, has been very strong as well, at 4.5%. This is vastly better than the comps sales performance of the U.S. restaurant industry as a whole, which is battling with very weak comps sales right now:

(tdn2k.com)

Growing comps are a big positive, as those results in margin increases. Many expenses are fixed on a per-location basis; thus, higher comps are beneficial, as sales rise substantially while costs do not rise very much. This operating leverage should continue to drive margins for McDonald's company-operated restaurants going forward.

McDonald's is also continuously expanding its menu offerings, with one of the latest introductions being the fresh beef Quarter Pounder. With higher-quality, higher-price offerings, McDonald's is successfully distancing itself from other fast food restaurants. Such offerings at higher price points are also a way for the company to drive revenues per customer as well as margins.

McDonald's is also successfully cooperating with Uber (UBER) when it comes to rolling out McDelivery as a way to access more customers:

(mcdonalds.com)

The cooperation between McDonald's and Uber Eats is bearing fruit. The company can not only drive its total sales by utilizing Uber this move also helps increase the utilization during the evening and overnight hours. In that time frame, more than 60% of all McDelivery orders are placed, which means that restaurant kitchens stay busy for longer.

McDonald's doesn't need to increase the workload during the midday window where traffic peaks, but increasing the workload during the off-peak hours to get the most out of the existing restaurant base is a very smart move. As Uber Eats and other delivery services are likely to grow over the coming years, McDonald's should benefit from that trend quite a lot.

McDonald's As A Dividend Investment

MCD Dividend data by YCharts

McDonald's dividend has been raised for many years in a row, with the most recent dividend increase being announced last fall. The company raised the dividend by 7.4% last year, which is a bit more than the average over the last couple of years.

Due to the fact that McDonald's earnings per share have grown at a strong pace during 2017, this dividend increase hasn't been too aggressive at all. In fact, the $6.66 in EPS during 2017, which was up 16% year over year, brought down the dividend payout ratio significantly, as EPS grew much faster than the dividend. Based on last year's results, McDonald's is paying out about 61% of its earnings in the form of dividends right now.

That is a very manageable dividend payout ratio, which means that the risk of a dividend cut is very low. McDonald's strong earnings growth outlook means that the company will likely continue to grow its payout at an attractive pace going forward:

MCD EPS LT Growth Estimates data by YCharts

Analysts are forecasting an 8.5% EPS growth rate over the coming years. McDonald's could thus increase the dividend at a high single digits rate going forward, and the payout ratio would still remain at the 60% level.

MCD PE Ratio (Forward) data by YCharts

Since McDonald's is trading at 20 times this year's earnings while the earnings growth outlook is good, there is also substantial potential for share price gains.

If, for example, McDonald's manages to grow its EPS by 8.5% through 2022, investors would see a 6.2% annual share price gain even if the valuation declines to an 18 times PE multiple. When we further factor in the dividend yielding 2.6% right now, McDonald's would return about 9% annually in that scenario - despite its valuation declining considerably over those five years.

This means that the total return outlook for McDonald's is not bad at all right now, thanks to a solid growth outlook in combination with a valuation that is not overly high. For income-focused investors, the 2.6% dividend yield, combined with a lot of dividend growth potential over the coming years, looks quite good as well.

Final Thoughts

McDonald's comps sales performance is much better than that of the restaurant industry as a whole. On top of that, the company benefits from a smart strategic decision to re-franchise restaurants. This has freed up cash, which means that the company can return a lot of money to its owners, and at the same time, this move has allowed for higher margins.

Since the growth outlook is quite positive while the valuation is not overly high, McDonald's provides a solid total return outlook in combination with an attractive dividend.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.