MCD - McDonald's: It's A Good Time For The Delicious Taste Of Dividends

2023-10-12 09:00:00 ET

Summary

• McDonald's is a well-known and established brand that has been around since 1965 and has a strong global presence.
• Despite potential recession fears and the impact of higher interest rates, McDonald's has historically shown resilience and positive returns during economic downturns.
• The company has a track record of increasing dividends and has a relatively safe cash dividend payout ratio, making it an attractive investment option.
• In the last month, the stock price has declined by double digits, making it an attractive buy in my opinion.
• Additionally, MCD offers investors a large upside to its price target of $330.

Introduction

It's a good time for the taste of McDonald's (MCD). That was actually a slogan the company used back in 1984. They've had many over the years but this one was one of their most successful. Most people probably know, "I'm lovin' it" that started in the early 2000's and is still used today. The first slogan in particular came to mind for a few reasons. First, it was used in '84, the year I was born. And two, the current macro environment has some similarities to the one in the 1980's.

Although interest rates aren't as high as they were then, the country was dealing with high inflation. And to combat this, the FED decided to hike interest rates, similar to present day. And now they are seemingly starting to have a ripple effect throughout the economy. Soaring credit card debt, high oil prices, and talks of a recession are causing the market to sell-off as investors look to park cash, or invest in safer alternatives such as bonds or money market funds. Throughout the FED's rate hike history, they have rarely been able to slow the economy without starting a recession. But as I mentioned in prior articles, I'm staying invested looking for discounted, safe, blue-chip stocks like MCD that pay dividends while I wait for the market to recover.

Why McDonald's

McDonald's is one of the most well-known brands globally. The company needs no introduction in regards to what they do so I will save readers' time. But will tell you why you should consider owning a stock like MCD right now. For starters, they've been around forever and I don't see them going anywhere anytime soon. The company has been public since 1965 and you can't go anywhere in the world without seeing one. And although I don't eat there much, I will stop and get a breakfast sandwich or some oatmeal a few times a year.

But no matter when I pass by there's always a long line in the drive-thru. No matter the day of the week or the time of day, McDonald's is always busy. And ask a kid what they want any time, it will usually be McDonald's.

Below is a look at MCD's total restaurant count. Since 2016 the amount of restaurants have declined by 2.5% in the U.S., but have grown by roughly 5.5% in international operated markets, and by almost 16% in international developed licensed markets.

Recession Fears

Another significant thing that happened in the 80's was the recession. After rate hikes peaked at their highest in history, and the average 30-year mortgage rate spiked to 20%, this pushed the economy into a recession. Sound familiar? I can't predict what will happen with the economy nor am I saying that rates will ever get that high. I'm just stating that these are probably why talks are getting louder about a recession in 2024 or 2025.

As you can see below, rates were their highest in July of '81 at 19.04% and slowly came down over the years. And have been creeping up again since the start of hikes last year. The FED has already promised a higher for longer environment, and now some analysts are saying no rate cuts until 2025. If that happens, several companies will suffer as consumer spending becomes tighter than it already is.

So, that brings me to my next chart. How did McDonald's during our last known recession, the Great Financial Crisis? This is where the economy saw several banks fail and the government swooped in to rescue them. Again sound familiar? Remember the banking crisis that happened earlier this year with the failure of a few banks? Yes, I know this year was different than the one back then but I still feel like it was worth a mention.

Although MCD's business was negatively impacted like several other large companies, they still managed a positive total return during the time period. According to the U.S. National Bureau of Economic Research, the recession lasted a total of 18 months, from December of 2007 to June of 2009.

During the 18 months of the recession, MCD still managed to net a positive total return, although it was very small. If you had invested 10k into MCD, you would of made a whopping $3.34. LOL but at least you wouldn't have lost any money during that time. If you would have reinvested your dividends during that same period, you would have had a total return of 3.84% for a total of $10,384.11. MCD's peer Starbucks (SBUX) saw their price decrease before bouncing back while MCD proved to be more resilient. Additionally, both companies doubled their prices after the end of the recession with MCD reaching over $100 by the start of 2012.

Here is a chart of 10k invested at the end of the recession. If investors would have to put 10k into MCD stock a month after the recession was declared over until October 1st of this year, you would have netted a total return of 352% at a compounded annual growth rate of 11.18%, slightly outpacing the S&P 500.

With dividends reinvested, your total return would be 532% at a compounded annual growth rate of almost 14% during the same period. Your ending investment would have also increased by roughly $18k.

Recession Proof Dividend

During the last recession, MCD increased the dividend by 33% from $0.3750 to $0.50 further showing resiliency. They also increased the dividend earlier this month by 10% from $1.52 to $1.67. So investors may be wondering why Seeking Alpha gives them a dividend safety grade of D+. As you can see MCD's cash dividend payout ratio is higher than the sector median. And some may prefer to see a more ideal payout ratio of 40% to 60%.

But I don't see this as a problem as the company's FCF payout ratio has been decreasing since 2020 when it was elevated to 81%. This is expected to be 53% over the next 12 months so shareholders should have no worries. Since 2019 the company has had an average FCF of $5.73 billion and paid out average dividends of $3.8 billion during the same time, giving them roughly a 67% payout ratio which I think is safe.

Of course we would all like to see this lower but investing in a company of McDonald's caliber should help you sleep well at night. They've also been growing their free cash flow per share over the last decade. This has increased from $4.30 a share in 2013 to $9.07 in the last 12 months, and this is expected to increase to $12.70 over the next year.

Risks

One risk I don't see many analysts touch on is McDonald's debt. Although I think a company of MCD's caliber will be fine, this is something to be cautious of given the current environment. Over the last decade, MCD has found innovative ways to grow its brand, but one thing that has also grown is the debt load. I consider this a small to medium-risk but still a risk nonetheless. As you can see their debt has grown pretty significantly while their cash on hand has remained relatively the same over the same time frame.

And while this has come down since the COVID high of $39.1 billion, it has more than doubled from $14.1 billion at the end of 2013. Since the company has allocated its cash to rewarding shareholders with buybacks and dividend increases, it has had to use debt to grow. I think for now MCD is fine but investors & shareholders should keep a close eye on the company's balance sheet going forward.

Another risk for the company is obviously high interest rates. And with the expected higher for longer now, this will continue to put pressure on them for the foreseeable future. Over the last 2 quarters inflation has caused MCD franchisees to require financial assistance, mainly in the European market. This has continued to put pressure on restaurant cash flows and management expects this to be between $100 to $150 million for the year. There's also the rising cost of goods due to higher inflation.

Valuation

As we all know, stocks like McDonald's normally always trade at a premium. But analysts currently have the stock rated as a strong buy, and it offers some nice upside to its price target of $330. At the time of writing MCD is trading at $248 and has come down from a price of roughly $285 in the last month. Compared to its peers Starbucks and Chipotle (CMG), the stock is relatively cheap on a P/E basis compared to the peer average of 32x. The last time the stock traded at a P/E lower than the current one was in 2020 when it was 21x.

But I understand investors wanting a greater margin of safety. And if we enter into a recession, I can see the price continuing to slide. Another thing I think will play a large part in MCD's stock price movement is treasury rates. The stock has a 5-year average dividend yield of 2.2%. So even though companies like MCD & Walmart ( WMT ) have a strong presence and are considered safe, I think further rises will cause these behemoths to sell off even more.

DDM Analysis

As you can see in my fair value calculations, I decided to be more conservative than Wall Street analysts due to the expected recession. I also chose SA's consensus dividend estimate of $6.47 for my analysis. MCD's 3-year dividend growth rate is 6.74% and their 5-year growth rate is 8.52% according to Seeking Alpha. Using an expected rate of return of 8% and more conservative dividend growth rate of 6%, this brought me to a fair value of $323. But again this is more on the conservative side.

Even in a recession, I expect MCD will raise the dividend by a minimum of $0.04 like it did in 2020. This would give the company an annual dividend of $6.72. Using the same WACC and growth rate, this would give them a fair value of $336, giving investors even more upside from here.

Conclusion

MCD is blue-chip that rarely trades at a discount. The company has outperformed the S&P since the last recession and has been a safe-haven stock for investors for decades. Additionally, they have a strong global presence and have managed to continue growing in the last decade. Although the company's debt has increased over the same period, I think they are safe as they have been making an effort to pay it down since 2020. Furthermore, the stock has come down in price in the last month, giving those with a longer-term outlook a buying opportunity right now. If we do enter into a recession and treasury rates continue trending higher, I suspect MCD's stock price will continue to fall as investors rotate into safer, and higher-yielding investments. Although their FCF payout ratio is slightly elevated, this has been decreasing. With a price target of $330 and their strong business model, I rate MCD a buy.

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