McDonald's (NYSE:MCD) has raised its dividend for 43 consecutive years, qualifying it as one of just 57 Dividend Aristocrats, an exclusive group of stocks in the S&P 500 Index with more than 25 years of dividend increases.
We believe McDonald's dividend is highly attractive for income investors due to its above-average yield and the company's ability to grow the dividend each year, regardless of the economy.
McDonald's has approximately 38,000 restaurants in more than 100 countries. The company has an exceptional multi-decade growth record. To be sure, it is the only restaurant chain that belongs to the group of dividend aristocrats.
McDonald's stumbled in 2012-2014 under the tenure of its previous CEO. The company stopped growing its earnings due to intense competition from other restaurant chains, the increased health consciousness of consumers and the outdated appearance of many of its stores. The previous CEO of the company failed to address these issues.
However, as soon as the current CEO took the helm in 2015, McDonald's returned to its growth trajectory. The company remodeled its stores and thus made them much more attractive. Wendy's (WEN) and Domino's (DPZ) have implemented similar initiatives in recent years. The investment of McDonald's in the remodeling of its stores has certainly born fruit, as its remodeled stores have grown their same-store sales by at least 3% per year in each of the last four years.
Moreover, McDonald's has greatly improved its menu in the last few years. A key strategic move was the initiation of all-day breakfast, which provided a great boost to same-store sales. In addition, the restaurant chain enhanced its menu with healthier options such as organic meat and premium burgers. Thanks to all these successful moves, McDonald's has grown its earnings per share at a 12.5% average annual rate in the last four years. It has thus returned to its solid, long-term growth trajectory.
This week, McDonald's reported its results for the third quarter of the year. The company maintained its strong momentum, as it grew its U.S. same-store sales by 4.8% and its total same-store sales by 5.9%. These figures are impressive when compared to the figures of the vast majority of competitors.
However, McDonald's used national and local promotions to boost its traffic and thus saw its margins shrink in the quarter. Consequently, its earnings per share remained flat at $2.11 and thus missed the analysts' consensus by $0.10. As the company had exceeded the analysts' consensus in 6 of the last 8 quarters, the earnings miss resulted in a 5% sell-off of the stock on the day of its earnings release. The market was also disappointed by the 4.8% U.S. same-store sales growth, which was below the consensus of 5.2%.
We believe that the correction of the stock was justified, as the stock had climbed to overvalued territory. When a stock is highly overvalued, it becomes very sensitive to any negative detail in its results. However, we believe that the growth prospects of McDonald's are intact and expect the restaurant chain to continue growing at a much faster pace than the majority of its peers.
While McDonald's has grown its earnings per share at a 12.5% average annual rate in the last four years, investors should realize that double-digit growth rates are unsustainable in the long run for a relatively mature company of the size of McDonald's . Indeed, its management expects to grow the revenue at a 3%-5% average annual rate and the earnings per share at a high single-digit annual rate in the long run. While we believe that McDonald's management is exemplary, we prefer to be somewhat conservative and thus expect approximate 6.0% average annual earnings-per-share growth in the upcoming years.
Despite its latest correction, McDonald's is trading at a forward price-earnings ratio of 25.0, which is much higher than the historical average of 18.5 for the last decade. In fact, with the exception of the last four months, the current valuation of the stock is the richest in more than a decade. It is thus evident that the stock is overvalued, particularly given the relatively mature status and the size of the company.
A great part of the rich valuation of McDonald's should be attributed to the recent interest rate cuts by the Fed and its dovish stance, which have rendered the dividends of consumer-staples stocks much more attractive. However, investors should be aware of the risk that accompanies this trend. Whenever the Fed resumes raising interest rates, McDonald's and the other popular consumer-staples stocks will face significant downside risk.
We expect McDonald's to revert to a price-earnings ratio of around 18.0 over the next five years. In such a case, the stock will incur a 6.4% annualized drag in its returns due to the contraction of its valuation level. In other words, most of the benefit from the earnings growth of McDonald's is likely to be offset by a normalization of its valuation level in the upcoming years.
As mentioned above, McDonald's has an unparalleled dividend growth record in the restaurant universe. It has raised its dividend for 43 consecutive years and thus it is very popular in the income-oriented investing community for its reliable and growing dividend.
The company raised its dividend by just 5.1% per year on average in the rough 4-year period from 2012-2016. However, thanks to its return to earnings growth mode, it has accelerated its dividend growth rate to 10.0% per year on average in the last three years. Given its healthy payout ratio of 63% and its promising growth prospects, McDonald's will easily continue growing its dividend at a meaningful rate for many more years.
On the other hand, investors should note that the rich valuation of McDonald's has sent its dividend yield to an almost 10-year low level of 2.5%. This yield is much lower than the approximate 3.0% average historical yield of the stock and signals that income-oriented investors should probably wait for a better entry point.
Despite the negative reaction of the market to the latest results of McDonald's, we believe that the growth trajectory of this exceptional company is intact. While the stock remains richly valued, with an almost 10-year high in price-earnings ratio, McDonald's remains one of the most recession-proof dividend payers in the entire stock market.
Disclosure: No positions in any stock mentioned.
Read more here:
Not a Premium Member of GuruFocus? Sign up for a free 7-day trial here.
This article first appeared on GuruFocus.