Among dividend growth blue chips there is a special class of companies, known as dividend aristocrats, which have shown extraordinary dedication to rewarding dividend lovers with decades of uninterrupted annual payout increases.
McDonald's is a dividend aristocrat, with an amazing 40 consecutive years of dividend growth that has made it among the most beloved and trusted sources of income for low risk investors; such as retirees living off dividends.
However, while McDonald's remains a safe dividend growth choice for income, that doesn’t mean that it’s necessarily a good idea to buy at this time.
Let’s take a look at both the company’s challenges and opportunities to see if you might want to wait for a pullback before adding the golden arches to your diversified dividend growth portfolio.
Founded in 1940 in Oak Brook, Illinois, McDonald's is the world’s largest quick serve restaurant chain. It operated 36,899 global stores at the end of 2016 in 120 countries. Close to 5,700, or 15.4%, of these stores are company-owned, with the rest being franchises.
That means the stores are owned and operated by independent business owners who pay upfront capital to open a restaurant and then pay McDonald's 4% of gross sales (plus other associated licensing fees) to benefit from the company’s brand and marketing.
Here’s a look at some of the key terms in a franchise agreement:
By geography, the business is very international; just under half of McDonald's operating income is derived in the U.S.
In recent years McDonald's has been struggling with falling sales, and flat earnings and free cash flow (FCF).
Part of this has been due to shifting consumer food preferences, including the growing trend towards healthier eating that has caused flat same store sales growth. However, in fairness to the company, most of the decline in sales is due to CEO Steve Easterbrook’s turnaround effort which was launched in 2015.
Specifically, McDonald's is re-franchising 4,000 of its company-owned stores by the end of 2018, with an ultimate goal of 95% of its locations being franchisee-owned (up from less than 85% in 2016). This means that the company is selling its stores to independent businessmen and women and is therefore losing the vast majority of cash flow from these company-owned locations.
However, in the long-term the company’s strategy should help to create a far less capital intensive and more profitable business model. That’s because by shifting towards an almost completely franchise strategy, McDonald's will be responsible only for advertising, brand awareness, and global business strategy, with the franchisees responsible for most of the actual costs of building, maintaining, operating, and upgrading its physical locations.
In fact, by the end of 2018 management believes it will be able to reduce operating and administrative costs by $500 million annually.
This strategy has already made McDonald's one of the most profitable restaurant corporations in America, and indeed the world. Going forward, a 95% franchise business model, combined with gradual store openings around the world (in developing markets), as well as ongoing cost cutting and efficiency efforts, should help McDonald's to grow steadily while further boosting its margins and returns on shareholder capital.
However, McDonald’s long-term strategy isn’t just to become a much leaner, more free cash flow rich company. Rather it’s just one part of a three-pronged strategy for revamping and evolving McDonald’s into a more premium restaurant that’s better able to compete in the cutthroat competitive world of quick-serve fast food.
Part two of the plan involves revamping the company’s menu in two ways. First, McDonald’s is focused on improving the quality of its ingredients in order to shed its “junk food” image. For example, the company is shifting entirely to free-range eggs and switching from frozen hamburgers to fresh patties.
Next is management’s attempt to boost same-store sales and profitability via optimizing the menu through experimental initiatives such as the McPick 2 value menu, all-day breakfast, and an international availability of popular regional products such as certain muffins, biscuits, and McGriddles.
Finally, McDonald’s is planning to expand its “experience of the future,” which is the company’s tech-based effort to revamp its restaurants to allow customers to order, customize, and receive food more quickly and efficiently.
For example, the company will soon roll out a mobile app that allows customers to order ahead of time and have the food freshly prepared when they arrive.
The company is also partnering with Uber to allow home delivery in certain key markets, which could help drive sales growth through increased convenience.
Meanwhile, the data the company gathers about real-time sales will likely allow McDonald’s to further improve the efficiency of its distribution chain and make it easier to try different menu options in the future.
That’s important because in the past McDonald’s has faced strong pushback from franchisees over expanded menu options and the high cost of remodeling its stores. That being said, the company’s turnaround efforts are bearing fruit.
For example, “experience of the the future” has proven to be highly successful in the UK, Canada, and France. Meanwhile, new menu options such as all-day breakfast, as well as increasing focus on more upscale drinks and coffees under the “McCafe” moniker have resulted in same-store sales growing once more.
In fact, in Q1 of 2017 global same-store sales growth clocked in at a very impressive (for a restaurant) 4%. Meanwhile, despite revenue slightly declining due to ongoing re-franchising, earnings per share grew an impressive 18%, thanks to rising margins and cost savings.
Now, it’s important to note that 8% of that growth in EPS was due to the company’s massive buyback program (8% net share reduction in the past year), which is part of the company’s recently completed three-year $30 billion capital return program.
Over the next three years management expects to return $22 to $24 billion to shareholders in the form of buybacks and dividends, most of which will be in the form of