History has shown that dividend growth stocks are one of the best ways for regular investors to grow their wealth and income over time.

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.

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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.

Business Description

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:

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McDonald's (MCD)

MCD anciallary franchise fees

Source: FranchiseDirect.com

By geography, the business is very international; just under half of McDonald's operating income is derived in the U.S.

Business Analysis

In recent years McDonald's has been struggling with falling sales, and flat earnings and free cash flow (FCF).

MCD annual sales and earnings trends

Source: Simply Safe Dividends

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.

MCD profitability vs peers

Sources: Morningstar, Gurufocus

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.

MCD exprience of the future

Source: SOTI

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.

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MCD share count over time

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 share buybacks. That will continue the company’s strong record of reducing share count, as it has by 3.8% annually over the past decade.

Going forward, once the re-franchising effort is complete, management believes it can grow its top line at a solid 3% to 5% rate while achieving far higher margins. This should result in strong earnings and free cash flow growth that bode well for its continuing dividend growth.

MCD guidance beyond 2019

Source: McDonald’s Guidance

Key Risks

While McDonald’s has a well-thought-out strategy for competing in a more health-conscious world, there remain several key risks to be aware of.

The biggest is that the company operates in a highly competitive industry, one where new restaurants and chains spring up and fail all the time. This means that it’s not certain that the roll-out of “experience of the future” in key markets, such as the U.S., will necessarily prove successful in driving strong same-stores sales. For example, despite all the changes the company has made in recent years, U.S. comps have been flat for five straight quarters, before finally rising in Q1 2017.

Next, there are numerous risks to the company’s profitability that management simply can’t control, such as rising minimum wage laws, food commodity prices, food scares (as Chipotle is still recovering from), and currency fluctuations.

And finally, investors need to be aware that most of the company’s massive capital return over the past few years has been financed with low cost debt. In fact, McDonald’s has issued $21.3 billion in net debt over the past decade, causing its long-term debt to capital ratio to jump.

MCD debt to capital over time

In a rising interest rate environment, the company’s ability to refinance this debt and borrow further to continue buying back shares could become impaired. That in turn could result in slower EPS and FCF per share growth, making it harder to grow the dividend at a rate that investors have become accustomed to.

McDonald's Dividend Safety

We analyze 25+ years of dividend data and 10+ years of fundamental data to understand the safety and growth prospects of a dividend.

Our Dividend Safety Score answers the question, “Is the current dividend payment safe?” We look at some of the most important financial factors such as current and historical EPS and FCF payout ratios, debt levels, free cash flow generation, industry cyclicality, ROIC trends, and more.

Dividend Safety Scores range from 0 to 100, and conservative dividend investors should stick with firms that score at least 60. Since tracking the data, companies cutting their dividends had an average Dividend Safety Score below 20 at the time of their dividend reduction announcements.

We wrote a detailed analysis reviewing how Dividend Safety Scores are calculated, what their real-time track record has been, and how to use them for your portfolio here.

McDonald’s Dividend Safety Score of 89 indicates it has one of the safest and most dependable dividends on Wall Street. That’s not a surprise given its dividend aristocrat status.

MCD dividend over time

The key to McDonald’s safe and consistent dividend growth is twofold.

First, management has been disciplined in not growing the payout too quickly, resulting in moderate EPS and FCF payout ratios. While it’s true that the company’s payout ratios have been rising over time, McDonald’s improving profitability ensures that the dividend is well covered by earnings and free cash flow.

As a result, McDonald’s has a nice buffer that protects it against an unexpected economic shock, such as a recession or the 2008-2009 financial crisis.

MCD EPS payout ratio over time

MCD FCF payout ratio over time

Next is the fact that, despite taking on a lot of debt in the past decade, McDonald’s still enjoys a strong balance sheet that prevents management from having to divert free cash flow from the growing dividend in order to service its debt or short-term liabilities.

MCD credit metrics

For example, while McDonald’s $27.2 billion in debt may appear alarming at first, we have to keep things in perspective because the restaurant industry is highly capital intensive. When we compare McDonald’s relative debt metrics against those of its peers, we can see that it’s debt load, though high, is far from dangerous.

In fact, the company enjoys an investment-grade credit rating that helps ensure it will continue having ample access to low cost debt, which has an average interest rate of just 3.25% today.

MCD balance sheet vs peers

Sources: Morningstar, Gurufocus

McDonald's Dividend Growth

Our Dividend Growth Score answers the question, “How fast is the dividend likely to grow?” It considers many of the same fundamental factors as the Safety Score but places more weight on growth-centric metrics like sales and earnings growth and payout ratios. Scores of 50 are average, 75 or higher is very good, and 25 or lower is considered weak.

McDonald’s Dividend Growth Score is 48, indicating that investors can likely expect about average dividend growth compared to the S&P 500, which has a 20-year median dividend growth rate of 5.8%.

While that may be a lot lower than the company’s historical payout growth, which averaged 13.7% per year over the last decade, it’s actually not bad for a large, mature blue chip, especially one with such a shareholder-friendly culture.

MCD dividend growth over time

More importantly, that growth rate would be about in line with management’s stated goal of achieving 7% to 9% long-term EPS and FCF per share growth. And since McDonald’s payout ratios can’t rise above 70% to 75% without risking the security of the dividend, investors should expect mid to high single-digit future payout growth as well.

Valuation

In the past year McDonald’s successful turnaround has caught the market’s attention and shares have outperformed the S&P 500 by about 10%. However, the company’s valuation is now looking a bit rich.

For example, the company’s forward P/E ratio of 24.2 is far above the S&P 500’s 17.3 and much higher than its historical norm of 17.6. Meanwhile the dividend yield of 2.5%, while greater than the market’s 1.9%, is significantly below MCD’s 13-year median yield of 3.0%.

In other words, much of the good news already appears to be priced into the stock. Going forward investors might expect around 9.5% to 11.5% annual total returns (2.5% yield + 7% to 9% annual earnings growth).

While that’s far from a poor return, it could be reduced if McDonald’s valuation multiple contracts back to its long-term average. It might be a better idea to wait for shares to pull back closer to $120 per share (a forward P/E ratio around 18.5) before starting or adding to one’s position in this dividend growth blue chip.

Concluding Thoughts on McDonald's

Few companies have been as good to dividend growth lovers as McDonald’s over the years. Management’s current turnaround plan, in which it pivots to a more scalable and profitable business model, should help this low-risk, future dividend king retain that status for the foreseeable future.

Burgers will likely remain one of the top dine-out segments in America, and McDonald’s top real estate locations and continued shift to a franchisee-owned business model will likely keep the cash rolling in for a very long time.

That’s especially true given the company’s strong international presence. Over the long-term, McDonald’s can continue growing in China and other developing economies where middle class growth will remain in an uptrend and there are fewer restaurants per capita compared to the U.S.

With that said, McDonald’s current valuation feels a little too high to justify using new capital to buy additional shares. Instead, McDonald’s seems more like a solid “hold” until there is a pullback in price.

Article by Simply Safe Divdends