Is McDonald's Still a Solid Dividend Stock?

Is McDonald's Still a Solid Dividend Stock?

Over the past decade, McDonald's has achieved enormous success. Investors have seen the stock steadily rise as earnings and dividend payments grew at a double-digit pace. However, the company has suffered slowing growth over the past couple of years. The stagnant stock price since the beginning of 2012 is reason for concern. The most recent dividend increase was just 5.2%, well below the 10-year average. Is McDonald's still a solid dividend stock, or should investors look elsewhere?

A look back
The structure and scale of McDonald's allows the company to maintain spectacular margins. About 80% of locations are franchised,and McDonald's collects high-margin rent/fees from the franchisees. About a third of its revenue is derived from franchisees, and most of that is pure profit. Last year McDonald's had a net income margin of 20%, earning about $5.5 billion on $27.6 billion of revenue.

Over the past decade, McDonald's has grown its earnings at an annualized rate of roughly 18.5%. Dividends have grown even faster, increasing at a 24.5% annualized rate. It's tempting to simply assume that this kind of growth will continue into the future, especially given McDonald's wide economic moat.

However, it's important to understand exactly how McDonald's has achieved this exceptional growth. There was revenue growth, sure, but most of the heavy lifting was done via margin expansion. Net income margin grew from just 8.6% in 2003 to 20% last year, accounting for a majority of the decade's earnings growth. The dividend was boosted by both this margin expansion as well as a rise in the payout ratio, which grew from 33.9% in 2003 to 53.6% last year.

This kind of expansion cannot be repeated in the next decade. Margins are likely about as high as they'll go, which leaves revenue growth as the main driver of earnings and dividend growth going forward.

Reasonable expectations
McDonald's is no longer a growth stock, and the next decade will look very different than the last decade for the company. There's still plenty of room to grow, particularly in international markets. China and India alone have a combined population of about 2.5 billion people, and McDonald's currently has just a small share of these markets.

Growth will have to be slow and methodical, however, in order to maintain the balance between company-owned and franchised locations, and to ensure that the stores will be successful. Competition from local firms represents a real threat in international markets.

Realistically, revenue should grow somewhere in the mid-single digits going forward. A few percent from new store openings, coupled with a few percent from same-store sales growth, leads to this estimate. If margins remain flat, then earnings will also grow at roughly this rate. Earnings-per-share growth will be a few percentage points higher due to share buybacks, and 7% to 9% annual EPS growth seems like a reasonable estimate.

Dividends should grow at about the same rate as EPS, as I don't expect the payout ratio to grow too far beyond where it is today. With a current yield around 3.33%, high-single-digit dividend growth is more than enough to make McDonald's an attractive dividend stock.

Comeback stories and competition
After dominating the U.S. fast-food market for years, McDonald's is facing renewed competition from its longtime rivals. Wendy's has seen its stock more than double since late 2012 as its turnaround efforts have shown progress. After selling the Arby's franchise in 2011, the company is focusing on revitalizing the Wendy's brand. Differentiating itself via premium offerings seems to be working, with sandwiches that feature a pretzel bun performing well. The company is also remodeling many of its stores, introducing a more modern look and feel. Stores that were remodeled in 2012 have seen, on average, a 20% jump in sales, which is an encouraging trend.

Burger King Worldwide is also working on a turnaround effort, and the results so far are equally impressive. The company is introducing new premium items like a chicken Parmesan sandwich as well as low-cost items such as the $1 french fry burger in an attempt to appeal to consumers across the board. In September, the company introduced Satisfries, a healthier version of french fries. Compared to McDonald's fries, Satisfries have 40% less fat and 30% fewer calories. Like Wendy's, Burger King is remodeling many of its stores, and so far it's seeing a 10% to 15% sales boost.

While McDonald's is in an entirely different league than Wendy's and Burger King right now, these two companies are making progress toward becoming more profitable and competitive. Continued success could pressure McDonald's lofty margins, but scale gives the company a considerable advantage.

The bottom line
McDonald's cannot repeat the margin expansion of the past decade, but its wide moat and international growth prospects give the company plenty of room to continue steadily growing earnings. With a 3.33% yield and high-single-digit dividend growth expected, McDonald's offers an attractive investment for those looking for dividend growth.

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Fool contributor Timothy Green has no position in any stocks mentioned. The Motley Fool recommends Burger King Worldwide and McDonald's. The Motley Fool owns shares of McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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Originally published