McDonald’s Corporation is Executing a Successful Turnaround

McDonald’s Corporation (NYSE:MCD) is one of the 51 Dividend Aristocrats, a group of companies in the S&P 500 Index, with 25+ consecutive years of dividend increases. McDonald’s stock paid its first dividend in 1976 and has increased it every year since.

Recently, McDonald’s has implemented a successful turnaround, which allowed it to return to higher dividend growth rates. On September 21st, McDonald’s increased its dividend by 7%. The turnaround involved new menu offerings, remodeled restaurants, and a greater push to franchise restaurants.

Put together, these efforts have done the trick. McDonald’s has reported strong sales and earnings growth in the past year.

Business Overview for MCD Stock

McDonald’s was founded in 1954, by Ray Kroc and his partners, Dick and Mac McDonald. Together, they formed the McDonald’s System Inc. In 1960, Kroc bought the exclusive rights to the McDonald’s name.

Today, McDonald’s is the largest publicly-traded fast food company in the world.

It operates over 37,000 locations, in more than 100 countries around the world. The company generates over $24 billion in annual sales.

Revenue is split into the following categories:

2016 was a year of recovery for McDonald’s. Previously, the company was struggling, with falling sales and profits. In 2015, it even made the rare decision to close more stores than it opened in the U.S., for the first time in 40 years.

2015 and 2016 were difficult years for the top line, but franchised sales increased last year.

Source: 2016 Annual Report, page 17

Global comparable-restaurant sales increased 3.8% for the year. Comparable sales is a very important financial performance metric for restaurants. It measures sales at locations open at least one year, and is a sign of durable brand strength after the initial buzz of a new restaurant opening fades.

Earnings-per-share for McDonald’s stock increased 16% last year, after adjusting for currency.

Previously, the company was struggling, with falling sales and profits. In 2015, it even made the rare decision to close more stores than it opened in the U.S., for the first time in 40 years.

Fortunately, McDonald’s got back on track last year, and its momentum should continue moving forward.

Growth Prospects

McDonald’s performance has improved, due in large part to the strategic initiatives put in place to restore growth. These initiatives are working well, which puts McDonald’s in a good position to continue growth moving forward.

First, McDonald’s announced new menu offerings, including all-day breakfast, and the McPick 2 promotions. A renewed focus on providing value to customers has helped restore traffic. McDonald’s expects 3%-5% sales growth each year.

In addition, McDonald’s has undergone a new wave of re-franchising. It expects to re-franchise 4,000 restaurants by the end of 2017. By next year, approximately 93% of McDonald’s restaurants will be franchised.

Accelerated franchising has worked particularly well in the international markets.

Source: 2016 Annual Report, page 19

Refranchising will help expand McDonald’s profit margins, as will its cost-cutting measures. McDonald’s expects to trim $500 million from its general and administrative cost structure. By 2019, it expects to cut another 5%-10% from its cost structure.

On an annual basis, McDonald’s expects high-single digit earnings growth. It has more than reached this so far in 2017.

Adjusted earnings-per-share increased 20% in the first half of the year compared to the same period a year ago. Global comparable sales increased 6.6% last quarter, while refranchising and cost savings drove additional earnings growth.

Competitive Advantages & Recession Performance

McDonald’s enjoys several competitive advantages that separate it from its industry peers.

First, it is the largest publicly-traded fast food company in the world. It has enormous scale, which allows it to keep prices low.

And, it has a very strong brand. According to Forbes, McDonald’s is the #9 most-valuable brand in the world, worth over $40 billion.

One of the big reasons why McDonald’s continues to increase its dividend year in, and year out, is because it has a defensive business model.

When the economy takes a downturn, consumers tighten their belts, particularly when it comes to dining. Rather than go to higher-priced sit-down restaurants, consumers will often shift down to fast food during a recession.

It seems strange, but from this perspective, McDonald’s actually benefits from recessions. For evidence of this, its earnings-per-share during the Great Recession are shown below:

McDonald’s grew earnings in each year of the recession, at a double-digit compound annual rate. This is highly impressive, and speaks to its recession-resistant business model.

Investors can be reasonably assured the company can continue raising the dividend, even if another recession hits.

McDonald’s Stock Valuation & Expected Returns

McDonald’s stock has generated huge returns in recent months. The stock has appreciated 50% in the past one year.

This has caused McDonald’s valuation to expand. It now has a trailing price-to-earnings ratio of 27. According to ValueLine, the stock held an average price-to-earnings ratio of 19 since 2001. And, the S&P 500 Index has an average price-to-earnings ratio of 25.

Therefore, McDonald’s appears to be slightly overvalued, based on relative comparisons to the broader market, as well as to its own historical average.

Investors cannot rely on continued expansion of the price-to-earnings ratio to drive returns. Going forward, returns will be generated from earnings growth and dividends.

In the past 10 years, McDonald’s grew earnings-per-share by 7% compounded annually. With its turnaround underway, this could be a reasonable baseline of expectations going forward.

A potential breakdown of future returns is below:

From this, total returns would reach approximately 7%-10% per year. However, a declining price-to-earnings ratio would lower McDonald’s future returns.

Final Thoughts on McDonald’s Stock

McDonald’s stock has paid a dividend for over 40 years in a row. Over those four decades, it has had to reinvent itself from time to time, to stay on top of changing consumer trends.

It recently had to do this once again, but the results are already materializing. Sales and earnings are growing, which is powering McDonald’s dividend growth.

McDonald’s stock does not appear to be undervalued right now, and investors should consider waiting for a better buying opportunity. That said, it should continue to deliver for dividend growth investors.

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