The Dividend Play for a Lifetime

Last week I highlighted Yum! Brands (NYSE: YUM  ) as the best China play that wasn't Chinese. As the company behind such brands as KFC and Taco Bell, Yum! offers a compelling prospect for gain. McDonald's (NYSE: MCD  ) also allows dividend investors to reap payouts for a lifetime, and has a few less-obvious catalysts up its sleeve to unlock value.

High growth vs. high yield
Over the years, McDonald's operational performance has been exceptional, leading to its ability to pay and increase dividends for decades. The restaurant titan currently yields 3.1%, or $2.20 per share. That dividend has more than tripled over the past five years. Nice if you owned the stock since then, I hear you grumble. As a dividend investor, you need to consider how your company might increase its payouts in the future. Knowing the dividend growth rate is as important as knowing the dividend.

Consider the companies in the following table:

Company

Dividend Yield

5-Year Dividend Growth Rate

McDonald's

3.1%

31.3%

Procter & Gamble (NYSE: PG  )

3.1%

11.9%

Frontier Communications (NYSE: FTR  )

9.7%

0.0%

Annaly Capital (NYSE: NLY  )

15.2%

6.9%

Source: Capital IQ.

While McDonald's and Procter & Gamble offer lower yields, they also have the ability to raise their dividends because of their strong consumer franchises. In fact, it's difficult to think of better consumer companies.

On the other hand, both Frontier and Annaly are less able to sustainably deliver dividend growth. While their yields are both sizable, the prospects for future gains are limited. Frontier operates in the declining fixed-line telecom space, and just cut its payout as it integrates some rural operations recently acquired from Verizon.

Meanwhile, Annaly has been able to increase its yield because net interest margin has increased as interest rates dredged the bottom. While Annaly is a nice play in disinflationary times, interest rates won't remain low forever, so there's likely to be a hiccup in its dividend at some point. Those criticisms, though, don't mean either company isn't worth owning -- I own both -- but rather a reminder that you need to know the sustainability of your dividends. Blending high payouts with high dividend growers could make a lot of sense. (I also own Procter & Gamble.)

McDonald's occupies something of a middle ground, and its recent massive increase in its payout is just the beginning. There are good signs that the company has plenty more in store.

Two hidden dividend sources
McDonald's has indicated that for the future it intends to pay out all its free cash flow. Now, some of that cash will go to repurchase shares. In September 2009, McDonald's authorized a $10 billion repurchase plan, and the company has wasted no time in snapping up shares. It bought back about $1 billion in shares in the recent quarter, and nearly $480 million the quarter before that.

But the rest of that cash looks earmarked for dividend increases, which could be very significant.

McDonald's also has at least two other potential opportunities to unlock cash. The company has been undergoing significant refranchising, selling off its company-operated stores to franchisors, and it now operates just 19% of its locations. That's great news, because franchise fees allow McDonald's to realize a better-than-80% margin on franchised stores. In contrast, its company-operated stores have less than a 20% operating margin. By refranchising more stores, McDonald's has been increasing its margins and freeing capital tied up in its stores, even though refranchising makes revenue growth look sluggish.

OK, McDonald's is a mature franchise, even if it does have a few growth areas left, such as China. So McDonald's can't post the type of stellar top-line numbers that quickly growing Chipotle (NYSE: CMG  ) and Buffalo Wild Wings (Nasdaq: BWLD  ) are able to. Those companies can take advantage of store build-out and increasing efficiency to grow margins, which is why McDonald's spun off Chipotle more than four years ago so that the market would appreciate this distinction. Still, according to perhaps the most honest gauge of retail -- same-store sales -- McDonald's is truly holding its own.

The second hidden store of value is in McDonald's real estate holdings. Even as the company sells off franchises, it maintains the rights to most of its land and buildings. Some of that real estate is in prime locations and has been sitting on the company's books at cost for decades.

The mechanism that Mickey D's might use to unlock that value is unclear, but the value is certainly there. And given how CEO Jim Skinner is pulling out all the stops to make the company a more efficient user of capital, it won't be surprising if he gets that value back to shareholders somehow. I don't factor that into my valuation below, but it offers some potential upside nonetheless.

An apple pie to go
A quick dividend discount valuation suggests that McDonald's may be undervalued. Assuming annual dividend growth of 10% in years 1-5, 7% in years 6-10, and a 2% terminal increase, McDonald's shares should be valued at $82. OK, so you don't think McDonald's dividend can grow at 2% for that long? The current price of $70 implies the same growth rates as above, except no dividend increase ever again after year 10. Given the company's willingness to return all its free cash flow, I'm willing to bet that the company can do much better than no dividend growth after year 10. Are you?

Jim Royal, Ph.D., owns shares in Annaly, Frontier, and P&G. Chipotle is a Motley Fool Rule Breakers recommendation. Buffalo Wild Wings and Chipotle are Motley Fool Hidden Gems picks. Procter & Gamble is an Income Investor recommendation. The Fool owns shares of and has written covered calls on Procter & Gamble. Motley Fool Options has recommended a bull call spread position on Yum! Brands. The Fool owns shares of Chipotle. Try any of our Foolish newsletters today, free for 30 days. The Motley Fool has a disclosure policy.


Read/Post Comments (15) | Recommend This Article (180)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On July 28, 2010, at 3:10 PM, nontechie wrote:

    You said it (albeit as an aside)--own both companies with growing dividends and the best of the very high yielders like Annaly. For most people, investing is all about diversification and this is just another form of it.

  • Report this Comment On July 28, 2010, at 5:54 PM, financeguy85 wrote:

    For such an excellent company as McDonald's is, I'm extremely confused as to how it doesn't manage to be a recommendation by any of the Fool's services. I would think at the very least Income Investor would consider it a core pick.

  • Report this Comment On July 28, 2010, at 7:38 PM, sagitarius84 wrote:

    I am a big fan of McDonald's (MCD):

    http://www.dividendgrowthinvestor.com/2010/07/mcdonalds-corp...

    McDonald’s is currently attractively valued. The stock trades at a P/E of 16.50, yields 3.10% and has an adequately covered dividend payment. The company has proven to be somewhat recession resistant. I would be a buyer of MCD at current prices.

  • Report this Comment On July 28, 2010, at 8:40 PM, goalie37 wrote:

    When I did some research on MCD, I liked what I saw. I didn't buy it because I already owned YUM. After reading this article, I think I should go take another look and maybe be happy owning both!

  • Report this Comment On July 29, 2010, at 10:42 AM, Gregeph wrote:

    Good article. McDonald's also has significant and growing exposure to China. Here's a comment from the Q2, 2010 conference call, "Now China remains a tremendous opportunity for McDonald’s and we’re committed to growing there. We have opened 48 restaurants this year and on track to open between 150 and 175 for all of 2010. This is nearly a 15% increase over our base."

    They have also done a better job than anyone at layering on profitable dayparts: they own breakfast and have added wraps for midday snacking, coffee drinks and most recently smoothies.

    Their high ROE has allowed them to update their stores which builds customer loyalty and drives traffic.

    http://gregspeicher.com/

  • Report this Comment On July 29, 2010, at 9:11 PM, Pat4Ra wrote:

    Your discounted dividend valuation model for MCD is over how many years?

  • Report this Comment On July 29, 2010, at 9:16 PM, Pat4Ra wrote:

    Sorry, the answer is in the last bit of the article.

  • Report this Comment On July 30, 2010, at 5:22 PM, DYCRIL wrote:

    I find this site, PERSONAL FINANCE, and MORNINGSTAR/DIVIDEND INVESTOR to be the very BEST sites for financial help.....if one is not greedy and if one does not have fear.....so far so good....from beautiful Prescott, AZ.....DYCRIL

  • Report this Comment On July 30, 2010, at 7:10 PM, pkluck wrote:

    Only problem with dividend stocks is starting in 2011 they will be taxed at ordinary income tax rates. For top earners that is taxed at 40-45% fed, and for me living in Minnesota another 8.5% state income tax. I'm cutting my exposure to dividend stocks and going for more growth oriented stocks.

  • Report this Comment On July 30, 2010, at 9:42 PM, Latinus wrote:

    "Only problem with dividend stocks is starting in 2011 they will be taxed at ordinary income tax rates."

    Is this certain?

  • Report this Comment On July 30, 2010, at 11:43 PM, weihou258 wrote:

    Chinese does not like the smell of the cheese very much, not sure about the young ones.

    YUM entered China much earlier than MCD.

    I owned some MCD. Actually, I do not remember at what price I bought them and how much they are now. -- Save worry.

    Will not be doubled in short time, but with 50% gain + 4% devident is much better than puting the money in bank.

  • Report this Comment On July 31, 2010, at 1:57 PM, ikkyu2 wrote:

    I look at McD the same way I look at MO - a cash cow whose major future risks come from regulation and health modification.

    Before anyone buys a share of McD, they need to go look at a menu - one of the ones posted on the website, with ingredients. Read the ingredients for one of McD's bestsellers - say, a Chicken McNugget:

    Chicken McNuggets®:

    White boneless chicken, water, food starch-modified, salt, seasoning (autolyzed yeast extract, salt, wheat starch, natural flavoring (botanical source), safflower oil, dextrose, citric acid, rosemary), sodium phosphates, seasoning (canola oil, mono- and diglycerides, extractives of rosemary). Battered and breaded with: water, enriched flour (bleached wheat flour, niacin, reduced iron, thiamin mononitrate, riboflavin, folic acid), yellow corn flour, food starch-modified, salt, leavening (baking soda, sodium acid pyrophosphate, sodium aluminum phosphate, monocalcium phosphate, calcium lactate), spices, wheat starch, whey, corn starch. Prepared in vegetable oil (Canola oil, corn oil, soybean oil, hydrogenated soybean oil with TBHQ and citric acid added to preserve freshness). Dimethylpolysiloxane added as an antifoaming agent.

    Does that read like food to you?

  • Report this Comment On August 01, 2010, at 12:27 AM, Quick2learn wrote:

    When it comes to selling the MCD product, the children of today and tomorrow will help drive the profits of this company. They are the ones who like the tastes they are offered, it is part of their social structure, where they hang out and meet each other. It is at first families but then, the well heeled teen who has extra cash to make the buying decisions on a grand scale that will push MCD forward, making the bottom line a black one where dividends will be a rich and rewarding experience for the shareholders.

  • Report this Comment On August 11, 2010, at 10:37 AM, grannyfae wrote:

    Best dividend stocks of the NYSE:

    http://phoenixmir2.com/NYSE

  • Report this Comment On January 24, 2011, at 4:39 PM, vaidybala wrote:

    Dear readers: MCD is implicated in obesity in North American children. ChickenMcNugget contensts revealed inthis site is an eye opener. I stay away, I am a vegetarian knowing the hurdles in my path. We will be encouraging this fatty behavior in society which cost the health budget treating these people with CVD, Diabetes and gastric surgery. Should we being doing this as socially responsible?

    Thanks for my 2CC worth!

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