Is McDonald's a Top Dividend Stock to Buy Now?

Source: McDonald's.

McDonald's (MCD -0.42%) is widely considered a top dividend stock, and for valid reasons. The fast-food giant has a remarkable trajectory of dividend growth over the years, the business generates succulent cash flows on a consistent basis, and the 3.6% dividend yield is quite attractive for such a dividend powerhouse.

However, the company has faced some serious challenges lately. Sales have been stagnant or even declining over the past several months, as consumers seem to prefer more innovative and dynamic competitors such as fast-casual player Chipotle Mexican Grill (CMG 6.33%).

Is the short-term weakness in McDonald's a buying opportunity for long-term investors, or is it better to stay away from McDonald's stock until the company can find a solution to its problems?

The strengths
McDonald's is part of the S&P 500 Dividend Aristocrats index. To be included in this select group, a company needs to have 25 consecutive years of dividend growth under its belt. McDonald´s goes even beyond that: The fast-food giant has raised payments every year since making its first dividend payment in 1976, accumulating 38 consecutive years of consistent dividend growth.

This impressive track record of dividend growth reflects some important advantages at the operating level. McDonald's is an industry giant, with more than 35,000 restaurants in 119 countries, so the company can leverage its massive scale to obtain favorable prices and financial conditions from suppliers. Marketing firepower and prime real estate locations around the planet are additional sources of competitive strength for the company.

In May, McDonald's announced a new and generous three-year cash return plan, through which management intends to distribute $18 billion to $20 billion to investors via dividends and buybacks between 2014 and 2016. Those figures imply a 10% to 20% increase versus the cash returned from 2011 to 2013, so management is clearly committed to continue making big distributions for investors in McDonald's stock over the middle term.

The challenges
McDonald's produced nearly $2.24 billion in free cash flow during the first two quarters of 2014. Dividends absorbed $1.6 billion, while share repurchases took up $1.14 billion, for a total of $2.74 billion in cash distributions to investors over the first half of 2014.

That means capital distributions are moderately above internal cash-flow generation. McDonald's isn't going overboard when it comes to dividends and buybacks; however, there isn't much room to raise payments from current cash flows, either. If McDonald's wants to continue raising cash payments to investors without resorting to debt, the company will need to grow its free cash flows in the years ahead.

Lack of growth is becoming a big problem for McDonald's lately, and management doesn't seem to be able to find a way to jump-start sales. Same-store sales have been falling over the past several months, with August showing a worrisome 3.7% decline versus the same month in 2013.

Consumers around the world are increasingly concerned about the calories and other health implications of the food and drinks they consume, and McDonald's is clearly not well positioned on that front. The company is trying to revamp its menu with premium sandwiches and more sophisticated coffee offerings, but this approach isn't generating the desired traction among customers. Making things worse, service quality and speed are under pressure because of the increased complexities of these new products.

According to a recent survey from Consumer Reports, McDonald's ranks in the last place among U.S. fast-food restaurants when it comes to customer satisfaction. Unless the company manages to reverse its image and generate both growing sales and cash flows, this will remain a considerable drag on dividends and buybacks in the coming years.

Competition is on the rise, too. Chipotle Mexican Grill is achieving extraordinary success by giving clients precisely the opposite of what McDonald's has to offer: higher-quality food made with fresh and natural ingredients and a remarkably fast and efficient service. Chipotle reported a jaw-dropping 28.6% sales increase during the last quarter, while same-store sales jumped 17.3% during the period.

McDonald's needs time to streamline its menu and operations to improve sales performance. However, time is not unlimited by any means. The longer it takes for McDonald's to get back on track, the more clients it will lose to Chipotle Mexican Grill and other industry players positioned on the right side of the trend.

The bottom line
McDonald's is a financially solid company, and the tasty dividend yield provides considerable upside potential if things turn for the better. However, as long as customers are choosing to spend their money at other fast-food restaurants, investors may want to pick some other dividend stocks from the menu.