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The Dividend Play for a Lifetime

By Jim Royal - Updated Apr 6, 2017 at 12:31PM

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Live well under the Golden Arches.

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?

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Stocks Mentioned

Yum! Brands, Inc. Stock Quote
Yum! Brands, Inc.
YUM
$112.47 (0.26%) $0.29
Annaly Capital Management, Inc. Stock Quote
Annaly Capital Management, Inc.
NLY
$6.45 (-3.59%) $0.24
The Procter & Gamble Company Stock Quote
The Procter & Gamble Company
PG
$154.68 (-0.28%) $0.44
McDonald's Corporation Stock Quote
McDonald's Corporation
MCD
$241.63 (-0.99%) $-2.41
Frontier Communications Corporation Stock Quote
Frontier Communications Corporation
FTR
Chipotle Mexican Grill, Inc. Stock Quote
Chipotle Mexican Grill, Inc.
CMG
$1,322.06 (1.77%) $22.99
Buffalo Wild Wings, Inc. Stock Quote
Buffalo Wild Wings, Inc.
BWLD

*Average returns of all recommendations since inception. Cost basis and return based on previous market day close.

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