McDonald's (NYSE:MCD) recent troubles have been well publicized. The world's biggest restaurant chain has been hurt by sliding comparable sales in the U.S., a food safety scandal in Asia, and many have questioned its recent marketing efforts, which have conceded that asking, "Is McDonald's beef real?" is a reasonable question.
Not surprisingly, the stock has lagged along with the company's performance. Since last May, when trouble first started brewing, the stock has fallen 12% against the S&P 500's gain of 6%. But the stock's swoon has been good for at least one statistic. The dividend yield has climbed up to essentially an all-time high at 3.7%, ensuring at least some value for investors.
McDonald's first began paying a dividend in 1976 and has raised it every year, making it one of the vaunted S&P 500 Dividend Aristocrats -- a group of companies that have lifted their dividend every year in a row for 25 years or more. For McDonald's investors, the long history of growing dividends and the juicy yield are often the best reason to own the stock.
McDonald's last dividend hike came in September when it lifted its quarterly payout by 5% to $0.85 a share. It was the second year in a row that McDonald's raised its dividend by just 4 cents, and on a percentage basis, it was the company's smallest dividend increase since 2002. Considering the Golden Arches' current woes and the slowdown in dividend increases, shareholders may be wondering if McDonald's dividend growth is sustainable. Let's take a closer look at the numbers.
The next item on the Dollar Menu
When examining dividend safety, the most important figure to look at is the payout ratio. This is the percentage of cash a company pays out in dividends divided by either the net income or the free cash flow. As a rule of thumb, a payout ratio below 80% is generally considered safe. Above that line, however, the company may be in danger of cutting the payout if cash flow gets squeezed.
Thanks to its franchising model, McDonald's is a giant cash cow of a business, with profit margins around 20%. In 2013, the company reported $5.5 billion in net income, and spent $3.1 billion on dividends, giving it a reasonable payout ratio of 56%. However, the company made just $4.3 billion in free cash flow, or a 72% payout ratio based on that metric, closer to the 80% threshold. Though it's a more erratic figure than net income, free cash flow is a considered better indicator of dividend safety as companies need cash inflows in order to make the quarterly payouts.
McDonald's won't report fourth-quarter earnings until Jan. 23 so its 2014 results are incomplete, but net income will almost certainly decline for the year. Analysts are predicting earnings per share of $4.93 for the year, down from $5.55 in 2013, or a roughly 10% drop in net income. That will likely put more pressure on dividend growth as over the last four quarters McDonald's has a payout ratio of 64% based on net income and 71% on a free cash flow.
Should investors be scared?
Compared to other corporate titans, McDonald's does not have as strong of a balance sheet as one might expect. The company has a cash balance of $3.2 billion against debt of $14.5 billion. If the payout ratio creeps higher, that cash pile could be tapped to help fund continued increases but it's not a viable long-term strategy.
CEO Don Thompson is already under fire for the company's sour performance, and management would hate to relinquish its status as a dividend aristocrat. Therefore, the company will almost certainly continue to raise its dividend unless profits really crumble, which, again, is unlikely since the franchise model gives the bottom line a bit of a cushion. A continued 4-cent increase should be sustainable over the next couple of years even if current challenges persist, but the dividend yield seems to have reached its natural peak as a large increase would put the payout ratio in dangerous territory. So, only undesirable news leading to a falling share price would boost the yield.
That means shareholders should expect little in the way of dividend growth over the coming years. Unless profit growth takes off, which is doubtful given the number of factors weighing on the company's performance, the dividend should only grow by 5% or less in the near future.
Jeremy Bowman has no position in any stocks mentioned. The Motley Fool recommends 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.