McDonald's (NYSE:MCD) is going through a challenging phase. Consumers around the world are turning their back the fast food giant lately, and this is a big reason for concern among investors. On the other hand, recent initiatives from management seem to be going in the right direction, and McDonald's looks attractively valued in terms of dividends and buybacks.
Is McDonald's presenting a buying opportunity for investors or is it better to stay away from the company until things change for the better?
Consumers are not very fond of McDonald's lately. The company reported a 0.3% decline in global comparable sales during the month of May, driven mostly by a 2.2% decline in the U.S. and a 3.2% fall in the APMEA -- Asia-Pacific, Middle East, and Africa – region. Europe was comparatively better, with comps growing by 2.3%, but still not enough to move the needle by much regarding overall sales.
This was not a one-time problem; the trend has been in place since 2013, as customers are clearly more inclined toward competitors in the fast-casual category, which typically offer higher quality menus made with fresher ingredients.
Management is exploring a series of initiatives to reverse the situation. This includes reducing the store count in oversaturated regions, kiosk ordering, more premium burgers, healthier choices, and increased options for customization, among other possibilities. McDonald's has also been testing its breakfast menu as an all-day option in 94 locations in San Diego, and the company will now reportedly expand that test to 12 additional stores in Greenville and Greenwood, Mississippi.
Many of these initiatives look well intended and in accordance to industry trends, but implementation is crucial. It won't be easy for McDonald's to deliver a better tasting and more customizable menu while at the same time taking care of service speed and keeping prices competitively low.
Importantly, McDonald's has recently announced that it will stop reporting monthly sales figures, so investors will be facing reduced visibility regarding the effectiveness of the company's turnaround efforts. Many other restaurant chains have stopped reporting monthly numbers, so this is no reason to panic. However, the decision does not speak well about management's confidence on its ability to jump-start growth in the coming months.
On valuation and cash flows
McDonald's looks attractively valued when looking at cash flow distributions including both dividends and buybacks. The stock pays a dividend yield of 3.5%, and McDonald's has proven its ability to sustain growing payments through all kinds of scenarios. The company increased dividends in every year since making its first payment in 1976, accumulating 38 consecutive years of consistent dividend growth under its belt. This includes a 5% hike for 2014, announced last September.
Management plans to return between $8 billion and $9 billion to shareholders via dividends and buybacks in 2015, and reaching the top end of its targeted three-year, $18 billion to $20 billion capital return program by the end of 2016. McDonald's has a market capitalization in the neighborhood of $92.7 billion, so investors are getting nearly 9% of the market value via dividends and buybacks this year.
However, it's important to keep in mind that the business brought in $6.7 billion in operating cash flow in 2014, while capital expenditures absorbed $2.6 billion, leaving McDonald's with $4.1 billion in free cash flow to distribute to investors. In an optimistic scenario, free cash flow can grow over time, but McDonald's does not currently make enough money to sustain these distributions over the long term without resourcing to debt.
Dividends amounted to $3.2 billion in 2014, easily sustainable with free cash flow of $4.1 billion, so there is no reason to believe a dividend cut is coming anytime soon. When it comes to buybacks, however, I wouldn't buy McDonald's stock on the assumption that the company can continue repurchasing shares at the current rate.
Big cash flow distributions could provide some downside protection for investors while the company works on solving its problems, but the main game changer to watch is management's ability to turn the ship around. Until, or unless, sales start growing again, upside potential will most likely remain subdued.