Source: McDonald's.
McDonald's Corporation (MCD 0.27%) is one of the most renowned dividend stocks in the market. The fast-food giant has a rock-solid track record of dividend growth, as it has increased dividends every year since 1976. Besides, McDonald's stock is paying a dividend yield of 3.5% at current prices, not bad at all coming from a company with a pristine trajectory of increasing cash payments over the years.
On the other hand, McDonald's is facing serious challenges. Sales have been stagnant or even declining over nearly three years. The company is losing its touch with consumers, and competitors in the fast-casual category are stealing market share away. This raises an important question for investors: Is McDonald's strong enough to sustain dividend growth in the future?
The cash flows
To begin with, it's important to look at dividend sustainability in terms of the company's cash flows. McDonald's produced $3.2 billion in operating cash flow during the first half of 2015, and capital expenditures are notoriously low, at only $809 million during the period.
This leaves McDonald's with almost $2.4 billion in free cash flow over the first two quarters of 2015. Dividends absorbed $1.6 billion of that money, or roughly 67% of free cash flow over the period. That's not particularly low, bit it's still quite sustainable considering McDonald's is a big and stable business.
In addition, the company is restructuring its store base. McDonald's is closing nearly 700 underperforming stores around the world, marking the first time in four decades the company is reducing its store base, so management seems to be deeply committed to keeping operations lean and increasing profitability. Also, McDonald's is planning to refranchise 3,500 units by 2018, increasing the total franchised store base from nearly 80% to 90% of all units. A more efficient structure with a growing share of franchised locations should be a positive driver for cash flows in the future.
Unless there is a massive deterioration in sales and cash flows over the coming years, there is no reason to believe that McDonald's will need to cut dividends over the middle term.
The problem
Consumers aren't very fond of McDonald's lately, especially millennials, a key demographic group for companies in the industry. Fast-casual competitors are offering superior-quality food, focusing on fresher ingredients, and providing a better atmosphere, while still keeping the speed and convenience of typical fast-food chains. Fast-casual restaurants generally cost a few extra bucks than McDonald's, but customers seem more than willing to pay up for healthier and better-tasting meals.
This is really hurting McDonald's. The company has now posted seven consecutive quarters of declining sales, and financial performance for the second quarter of 2015 didn't give much room for hope. Total consolidated revenue fell 10% to $6.5 billion last quarter. Foreign currency headwinds were a major drag during the period, since the decline in constant currency revenue was a much more moderate 1%.
Still, the trend doesn't look very encouraging, especially since comparable sales are also moving in the wrong direction. Global comparable sales decreased 0.7% during the quarter, reflecting negative guest traffic in all major segments.
Looking for McSolutions
Management is implementing a series of initiatives to jump-start growth. The company will be offering all-day breakfast in the U.S. starting on Oct. 6. Breakfast food is one of the most popular items among McDonald's customers, and this could be a smart way to increase sales in a cost-efficient way by generating more traffic at different hours through the day. Moreover, many customers drink coffee with their breakfast meals, and coffee is a particularly profitable item for McDonald's.
The company is successfully turning things around in select markets via menu innovations. In Australia, McDonald's has registered 10 consecutive months of positive comps growth and increasing traffic by relaunching the everyday value menu and offering barista-crafted McCafe beverages in the drive-through.
The U.K. is doing particularly well for the company, accumulating 37 consecutive quarters of comparable sales growth. McDonald's is successfully introducing premium items such as Chicken Legend and Big Tasty, and the breakfast segment is especially strong on the back of its first ever promotional breakfast item, the sausage and bacon sandwich. Also, McDonald's is actively improving the service in the U.K. with its "experience of the future" initiative.
These are just a couple of examples proving that McDonald's still can get back in track if management plays its cards well and it aligns the menu and experience in accordance with customer demand.
Dividend growth will probably remain modest until global sales start growing again. But investors in McDonald's have no reason to panic. The company generates abundant cash flows, and the business has a lot of room for improvement if it can replicate on a global scale the smart moves it's making in markets such as Australia and the U.K.
