Receiving dividends is great! Getting that quarterly paycheck feels special every time, that is unlike to shares gradually appreciating. As investors, one of the reasons we like dividends is because they provide tangible and more predictable capital returns.
As a result, we like companies that have a long track record of dividend payments, especially if these dividends are growing. A list of potential trustworthy investments for dividend growth investors is often this of Dividend Aristocrats, which have displayed decades of consistent dividend increases. Keep in mind that this group of companies can also include some risky dividend payers and potential yield-traps, as we highlighted in our latest Universal Corp. (UVV) article.
In this one, we want to take a look at another Dividend Aristocrat whose distributions have grown annually for the past 44 years. On Thursday, McDonald’s (MCD) raised its dividend once again, as it has done every year since 1976. Dividend increases are always appreciated, especially when they occur during a pandemic, by a company operating in one of the most affected sectors -restaurants.
Not to complain, but this particular dividend increase of McDonald’s is unique in that it is the weakest dividend increase in its history. Management increased its quarterly dividend by 3%, to $1.29/share. Previously, McDonald’s weakest DPS increase was in 2002, by 4.4%. Further, the company’s past 5-year DPS CAGR has been 7.6%. As a result, such a steep deceleration in dividend growth came to us at a surprise.
The questions that have been raised now are:
- What the latest DPS increase imply about McDonald’s dividend safety?
- How are medium-term investor returns affected?
Image by: Shutterbug75
Such a deceleration of dividend increases can possibly signal two things. The dividend’s safety is either at stake or that the board prefers to act prudently by retaining earnings for increased liquidity. In any case, it’s more worrying than exciting.
As shown on the company’s latest earnings report, comparable YoY sales took a significant hit during the early months of the pandemic. For example, in April, International Operated Market sales had declined by a massive 66% during the month.
Source: Earnings release
However, this disastrous performance quickly turned, with the U.S., for example, reporting an almost steady YoY turnover by the end of June. This trend was almost certainly pointing towards the resumption of revenue growth in the U.S. Indeed, in the company’s brief update published on Thursday, the company reported total comparable sales declining by 2.2% YoY, and U.S. sales growing by 4% YoY.
This is great news, as not only does the demand for the company’s products remains robust in the States, implying healthy brand value, but also such a small decline in total comparable sales means that the other regions have almost fully recovered as well.
Further, the company’s dividend remains incredibly well-covered, even when including its couple of past weak quarters. Even with a temporary and to-be-resumed-to-normality EPS of $6.37, McDonald’s has a forward payout ratio of 81%. Assuming EPS returns to normal, that figure should be around 65%, which considering the company’s update, should not be that far in the future.
In that regard, we believe that the dividend is safe and that management indeed chose to slow down the recent increase to preserve liquidity. However, we need to assess if this slowdown could affect shareholder returns and what investors expect in terms of their returns.
To assess current expected investor returns, we have emulated analyst estimates pointing towards an FY2021 EPS of $8.16, implying full recovery, which the company’s recent update also supports. Further, we have taken a more prudent approach by estimating EPS CAGR of 8% in the medium term, vs. a consensus 10% over the medium term. Keep in mind McDonald’s EPS is partially assisted by consistent buybacks.
Further, we have included the company’s most recent forward payment, which we have assumed it grows by around 5% over the same future 5-year period. We believe that this is a reasonable estimate, as McDonald’s has always increased its dividend close to its previous rate whenever it did slow it down.
A significant dividend growth slowdown could greatly affect the dividend’s future growth trajectory, hence why the current slowdown is important to assess.
Further, we need to take into account the stock’s current valuation. It’s important to notice how McDonald’s valuation has acquired a premium over the past few years compared to the past. As the company’s presence has been growing rapidly, its iconic brand value and consistent dividend payments have given the company a “safe-haven” status. Hence the valuation premium.
The bad news is that current investors are subject to lower expected returns going forward, as they are paying more dollars for less value. In any case, let’s do the math.
By plugging in McDonald’s current stock price of around $225, our projected EPS & DPS estimates, and a fair range of potential valuations, we get the following expected returns:
As you can see, at a P/E ratio of around 24 to 28, which we believe is the most likely outcome, investors should expect CAGR returns of around 5.5% to 8.5%, despite the possibly underwhelming dividend increase prudent projected dividend growth rate.
While McDonald’s latest dividend increase may not have been the most pleasing outcome, it’s important to appreciate the company’s commitment to creating shareholder value during such adverse economic times in the restaurant industry.
As we explained in this article, the dividend remains safe, and management’s DPS deceleration is probably attributed to behaving prudently and retaining liquidity. Further, we believe our projected returns remain at adequate levels and could be attractive for more conservative dividend growth investors. This is the case as shares offer a great margin of safety, with positive returns even under a valuation compression scenario.
At the same time, the yield remains near a decade low, and overall returns may be quite limited overall. While we are not trying to time the market, we would be much more comfortable initiating a position at a more attractive price point. Hence, we will stay on the sidelines for now.
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Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.