Over the past three years, McDonald’s Corporation (MCD ) has taken shareholders on a bumpy ride. The stock fluctuated between $80 and $90, before finally breaking out above $100 this year.
McDonald’s strong performance in 2015 is due to its turnaround materializing. The company is cutting costs, closing under-performing restaurants, and launching promising new initiatives, such as all-day breakfast to win back customers. These efforts have been successful: McDonald’s earnings have recovered this year fueling impressive free cash flow growth.
To demonstrate its shareholder-friendly practices, McDonald’s rewarded shareholders with a 5% dividend increase on Tuesday, November 10.
Earnings Recovery Boosts Free Cash Flow Generation
As McDonald’s revenue and earnings declined in recent years, it made it difficult for the company to increase its dividend. Now that the company has significantly cut costs and its sales are recovering, it is generating higher free cash flow. Free cash flow is crucial to a company paying dividends, as it cannot distribute dividends to investors without the supporting cash flow produced by its underlying business.
McDonald’s has shown a great deal of progress this year and its earnings suggest a meaningful recovery. McDonald’s U.S. comps rose 0.9% last quarter — a big achievement as this was the first quarterly increase in U.S. comps in two years. Internationally, comparable sales increased 8.9% in McDonald’s high growth markets, which contain emerging markets such as China. Overall, McDonald’s global comps increased 4% last quarter. Earnings per share rose 28% year over year.
Such a strong performance was crucial for McDonald’s. The company generated $3.9 billion of free cash flow over the first nine months of 2015, up 14% from $3.4 billion in the same period in 2014. McDonald’s brings in much more cash flow than it pays out in dividends. For instance, McDonald’s dividend payout ratio as a percentage of free cash flow was 61% over the first nine months of 2015, down from 70% in the same nine month period last year. The surge gave McDonald’s management the confidence to increase the company’s dividend.
Leveraging the Balance Sheet to Finance Cash Returns
Along with internally-generated free cash flow, McDonald’s will leverage its excellent balance sheet to finance its capital return program. At the company’s annual investor meeting on November 10, management stated it would access the credit markets to fund its share buybacks. Through the three year period ending 2016, McDonald’s plans to return $30 billion to investors through share repurchases and dividends. That figure represents nearly double the amount returned to investors in the preceding three year period through 2013, and is also a $10 billion increase from the company’s previous 2016 capital allocation target.
The incremental $10 billion of cash returns will be funded largely by debt. McDonald’s notified investors that this will result in a credit rating downgrade, but will not threaten its strong balance sheet or its ability to invest in its future growth. McDonald’s has $17 billion in long-term debt but $44 billion in retained earnings. Clearly, McDonald’s has been a highly profitable enterprise for the many decades of its existence, and should continue to be so for the foreseeable future.
McDonald’s Remains a Top Dividend Stock
Despite its struggles over the past few years, McDonald’s has displayed a keen ability to weather any storm. It has increased its dividend each and every year since paying its first dividend in 1976. This amounts to a streak of 39 years of consecutive annual dividend increases, which qualifies McDonald’s as a Dividend Aristocrat. McDonald’s management knows that investors take the dividend very seriously, and is committed to providing annual dividend increases.
Its new annualized dividend of $3.56 per share represents a 3.1% dividend yield. That is significantly higher than the S&P 500 Index average yield of approximately 2%. McDonald’s consistently raises its dividend each year at rates that beat inflation, and the stock provides a dividend yield in excess of the market average. This makes McDonald’s an attractive top dividend stock pick for income investors.
Disclosure: The author is long MCD