A Stock for Our Time

12/02/2008 11:05 am EST

Focus: STOCKS

Josh Peters

Editor, Morningstar DividendInvestor

Josh Peters, editor of Morningstar DividendInvestor, says fast-food giant McDonald’s has strong finances and a rising dividend.

During the five years ended in 2007, McDonald’s (NYSE: MCD) revenue soared 57% and, excluding one-off charges, operating profit leapt 87% [while earnings per share climbed 125%].

The company’s positive momentum has continued into the current year. This performance has been nothing short of amazing, which raises the question: How much longer can the fast food chain keep this up?

We believe it is inevitable that top- and bottom-line growth will slow. Still, we think the Golden Arches is capable of delivering solid results. The company is rolling out some exciting new products, including a McSkillet burrito, a Southern-style chicken sandwich, and specialty coffee drinks. Remodeling additional restaurants with a more modern decor should contribute to higher sales. Management is also working hard to increase the efficiency of its kitchens and drive-through windows.

Our confidence in McDonald’s prospects is rooted in its wide economic moat. The company has tremendous advantages in scale, generating more than $63 billion in systemwide sales last year. This provides significant advertising muscle, which, along with its convenient locations and consistent customer experience worldwide, makes McDonald’s an incredibly strong brand.

McDonald’s scale also provides significant bargaining power over its suppliers, many of which owe their existence to the company. We think this helps ensure a reliable supply of food at predictable, competitive prices.

We also like McDonald’s highly franchised business model. (Franchisees and affiliates operate a combined 79% of the restaurant chain.) The corporation collects an annuity-like stream of rent, service fees, and royalties from franchisees and affiliates, with little associated capital requirements. As a result, McDonald’s earns strong free cash flow and excellent returns on capital.

The business still faces challenges. Soaring food and energy prices have pressured company-operated restaurant margins. McDonald’s must also deal with a difficult consumer environment in the United States, as well as increasing competition, which includes a resurgent Burger King (NYSE: BKC).

McDonald’s, which held $8.3 billion of net debt as of June 2008, is in excellent financial shape. Its payout ratio, now 55%, is much higher than in the past, but we believe the firm’s steady cash flows provide ample coverage for a generous payout policy.

McDonald’s has raised its dividend every year since its first payout in 1976, including a 33% hike in late September. It’s raised the dividend tenfold since 1999, and although we don’t expect such rapid advances to continue, a mid-single-digit growth rate for sales, margin gains, and share buybacks suggest 8%—10% annual growth is attainable in the next five years.

[Before buying,] we would hold out for a [share] price of $49.50, at which point McDonald’s would yield 4% with a total return prospect of 12%–14%. (It closed above $56 Monday—Editor.)

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