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McDonald's: A Quality Dividend Aristocrat

Founded in 1940, McDonald's (MCD) is the world's largest quick-serve restaurant chain, with over 38,000 locations in more than 100 countries. Almost all of its restaurants are franchised, meaning the stores are owned and operated by independent business owners. Under a typical franchise arrangement, McDonald's owns or leases the property while the franchisee pays for equipment, signs, seating, and décor.

McDonald's ownership of real estate, combined with the co-investment by franchisees, enables the company to achieve restaurant performance levels that are among the highest in the industry. Franchisees are responsible for reinvesting capital in their businesses over time, but McDonald's frequently co-invests with them to help improve their restaurants and operating systems to maintain the company's brand value.

A typical franchise term is 20 years and requires franchisees to meet rigorous standards, helping ensure consistency and high quality at all McDonald's restaurants. Franchisees contribute to McDonald's revenue through the payment of rent and royalties based upon a percent of sales (typically 4%), with specified minimum rent payments, along with initial fees paid upon the opening of a new restaurant.

This structure enables McDonald’s to generate significant levels of cash flow while franchisees benefit from the company's brand and marketing.

McDonald's is highly globalized with only 36% of sales generated from its U.S. restaurants. The other 64% of sales is derived from a mix of mature, developing, and fast-growing international markets.

With 44 consecutive years of dividend increases under its belt, McDonald's is a dividend aristocrat and slated to become a dividend king in 2024.

Business Analysis
McDonald's rise to success in the fast food industry was largely attributable to the company's focus on convenience, consistency, and value, all tied together by its unique and successful franchising model. 

Notably, McDonald's former president and chief executive Harry Sonneborn once said, "We (McDonald's) are not technically in the food business. We are in the real estate business. The only reason we sell fifteen-cent hamburgers is that they are the greatest producer of revenue, from which our tenants can pay us our rent."

McDonald's is one of the largest real estate owners in the world, having snapped up thousands of property locations along highways and within busy cities over the course of many decades. McDonald's owns approximately 50% of the land and 80% of the restaurant buildings in its markets.

Importantly, McDonald's locations are financed by independent operators (the franchisees) who must pay an upfront fee to open a restaurant and send as much as 16% of their restaurant sales back to McDonald's for rent under their long-term lease agreements, according to The Wall Street Journal.

Historically, McDonald's has been supportive towards franchisees by co-investing to improve restaurants and collecting a reasonable percentage of sales instead of forcing franchisees to buy overpriced supplies from the company.

As a result, McDonald's has been able to maintain consistency between locations, whether they're owned by franchisees or the company itself.

With the help of the company's unique productivity innovations, such as multiple drive-thru lanes and industrial-like assembly lines in the kitchen, McDonald's has delighted customers with fast service, consistently hot food, and predictable quality. The company's simple, standardized menu and memorable marketing efforts have further fueled growth.

In addition, McDonald's significant scale and basic menu have translated into value for customers in the form of low prices. As one of the largest purchasers of beef, chicken, and potatoes, for example, McDonald's can exert meaningful pressure on its suppliers, resulting in lower food costs that can be passed on to customers.

Despite all this, the restaurant chain fell on hard times a few years ago. Specifically, the rise of fast-casual competitors, shifting consumer tastes for healthier food, and several managerial missteps at the company (declining service, more complicated menu, etc) resulted in several years of flat or negative sales and earnings growth.

In 2015, McDonald's embarked on a bold plan to revitalize the company under the helm of new CEO Steve Easterbrook.

First, the company doubled down on its franchising model by selling company-owned stores to independent operators. McDonald's had a goal of making 95% of its location franchisee-owned, up from 81% in 2015.

This transition led to a temporary decline in total revenue, but McDonald's is now a much more profitable business. The company can focus on advertising, brand awareness, and global business strategy while franchisees cover the large, ongoing costs of building, operating, and upgrading restaurants.

Second, McDonald's has invested significantly into what management calls the "experience of the future", which encompasses everything from self-ordering kiosks, ordering via a mobile app, curbside pickup, and a more modern store design:
Source: McDonald's

Together, these "experience of the future" initiatives are expected to increase customer satisfaction and, ultimately, sales.

The restaurant chain has also made big inroads into food delivery by partnering with Uber. The company noted that delivery orders tend to have high levels of repeat business and are usually 1.5 to 2 times larger than in-store orders.

Lastly, McDonald's continues to experiment with its menu. For example, frozen beef patties were replaced with fresh beef to win over more customers. In addition, McDonald's has invested heavily into the McCafe brand, rolling out premium coffees and ice beverages that it hopes will attract higher-end clientele.

Overall, management's growth strategy has largely been a success, as evidenced by a  significant increase in both the company's earnings per share and operating margin (a measure of profitability) since 2015.

If McDonald's can continue to execute on its plans, then it should be able to achieve high-single digit (6% to 9%) annual dividend growth for the foreseeable future, making the company an appealing candidate for long-term dividend growth portfolios. 

However, there's no guarantee that McDonald's impressive turnaround can continue without hiccups along the way. 

Key Risks
McDonald's turnaround under Steve Easterbrook has been impressive, but there are still numerous challenges facing the company. 

For one, McDonald's has significant foreign currency exposure due to its global presence. Consequently, the company's sales and earnings can be greatly affected when converted to U.S. dollars for accounting purposes.

However, while negative currency effects can impact the company's short-term growth rates, they seem unlikely to threaten the company's long-term earnings power.

Instead, what could impede management's long-term growth plans is its dependence on franchising. While the franchise business model generates high margins, it also places a large burden on franchisees. Store remodelings, digital kiosk installations, online ordering integrations, and other in-store improvements require restaurant owners to pick up much of the tab.

At the same time, labor costs are on the rise in the U.S. and around the world, further pressuring the profitability of franchisees' restaurants. (Some areas of the U.S., for example, will see minimum wages rise as high as $15 per hour.) Should running a McDonald's restaurant become substantially less profitable, McDonald's may have difficulty opening new stores and replacing franchisees that leave the chain.

Fortunately, many of McDonald's costly in-store investments are in the past, so it seems unlikely that dissatisfaction amongst franchisees will take a turn for the worse. Moreover, McDonald's could step up its share of spending if relations became fragile.

Finally, it's worth noting that while McDonald's has potential to grow by opening new new stores in emerging markets, it faces the risk of changing consumer tastes across the globe. Consumers are becoming increasingly health conscious, so McDonald's core food offerings may prove less appealing in the years ahead. That could potentially limit its long-term growth in more saturated markets such as in the U.S. and Europe.

As a result, management could face increased pressure to continually evolve the menu in order to keep up customer traffic and keep same-store sales growing. However, frequent menu changes could further strain relations with franchisees, upon whom the company is becoming ever-more dependent for its cash flow. 

Closing Thoughts on McDonald's
McDonald's has an impressive track record of delivering strong growth for decades, both in the U.S. and overseas. The company has become a darling among dividend growth investors, and for good reason: McDonald's has delivered 44 consecutive annual dividend increases.

More importantly, management's turnaround strategy is delivering strong results. While there are challenges that could slow McDonald's growth in the future, management's goal of high-single-digit earnings and dividend growth appears to be achievable.

When combined with the company's valuable real estate portfolio and predictable stream of high-margin rent payments and royalty fees from its franchisees, McDonald's appears to represent a fundamentally lower-risk dividend growth investment.

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