McDonald’s Corporation is one of the most well-known companies in the world, and the largest restaurant chain by revenue.

-Seven Year Revenue Growth Rate: 4.4%
-Seven Year EPS Growth Rate: 14.8%
-Seven Year Dividend Growth Rate: 23%
-Current Dividend Yield: 3.14%
-Balance Sheet: Strong

At the current price of under $100, I view McDonald’s as being rather attractively valued as a dividend growth stock.

Overview

McDonald’s Corporation (NYSE: MCD) was founded by the McDonald brothers, but it was the early partner Ray Kroc that expanded McDonald’s into the company it is today. The brothers wanted a small set of restaurants, and Kroc wanted to expand, which led to Kroc buy the company from the brothers. His vision built the company into the largest restaurant business in terms of revenue, and in many McDonald’s corporate statements, Kroc is called a “founder”.

McDonald’s has been in business since 1940, and has been raising their annual dividend consecutively since the mid 1970′s. The company has restaurants all throughout North and South America, Europe, Australia and Asia, but are only thinly available in the Middle East and Africa. The primary food products they serve are hamburgers, cheeseburgers, chicken meals, french fries, coffee and milkshakes, but they are beginning to offer products like wraps, salads, and smoothies.

McDonald’s serves 69 million customers each day, which is greater than the population of countries such as France, the UK, Italy, South Korea, Canada, and Thailand. As of the end of 2012, the company operates in 119 countries and has 34,480 restaurants, with around 80% being franchised or licensed businesses and the other 20% being company-owned. In 2012, 970 net new restaurants were opened. This included 1,439 openings and 469 closings.

The franchisee owned restaurants have higher profit margins than the corporate owned restaurants (McDonald’s collects rent and royalties), but the corporate owned restaurants allow McDonald’s to develop new products and new looks and keep management teams knowledgeable and well-trained.

In terms of geography, 32% of McDonald’s revenue comes from North America, 39% comes from Europe, and 29% comes from elsewhere.

New CEO
A year ago, Don Thompson took over the CEO reins from Jim Skinner. Thompson originally joined the company in 1990 as an electrical engineer, and rose through the ranks to become a regional vice president and eventually the COO and now the CEO.

McDonald’s maintains a separate chairman of the board from the CEO, which can allow for improved oversight of the board to the management team. McDonald’s managers, from the senior vice presidents, are expected to own at least 2x to 6x as much McDonald’s stock as their base salary; 2x or 3x for the SVPs, 4x or 5x for over executives, and 6x for the CEO.

Ratios

Price to Earnings: 18
Price to Free Cash Flow: 25
Price to Book: 6.5
Return on Equity: 36%

Revenue

(Chart Source: DividendMonk.com)

Revenue grew at an average rate of 4.4% per year over this seven year period.

EPS and Dividends

(Chart Source: DividendMonk.com)

EPS grew by an annualized rate of 14.8%. The dividend growth rate over the same period grew by 23%. These are strong values that should not be expected for the future; the dividend payout ratio increased over the period but must eventually keep in line with EPS growth, and future EPS growth itself will almost certainly be lower than this period.

The dividend yield is currently 3.14%, and the dividend payout ratio from earnings is approximately 55%.

Approximate historical dividend yield at beginning of each year:

How Does McDonald’s Spend its Cash?

For the fiscal years 2010, 2011, and 2012, McDonald’s brought in a cumulative $12.5 billion in free cash. Over the same period, $8.6 billion was spent on share buybacks, $7.9 billion was spent on dividends, and the company had a net acquisition profit. The company has reduced the outstanding share count by approximately 20% over the last decade.

The shareholder yield of the company is typically over 5% per year.

Balance Sheet

McDonald’s has a debt/equity ratio of about 85%, and less than 20% of the existing shareholder equity consists of goodwill.

The debt/income ratio is 2.4x, and the interest coverage ratio is over 16x. Overall, McDonald’s does use a moderate amount of leverage, but the balance sheet is extremely strong and the company maintains above average credit ratings.

Investment Thesis

As global business, there are numerous variables that drive McDonald’s profitable growth.

Franchisee Expertise and Prime Locations

We are in the real estate business, not the hamburger business.
-Ray Kroc

As a general rule, the typical McDonald’s location brings in substantially more customers and revenue than other fast food branded locations. This is partly because ever since the involvement of Ray Kroc, real estate has been a major focus of the company. While Pizza Hut or Wendy’s locations may often be in less ideal locations, McDonald’s generally benefits by being a first-mover in an area, or goes to the extra expense of securing the best location. Although not all of their locations meet this target, their ideal spot that they aim for is a corner location on the intersection of two major streets with traffic signals, and the company often owns the land and the building or has a very long term lease.

In addition, franchise owners of McDonald’s locations are particularly well trained. First, a potential franchisee must generally have $750,000+ in non-borrowed assets exclusive of their home to pay for a down payment. Larger business entities can operate multiple locations. Secondly, owners and managers attend Hamburger University. This is McDonald’s 130,000 square foot facility with 19 full-time instructors. Over 5,000 students attend each year, and since 1961 80,000 students have graduated.

The result of this is that McDonald’s does very well on a per-restaurant basis, and the turnover rate is very low. Well under 1.5% of McDonald’s locations close each year. Under-performing restaurant locations can harm the brand, so McDonald’s takes each location seriously and only moves forward if there is a strong calculated chance for long-term success.

Focus
MCD has been selling various investments in order to focus on the McDonald’s brand. They performed an initial public offering of Chipolte Mexican Grill in 2006, sold Boston Market in 2007, and sold Pret A Manger in 2008. The focus has been placed on the McDonald’s brand, which is revitalizing its image and introducing new products. The company has been remodeling their restaurants worldwide to include softer colors and more wood to replace the red and yellow plastic look, and has since remodeled 60% of interiors and expects to have remodeled 50% of exteriors by 2015 according to the 2012 annual report. Many of the remodeled locations had drive-through systems added in order to expand the customer base.

McDonald’s McCafe brand now has over 1,600 locations. McCafe can be combined with McDonald’s locations, but also can be put in new areas to enter new markets and reach new people.

McDonald’s spent three quarters of a billion dollars for advertising in 2012. The company’s size and focus allows it to outspend its rivals; smaller rivals don’t have the budget to advertise to nearly the scale of McDonald’s, and large rival Yum Brands must split their significant advertising budget into KFC, Taco Bell, and Pizza Hut.

Comparable Growth
The key metrics to watch with McDonald’s are guest count and comparable sales for their existing locations. It’s not that difficult for McDonald’s to continue to open new restaurants around the world, but it’s challenging to do that while also growing or maintaining the guest count and sales of their existing locations, on average. In 2012, average guest count was up 1.6% and comparable sales were up 3.1% according to the latest annual report. The 2012 figures for the United States are slightly stronger, and in fact the company has increased comparable sales in the country for ten consecutive years.

Profit Margins
The profit margins of McDonald’s are above competitors, which is evidence of a strong competitive advantage. MCD’s net profit margin is over 20%, which is almost double that of competitors such as Starbucks and Yum! Brands, and considerably higher than businesses like Dunkin Donuts or Wendy’s. Some of this has to do with their heavy focus on franchises; franchises produce better profit margins than company-owned restaurants. But some of this also has to do with superior performance per location; their sales figures per location are considerably above their peers, and their profit margins are quite high even on their company-operated restaurants. Most of the growth of the company is due to organic growth, which results in little goodwill piling up on the balance sheet, and means the free cash flow can be given back to shareholders.

Risks

McDonald’s faces the usual currency, litigation, and geographic catastrophe risks associated with all global businesses. Commodity cost changes have a meaningful impact on profitability as well.

The company has a rather defensive business, as evidenced by their strong performance through the recession and tough global economic times, but they still must continually stay relevant among consumers. The company is in the midst of a considerable modernization program for their restaurants, which shows their ability to identify and change along with trends.

Politics could present a risk, as much of the company’s food materials supplied by farmers are directly or indirectly federally subsidized. The company does have considerable pricing power over its suppliers, though. In addition, food items targeted for potentially contributing to national health problems could face taxes, bans, or simply changing consumer interest, and with McDonald’s visibility, they tend to face a considerable portion of criticism.

Conclusion and Valuation

McDonald’s continues to maintain a fierce position in a competitive industry. Their size and unrivaled advertising budget, along with popular new menu items, drove solid comparable results for the existing restaurants. Their properties are of high value, and their management teams are among the most highly trained, and their balance sheet is rather strong.

The company aims for 3-5% long-term system-wide annual sales growth and 6-7% annual operating income growth. An expected 1,500 new locations are expected to be opened by the end of 2013 compared to the end of 2012. If the company can continue to hold solid sales growth on existing locations, continues to open over a thousand new locations each year, and continues to use the profit to pay dividends and buy back shares, then McDonald’s should be able to deliver shareholders robust, diverse, and defensive returns.

McDonald’s dividend growth rate has been very high in the past, and the company has decades of consecutive annual increases without a miss. I believe that a fairly conservative estimate for the long-term dividend growth rate is at least 7%, based on a stable payout ratio from EPS. Their EPS can fairly easily grow by 7+% per year driven by 4% annual sales growth, 3% of the market cap in buybacks per year, and static profit margins.

Based on the Gordon Growth Model using a 10% discount rate, if McDonald’s long-term dividend growth rate is 7% per year, then the fair stock price is $107.

Therefore, I believe that the stock price at just over $98 is reasonably appealing at the current time.

Full Disclosure: As of this writing, I am long MCD.
You can see my dividend portfolio here.

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The Coca Cola Company is the largest beverage business in the world, serving 200 countries with thousands of different products.

-Seven Year Revenue Growth Rate: 11%
-Seven Year EPS Growth Rate: 9.8%
-Seven Year Dividend Growth Rate: 8.9%
-Current Dividend Yield: 2.70%
-Balance Sheet: Leveraged but Strong

Overall, I view Coca Cola as a reasonable dividend growth stock to buy in the low $40′s. While Coke stock is never cheap, the risk-adjusted growth from worldwide operations, five decades of annual dividend increases, and product diversification should make for a rather defensive investment for the next decade.

Overview

The Coca Cola Company (NYSE: KO), with one of the strongest brands in the world, is the largest non-alcoholic beverage company around. Established in 1886, Coca Cola has been growing sales for over a century now and has a presence in over 200 countries with more than 500 total brands, ranging from carbonated beverages to juices to teas to water. The company is a dividend aristocrat, and it has increased dividends every year for over five consecutive decades. Ironically, while the company has grown considerably in the past 15 years, it has been a fairly bad investment because it was valued so highly back in the 90s. Over the last several years, with a more reasonable valuation, shareholders have enjoyed solid capital and dividend growth.

Geographic Diversification:
-Latin America accounts for 29% of Coca Cola Company’s product volume.
-North America accounts for 21%.
-The Pacific region accounts for 18%.
-Eurasia and Africa together account for another 18%.
-Europe is last at 14%.

Ratios

Price to Earnings: 21.7
Price to Free Cash Flow: 24.1
Price to Book: 5.7
Return on Equity: 27%

Revenue

(Chart Source: DividendMonk.com)
Revenue grew at a brisk 11% per year pace over this period, but a significant chunk of the total growth was due to the acquisition of their North American bottling operations.

EPS and Dividends

(Chart Source: DividendMonk.com)

EPS grew at 9.8% per year on average over this period while the dividend grew at 8.9% over the same period. The dividend payout ratio from earnings is currently approximately 55% while the dividend yield is a moderate 2.70%.

Approximate historical dividend yield at beginning of each year:

Coca Cola’s dividend yield is in line with its recent historical average. A larger yield could have been obtained during the 2008-2009 period, which is true for most stocks.

How Does Coca Cola Spend its Cash?

Over the 2010-2012 period, Coca Cola brought in $21.7 billion in free cash flow. During the same period, $13 billion was spent on dividends and $12 billion was spent on share buybacks (along with $4.7 billion in stock issued, for a net buyback amount of about $7.3 billion). The company also had a $1 billion positive net on acquisitions; sales were larger than purchases for these cumulative three years.

Balance Sheet

Coca Cola has a total debt/equity ratio of about 110%, and nearly 40% of the existing shareholder equity consists of goodwill. The total debt/income ratio is about 4x.

The high interest coverage ratio of over 25x paints a very sturdy picture of Coca Cola’s debt management. Overall, Coca Cola does make substantial use of leverage, but their overall financial shape remains very strong.

Investment Thesis

Coca Cola potentially has a place in a portfolio as a defensive core dividend-growth holding.

2020 Vision
Coca Cola currently has what they call the “2020 Vision”. It’s a specific long-term plan for growth over the 2010-2020 decade. This is substantial because it shows that the company is looking ahead and setting tangible long-term expectations and benchmarks for their company, and also assists investors in estimating a stock valuation for the company. Most shareholder-friendly companies of course have objectives like “create shareholder value over the long run”, but this is a rather specific set of goals for a ten-year period.

The most concrete and useful goal is the volume growth. The 2020 Vision states that Coca Cola will increase it’s global servings per day to 3 billion (compared to 1.8 billion currently). That would represent rather aggressive volume growth.

Volume Growth
Over the past three years, Coca Cola has done a solid job at increasing volume of their products. They sold 25.5 billion cases (representing 192 ounces of finished beverage each) in 2010, 26.7 billion in 2011, and 27.7 billion in 2012. This represents 4.2% volume growth, which if extrapolated would lead to about about 38 billion cases per year or 2.5 billion servings per day in 2020. The company will therefore have to accelerate volume growth a bit to meet their 3 billion servings per day goal, but even a 3-4% volume growth rate is nonetheless very solid business growth.

Approximately half of their volume of products solid consists of the Coca Cola trademark brands, while the other half consists of the rest of their brands combined. Their total sparkling brand lineup grew in volume by 3% in 2012 while their total still brand lineup grew by 10%. So the company is slowly aligning itself a bit away from carbonated beverages, although carbonated beverages are still the bulk of the business.

Per Capita Consumption
Currently the annual per-capita worldwide consumption of all Coca Cola products (which includes all of their various brands), is 94 eight-ounce servings. This is up from 92 last year, 69 in 2001, and 44 in 1991.

-The United States, with 316 million people, consumes 401 per capita servings each year, which is down from 403 last year and 407 in 2001. This is more than one eight-ounce serving per day, per person, on average, and could come from a Coke product, another Coca-Cola owned soda brand, one of their juices or teas, or bottled water, etc.

-Several Latin American countries lead in per capita consumption. The highest is Mexico at 745 per capita servings, followed by Chile at 486 per capita servings.

-Europe is much more heavily populated than North America but on average has less Coca Cola product consumption. Belgium is highest at 333, Spain is next at 283. For the three strongest economies, Great Britain consumes 200, Germany consumes 191, and France is lower at 141.

-In Eurasia and Africa, the annual per capita consumption is much lower in the mid 30′s, although up from 17 in 2001. This includes India (population: 1.2+ billion) with only 14 per capita annual servings, Pakistan (population 187 million) with only 21 servings, Nigeria (population 158 million) with only 26 servings, Russia (population 143 million) with 79 servings, and others.

-In the Pacific group, 50+ servings are consumed annually, per capita. This is up from 33 in 2001. This includes only 39 servings in China (population over 1.3 billion), and only 15 servings in Indonesia (population 240 million). Some of the more economically developed east Asian countries consume more.

In other words, while Coca Cola is extremely global, they are not nearly as penetrated into several high population markets as they are in North America, Latin America, and Europe. Several of the most populous countries in the world, including China, India, Indonesia, Pakistan, and Nigeria, consume less than a tenth or twentieth of what Americans consume. Coca Cola only needs to achieve moderate per-capita volume growth in these population-dense countries in order to increase global volume by a fairly robust amount.

In terms of Coca Cola attempting to achieve 3 billion servings per day in 2020, and the previously mentioned need for mild volume acceleration compared to what they’re currently doing, it looks like this is where it’ll have to come from. The company seems to be predicting that it’ll hit certain critical points that allow some pretty solid overall volume growth from these populated regions. Still, coming short of the 3 billion goal with 3-4% annual volume growth and 1-2% annual inflation pricing growth, that translates into 4-6% revenue growth per year.

Risks

Coca Cola strong competition from Pepsico, and there isn’t really a move that one company can make that the other can’t copy. Both of them acquired their North American bottlers in the last few years, for example. Coca Cola will have to continually invest in its global bottling and distribution system if it hopes to continue to hold and take market share from their principle competitor.

Unhealthy beverages face headwinds in developed markets, as evidenced by stagnant per capita consumption. A majority of the company’s products primarily consist of sugar water, which adds calories of a rather unhealthy variety to a typical daily diet, and likely contributes to “diseases of affluence”. Even some of the juices and other drinks are certainly not what one would call healthy, though the company does have some healthier options in their overall product lineup. Political forces or consumer trends could adversely affect the volume growth of the business, but the company does have significant geographic diversification to buffer their bottom line from any specific market problems. In addition, the company can make key acquisitions or offer new options within its existing brands to continually match consumer preference.

Conclusion and Valuation

All of the ingredients of a successful company continue to exist in Coca Cola. Their wide moat is based on their strong brand and unmatched distribution footprint, and then further widened by their bottling partnership network. Their dividend has grown every year for more than 50 years. Lastly, their long-term vision includes continuing volume growth mixed with maintenance of the profit margin, share buybacks, and dividend growth.

If Coca Cola can grow volume by 4% per year on average over the next decade (which is lower than what they’re currently growing by on an annual basis) and can achieve 2% pricing growth per year, then that’s 6% annual revenue growth. Assuming margins are stable and net stock buybacks are 2% of the market cap each year, that translates into 8% annual EPS growth. A stable dividend payout ratio then leads to the assumption of 8% long-term dividend growth per year.

Using a two-stage Dividend Discount Model, if Coca Cola grows the dividend by 8% per year over the next decade followed by 7% thereafter, and a 10% discount rate is used, the calculated fair stock price is between $40 and $41.

Buying at the current price or waiting for a small dip therefore appears to be a reasonable move to achieve at least a high single digit rate of return of 9-10% per year.

Full Disclosure: As of this writing, I am long KO.
You can see my dividend portfolio here.

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Wal-Mart Stores Inc. (NYSE: WMT) is one of the largest retailers in the world.

-Seven Year Revenue Growth Rate: 5.8%
-Seven Year EPS Growth Rate: 9.4%
-Seven Year Dividend Growth Rate: 14.9%
-Current Dividend Yield: 2.43%
-Balance Sheet: Reasonable Leverage, Stable

Currently, Walmart’s $77 share price appears to be fairly valued for an expectation of 10% long-term returns.

Overview

Founded in Arkansas in 1962 by Sam Walton, Walmart is now one of the largest companies in the world, with revenue of over $460 billion and with 2.2 million employees. They have stores under a variety of brands in 25+ countries around the world. In addition to being a massive retailer, it’s the largest seller of groceries in the United States. Walmart also owns Sam’s Club, which is a membership warehouse much like Costco that offers bulk products for a reduced cost to people that pay for a membership.

For fiscal year 2014, $12-13 billion is expected to be invested by the company. This includes up to $6 billion in the U.S. segment, up to $5 billion in the international segment, and up to $2 billion in the Sam’s Club segment and other areas.

Walmart U.S.
Walmart U.S. contributes over $274 billion in sales, and in this last year has surpassed 4,000 locations and 641 million square feet of retail space. More than 135 million customers are served weekly by Walmart in the U.S. The number of locations has increased by an average rate of a bit under 2% per year over the last four years, from 3,703 in the year 2009 to 4,005 as of the most recent quarter.

Walmart International
Walmart International contributes over $135 billion in sales with over 6,000 locations and 348 million square feet of retail space. International locations are generally significantly smaller than the superstore format in the United States. Weekly customer numbers surpass 105 million. The number of locations has increased by over 14% per year over the last four years, from 3,595 in 2009 to 6,148 as of the most recent quarter.

Sam’s Club
Sam’s Club contributes over $56 billion in sales with 620 locations and 83 million square feet of retail space. Annual growth in the number of location has been less than half of one percent per year, from 611 in 2009 to 620 currently.

Ratios

Price to Earnings: 15
Price to Free Cash Flow: 20
Price to Book: 3.3
Return on Equity: 23%

Revenue

(Chart Source: DividendMonk.com)

Over the last seven years, the average annual revenue growth rate has been a respectable 5.8%.

EPS and Dividends

(Chart Source: DividendMonk.com)

EPS grew by an average of 9.4% per year over the last seven years, and the dividend grew by 14.9% per year over the same period.

The dividend yield is now 2.43% and the dividend payout ratio from earnings is a bit over 30%.

Approximate historical dividend yield at beginning of each year:

How Does Walmart Spend its Cash?

Walmart generated over $34 billion in free cash flow cumulatively in the fiscal years 2011, 2012, and 2013. Over this same period, a bit under $15 billion was spent on dividends, and over $28 billion was spent on share buybacks. About $4 billion was spent on acquisitions.

The shareholder yield of Walmart tends to be over 5% in these recent years.

Balance Sheet

The total debt/equity ratio is a bit under 70%, and the total debt/income ratio is approximately 3x. Goodwill makes up over $20 billion out of the $76 billion existing shareholder equity.

The interest coverage ratio is over 12x.

Overall, Walmart has historically used a decent amount of leverage to improve returns without much risk, and the current balance sheet continues to reflect this trend.

Investment Thesis

Walmart has essentially been a machine of consistent shareholder returns since its founding. Through a predictable use of capital for expansions, share buybacks, and growing dividends, Walmart has achieved atypically consistent EPS growth and overall shareholder returns. The larger portion of the expected returns are internal: from using capital to buy back shares and pay dividends, and the smaller portion is from actual growth: inflation, new stores, and comparable increases in existing stores.

During periods where Walmart has had lackluster stock performance, it has been because the stock valuation got ahead of itself. Walmart stock was a poor performer in the previous decade because the company was irrationally overvalued at the turn of the millennium, but the stock began offering better returns in recent years as the increasing EPS finally caught up with the stock price and hit the point of being rather fairly valued.

As far as I see it, the competitive landscape for Walmart is reasonable for the foreseeable future. Being a mid-level retailer rather than a high-end or bargain retailer is likely to be quite a challenge in the U.S. with rising healthcare and tuition costs hurting the middle class, and Walmart’s position as a bargain retailer keeps it out of that dangerous middle territory.

The company has some defense from online retailers and niche retailers due to its product diversification. Groceries account for more than half of Walmart sales, and this is not a segment that can be replicated by a purer play online retailer; even if ordered online, grocery sales require a substantial physical distribution system. Many Walmart locations include a pharmacy as well. The company’s other areas such as electronics, home care needs, and clothes are a bit more up in the air as far as future prediction is concerned, but they tend to be competitively priced.

Risks

Walmart, like any other company, has risks. When all is said and done, Walmart is really just a middle-man, buying products of others and selling them to customers. They are vulnerable to changes in consumer demand.

Walmart’s international business operations have not enjoyed the same consistency and success as the early expansion in the US. Growth is robust, and should continue to post good numbers, but the company hasn’t been able to generate the domestic efficiency on a worldwide basis. And on the domestic side, over the last few years, comparable same-store sales have gone down and up.

Online competitors threaten some of the product segments, at least to a certain extent. Amazon, for example, grew sales by whopping 25+% last year, and isn’t on any course to slow down. Quite often, if there are one or two things you need, it’s typically convenient to just buy them on Amazon and receive them a few days later at your home rather than to make a trip out to a store.

Continued growth for the company will have to come from successful international expansion and defensive positioning in the US, such as through strengthening of the online business and keeping physical locations as relevant as possible.

Conclusion and Valuation

Walmart’s value seems to have caught up with its share price. When I published a report on Walmart last year, the stock price was at around $73, and I stated that the stock appears to have gotten ahead of itself, wasn’t at very good price, and that it would be better to look for dips into the mid-$60′s. Since then, the stock did dip down into the mid-to-high $60′s, and has now climbed to a bit over $77. Since that report, the S&P 500 has climbed over 20% whereas Walmart stock has only increased by a bit over 5%.

With a year of EPS growth without much stock price growth, Walmart once again appears to be fairly priced.

According the Dividend Discount Model, the current price of over $77 is justified for a 10% expected long-term annual rate of return if dividend growth exceeds 7.5% for the foreseeable future. This is lower than the historical EPS and dividend growth, so there is a comfortable margin for Walmart to hit these numbers.

The yield is a bit on the low side, but quantitatively the price appears to be fair. The question then shifts towards the qualitative: if you believe Walmart will continue to be a competitive retailer with a decent economic moat, then an investment in Walmart at the current time appears reasonable.

Full Disclosure: As of this writing, I have no position in WMT.
You can see my dividend portfolio here.

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