Image Shown: Shares of McDonald’s Corporation have pulled back over the past couple of months after an epic run during most of 2019, which we view as the market recognizing shares of MCD had gotten way ahead of themselves.
By Callum Turcan
McDonald’s (MCD) is testing out a new crispy chicken sandwich offering in two US cities; Knoxville, Tennessee and Houston, Texas. This pilot project is expected to run through January 2020. While McDonald’s offers the ‘McChicken, its new chicken sandwich offering is far more substantial (the McChicken is to a chicken sandwich what the ‘McDouble’ is to a burger) and meant to compete with offerings from privately-held Chick-fil-A and Restaurant Brands International Inc’s (QSR) Popeyes Louisiana Kitchen. We still view shares of McDonald’s as overvalued as the top end of our fair value range estimate sits at $189 per share, and MCD trades at ~$195 per share as of this writing. Shares of McDonald’s yield 2.6% as of this writing, and while the company’s free cash flow profile is impressive, its large net debt load (~$31.7 billion as of the end of September 2019) weighs negatively on the strength of its dividend coverage.
Chicken in Vouge
The goal is to bulk up McDonald’s presence in southern US markets where serious chicken sandwich offerings are quite popular. While McDonald’s has rolled out various chicken sandwich offerings in the past and currently has such offerings as the ‘Artisan Grilled Chicken Sandwich’, the buttermilk crispy chicken sandwich (or something similar) seem to be what consumers want. Chicken nuggets remain a cornerstone of McDonald’s low-cost offerings, but the US consumer apparently wants a bit more than that.
We are intrigued by McDonald’s new approach. During the third quarter of 2019, Popeyes Louisiana Kitchen posted 9.7% same-store sales growth on a year-over-year basis, up sharply from the paltry 0.5% year-over-year growth rate recorded during the third quarter of 2018. A combination of new store openings and same-store sales growth saw system-wide sales at Popeyes Louisiana Kitchen grow by 15.6% year-over-year during the third quarter of 2019. Strong organic sales growth at Popeyes Louisiana Kitchen is attributed to the brand launching a very popular crispy chicken sandwich offering this past summer (a product that sold out very quickly and was subsequently relaunched, much to the chagrin of Chick-fil-A and other competitors).
McDonald’s franchisees want in on the action and are afraid that they will lose out if McDonald’s doesn’t do something soon, and it appears management is heeding the call. We will caution here that by adding new offerings to its menu, McDonald’s is increasing the complexity of its restaurant operations. However, as the company was able to successfully implement and roll out its all-day breakfast menu in the US and considering McDonald’s already serves chicken-based offerings, any new chicken sandwich item should be a relatively easy addition from an operational standpoint.
What We Think
In the excerpt down below, from our two-page Dividend Report (which can be accessed here), we cover what we view as the key strengths of McDonald’s dividend coverage:
“McDonald’s has been executing well as of late. The company’s decision to make breakfast an all-day proposition reinvigorated comparable store sales growth, and its efforts to refranchise company-owned restaurants and pursue net annual G&A spending reductions are working wonders on its operating profit line. No other restaurant chain can stand toe-to-toe with its iconic brand, geographic reach, and scale advantages, and it has raised its dividend every year since first paying one in 1976, but it is not immune to industry-wide traffic and competitive pricing issues. The company expects to return $22-24 billion to shareholders for the three-year period ending 2019, down from $30 billion in the preceding three-year period.”
On the other hand, here’s what we view as the potential weaknesses to McDonald’s dividend coverage (also from our two-page Dividend Report):
“McDonald’s is simply a fantastic restaurant concept. The company is executing its turnaround plan flawlessly, but part of that plan means it will issue additional debt, which may stress the pace of dividend expansion years from now as the benefits of near-term initiatives wear off. Its goal to become 95% franchised over the long run, however, should shield it from most operating problems, but franchisees are a fickle bunch, and management will have to stay on its toes strategically. All is well now, but we can’t forget that consumer trends can change fast, and the restaurant now has a much larger net debt load, which is why its Dividend Cushion ratio is under pressure. Dividend growth will proceed, even if it slows, however.”
Additionally, we caution that future dividend growth will need to contend with share buybacks, refinancing activities, and possibly future debt reduction efforts. McDonald’s has been steadily buying back its shares of late, reducing its weighted-average shares outstanding on a diluted basis from 788.5 million during the first three quarters of 2018 to 768.1 during the first three quarters of 2019. On the other hand, McDonald’s net debt load increased by ~$1.5 billion from the end of 2018 to the end of September 2019.
Concluding Thoughts
It’s unlikely that this new offering will provide the kind of growth catalyst required to justify McDonald’s lofty valuation as it stands today, but we are keeping this recent pilot project in mind as it could have significant ramifications for the entire fast food/causal dinning industry going forward. McDonald’s grew its company-wide same-store sales by 5.9% during the third quarter of 2019, with its US operations recording 4.8% same-store sales growth over this period. To achieve growth rates north of that level, McDonald’s is going to need to replicate the success Popeyes Louisiana Kitchen has had but at greater scale given McDonald’s larger store count footprint in the US. That’s no easy task.
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Callum Turcan does not own shares in any of the securities mentioned above. Some of the companies written about in this article may be included in Valuentum’s simulated newsletter portfolios. Contact Valuentum for more information about its editorial policies.