McDonald's: This dividend aristocrat is in trouble

Adam Levine-Weinberg | The Motley Fool

So-called "dividend aristocrats" hold a special place in the hearts (and portfolios) of income investors. These companies represent an elite group -- comprising about 10% of the S&P 500 -- that have increased their dividends every year for at least 25 years.

McDonald's Corporation (MCD) is one of the most prominent dividend aristocrats. The company also has one of the highest dividend yields of the group: about 3.6% based on the recent stock price. However, this high dividend yield, combined with weak operating results, may endanger its long-term membership in the club.

Earnings under pressure

McDonald's performed very well during the Great Recession, as consumers traded down to cheaper options for dining out. This allowed the company to maintain a streak of solid earnings growth despite the weak global economy.

McDonald's sales growth and earnings momentum began to slow during 2012, and the weakness continued in 2013. One cause of these financial woes was its U.S. menu, which had become overly complicated, slowing service times and driving some customers away.

Things came to a head in 2014. Operating margin declined significantly last year as beef prices have skyrocketed, and U.S. consumers have increasingly turned toward healthier options. To make matters worse, a variety of food quality scandals in Asia led to a sharp drop in sales and profitability in a region that was previously McDonald's main source of growth.

The net result was that EPS declined 13% to $4.82 in 2014. McDonald's attributed some of the decline to special items, but any way you slice it, EPS was down year-over-year. Tough market conditions are expected to continue at least through the first half of 2015.

Dividend growth in trouble

McDonald's has raised its dividend every year since 1977. However, its recent struggles could put this streak in danger.

The payout ratio is one key measure of dividend health. The payout ratio is simply the percentage of EPS paid out to shareholders. Up until 2012, McDonald's payout ratio was around (or below) 50%, but it has risen to more than 60% in the past few years.

If EPS stagnates or continues to decline, and McDonald's keeps raising its dividend, the payout ratio will only move higher.

This metric may actually overstate the sustainability of McDonald's dividend. The company needs cash to make payouts, not accounting earnings. And recently, cash flow has lagged behind EPS. Last year, McDonald's generated about $4 billion of free cash flow and spent $3.2 billion (80% of the total) on dividends.

The company is bringing in extra cash by selling off some restaurants to franchisees: nearly $500 million worth in 2014. On the flip side, it also spent $3.2 billion on share buybacks last year. This means the company generated $4.5 billion, including refranchising proceeds, but returned $6.4 billion to shareholders.

As a result, McDonald's drew down its cash balance last year, while also adding nearly $1 billion of debt. Clearly, this is not sustainable for the long-term. Nevertheless, McDonald's has stated that it plans to return $18 billion to $20 billion to shareholders between 2014 and 2016, implying a similar amount of spending on dividends and buybacks for the next 2 years.

Hanging by a thread

For now, McDonald's is still generating enough cash to cover its dividend. To preserve cash while keeping the streak alive, the company may resort to smaller dividend increases for the next few years. Fellow dividend aristocrat, Walmart, encountering similar earnings headwinds, recently raised its dividend by a measly 2%.

However, if McDonald's hits any more bumps that impact profitability, it may have to step back from its lofty capital return plan. The company would undoubtedly stop buying back shares before sacrificing its dividend. That said, given its relatively high payout ratio -- especially on a cash basis -- and its soft earnings trajectory, McDonald's may lose its aristocratic title.

Income investors counting on annual dividend increases would be wise to remember that past performance is no guarantee of future results.

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