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McDonald's -- a dangerous policy of returning too much cash to shareholders [ClearOnMoney]
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McDonald's -- a dangerous policy of returning too much cash to shareholders

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Investment

McDonald's -- a dangerous policy of returning too much cash to shareholders

9 Jun 2012 by Jim Fickett.

I recently posted a graph showing the 34-year history of dividends paid by McDonald's, adjusted for inflation (McDonald's dividend history). Here are the rather amazing results again, for easy reference:

This graph made me a little suspicious. Has the growth of the company really been good enough to raise the dividend by almost a factor of 10 in the last decade?

Well, growth has been pretty impressive. Here is net income and free cash flow, again adjusted for inflation, over the last 21 years:

Not too shabby. Still, it turns out that recent payouts are indeed excessive. When one combines the two main ways of returning cash to shareholders – dividends and buybacks – and compares this with the sum of the two main sources of cash – free cash flow and borrowing – it turns out that the total cash returned to shareholders has greatly exceeded those sources of cash over the last five years. In billions of nominal dollars:

Year Free cash flow + net borrowing Dividends + buybacks
2007 2.9 + 0.9 = 3.8 5.7 = 1.8 + 3.9
2008 3.8 + 0.9 = 4.7 5.8 = 1.8 + 4.0
2009 3.8 + 0.4 = 4.2 5.1 = 2.2 + 2.9
2010 4.2 + 0.9 = 5.1 5.0 = 2.4 + 2.6
2011 4.4 + 1.0 = 5.1 6.0 = 2.6 + 3.4

And because debt has been increasing greatly, book value per share (again adjusted for inflation), has been stagnant in recent years (though it grew strongly for many years previous):

At least the excessive payouts are mainly going to shareholders, not overpaid employees:

During 2011, 2010 and 2009, the total intrinsic value of stock options exercised was $416.5 million, $500.8 million and $302.5 million, respectively. …

The total combined liabilities for international retirement plans were $125.4 million and $153.2 million at December 31, 2011 and 2010, respectively, primarily in the U.K. and Canada. Other postretirement benefits and post-employment benefits were immaterial.

(All data and the above quotes are from the annual reports on the company website.)

Of course, with borrowing costs low, many companies are currently replacing equity with debt. And this makes perfect sense, at least if the share buybacks are done at a reasonable price. But when the buybacks are done at all-time record high prices, one has to wonder whether management is motivated by looking for the most economical source of capital or whether, in contrast, they are merely propping up the share price to make their options more valuable. At the very least one has to recognize that share options give managers mixed motives when it comes to buybacks.

So what's the bottom line? I think the stock may well be fairly valued. Growth over the long term has been impressive, and perhaps such growth will continue. On the other hand, much of the world's middle-class prosperity in the last few decades has been driven by cheap energy and strong credit growth; both contibutions may very well reverse. In addition, there is very strong protectionist sentiment in many of the markets big multinationals hope to expand in, including all of the BRICs.

Dividend Monk is one of the many authors lately touting McDonald's stock. In order to arrive at the conclusion that the stock is fairly valued, he assumes that growth will remain very strong forever:

McDonald’s Looks Fair Under $90

with dividend growth estimations starting at 12% per year and decreasing to 8% per year over time (compared to the most recent annual dividend increase which was 15%), I estimate that the stock is pretty fairly valued at its current price in the high $80′s. Anything under $90 currently looks quite fair to me as a long term investment for capital appreciation and growth of dividend income.

I do think at least the current dividend is fairly safe, but growth forever, and capital appreciation? I'm not convinced.

The current price to free cash flow ratio is 20. Benjamin Graham said 20 was the highest P/E he would consider, and that was only if he was very sure high growth would continue.

Maybe a purchase would work out well; it is entirely possible. But I don't see the margin of safety in this one.