Why McDonald's Dividend Is Safer Than It Looks

By Markets Fool.com

Income investors haven't had much to cheer regarding McDonald's dividend lately. The pace of payout hikes has slowed over the last few years, dropping from a double-digit percentage raise to only 5% now.

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Meanwhile, dividends are taking up a larger portion of earnings, which limits management's flexibility to announce big raises. In 2015, McDonald's dividend soaked up $3.2 billion, or just over 70% of profit. The payout ratio was 50% as recently as 2013.

The fast-food giant's dividend isn't in danger of a cut or a pause, though. In fact, it's well covered by cash flow and by McDonald's financing initiatives. An encouraging rebound in operations also suggests heftier hikes could be on the way.

McDonald's dividend history

McDonald's has paid -- and boosted -- its dividend for 40 consecutive years. That's long enough to put the restaurant operator in an exclusive group of just 50 companies, called Dividend Aristocrats, who boast a streak of at least 25 years of annual raises.

Metric

2015

2014

2013

2012

2011

2010

Dividend Raise

5%

5%

9%

13%

12%

10%

Payout Ratio

72%

68%

56%

54%

48%

49%

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Data source: Company financial filings.

The last five years have brought slowing growth that's tied to McDonald's declining earnings. Net income dropped 20% between 2013 and 2015. The company continued to boost its payout in those years, although at a reduced pace. Put those two trends together, and you get a payout ratio that's surged from the traditional 50% level to over 70% last year.

Why the stock dividend could rise

Operating trends are looking better so far in 2016. McDonald's recently posted a 6% jump in comparable-store sales (verses a 2% drop in the year-ago period) on the strength of an all-day breakfast initiative that's helping boost customer traffic levels in the United States. Its overseas markets, especially China, Russia, and Japan, are also enjoying a solid rebound.

McDonald's refranchising plan, whereby it sells company-operated restaurants to franchisees, is boosting financial results as well. The company now controls just 19% of its global store base and plans to get that number down to just 5% by the end of 2018. While the move puts pressure on sales growth, it also results in steadier, more predictable revenue and cash flow as dining sales are replaced with franchisee fees and rent. Investors can see evidence of this shift in the company's profitability, which has climbed back up toward 30% of sales from 26% last year.

MCD Operating Margin (TTM) data by YCharts.

McDonald's strong cash flow is the best reason to believe its dividend has a long future of raises ahead. Last quarter, the company generated $1.7 billion of cash, which exceeded its business needs by $1.3 billion. Its dividend payment, meanwhile, amounted to less than $800 million. In other words, the business produces ample excess cash that management can direct back toward shareholders.

For the moment, the company favors sending that cash back through the share buyback channel. Last quarter, it spent $3.7 billion on its own stock compared to its less than $1 billion dividend payout.

Image source: McDonald's.

That focus should shift back toward dividends as earnings rise high enough to provide more flexibility to CEO Easterbrook and his executive team. McDonald's payout ratio is already headed back down, falling to 66% -- down from 72% at the start of the year. If that trend continues over the next few quarters, shareholders may see a more substantial dividend boost for 2017 than the low single-digit range they've endured since 2014.

The article Why McDonald's Dividend Is Safer Than It Looks originally appeared on Fool.com.

Demitrios Kalogeropoulos owns shares of McDonald's. The Motley Fool has no position in any of the stocks mentioned. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.