McDonald’s Is A Fantastic Dividend Stock At A Premium Valuation (NYSE:MCD)

Investment Thesis

McDonald’s (NYSE:MCD) is a solid, sustainable business. The company has proven its resilience in a variety of economic conditions. In the future, I see digital channels as a major growth driver. The extra data and engagement can boost the company’s margins and top line.

However, shares are trading at an expensive valuation. The stock is likely to lag in appreciation. I believe shares are a reasonable deal for investors searching for consistent income and low volatility. I recommend growth and value investors wait for a pullback.

Growth is resistant to inflation and recessions

The two primary economic concerns of this year have been high inflation and the risk of a recession. I believe McDonald’s is well-positioned to grow and thrive in both of these conditions.

The business has proven itself resilient in the recent inflationary environment. In the US, last quarter’s comparable sales increased by 3.7% year over year. Abroad, the company grew comparable sales by double digits in both of its international reporting segments.

McDonald’s profitability remains strong. Operating profit margins stayed solid. The business reported TTM EBIT margins of just under 38%. These results are only slightly below the company’s recent average of 40%.

Management clarified that recent US top line growth is from price increases. Recent revenue growth is the result of pricing power rather than increased traffic. While the company doesn’t have a lot of pricing power, the chain has shown the ability to at least offset inflation.

Restaurants often see revenue decline during a recession. But I don’t think this is the case for McDonald’s. The chain is known for its value. Stores have menus full of lower priced items. The company has discussed a “trade down” in US markets across the first half of the year. This means that some customers are buying more from McDonald’s value menu. At the same time, they’re passing on higher priced combo offerings. This dynamic has a negative impact on McDonald’s top line. But it also generates solid revenue that offsets declines in higher priced products.

Besides, McDonald’s may be able to price its products competitively against food prepared at home. During their last earnings call, management discussed these trends.

We track as many of you do as well, food at home versus food away from home. And right now, we’re seeing a significant gap. In fact, we think, by our measure, it’s the largest gap we’ve ever seen and — well, is seen in 50 years between food at home and food away from home, meaning that food at home has increased pricing significantly faster than what food away from home, McDonald’s and others in our industry have done.

McDonald’s has proven its ability to withstand economic pullbacks. The company reported strong results throughout the 2008 recession. I think the company has limited downside to its revenue and earnings. The business’s value, brand, and pricing power are all solid competitive advantages. They each help make McDonald’s revenue and profit more sustainable.

Data is a growth and profitability driver

Traditional expansion methods are becoming less sustainable for McDonald’s. The company has already placed over 40,000 stores in 119 countries. As the business grows, the added impact of each new store decreases relative to the total company’s value. Simply opening new stores is becoming a less reliable growth strategy.

Now, the company needs to find a way to improve revenue and profit from existing customers. This is why I like the company’s digital sales efforts. I know that it seems like every company has an app nowadays. But McDonald’s has done a good job of getting customers to use their app on a regular basis. The company has the most downloaded QSR app in the United States by a wide margin. The pace of new downloads seems to be accelerating in recent months.

During the last quarter, digital sales in the top six markets made up about a third of total sales. About 22 million US loyalty members were active in the last quarter. This makes up almost 7% of the entire country’s population!

These apps allow a huge amount of insight into individual purchasing behaviors. The company can target customers with personalized offers. The massive amounts of data these apps generate can also inform the company’s strategy on a local level. This is significant for the company’s advertising and marketing efficiency.

In the past, offers had to be given to all customers. The deals then had to be advertised through expensive regional or national channels. Now, the company can target customers with individualized offers. Their apps are a direct, low cost advertising channel. Over time, I think this can be a significant driver of both top line growth and increased margins.

The valuation is still quite expensive

McDonald’s valuation is quite expensive for a company in the later stages of its growth. The company is trading at a forward P/E of 26 and a TTM P/system sales of about 1.7 times. I think this is high for a company that is projected to grow its top line at a mid single digit rate.

Here is where I see the primary risk in McDonald’s shares. It makes sense that a high moat business like McDonald’s would trade at a premium valuation. But the company needs to grow its bottom line at a fast rate to keep its multiples. Even if the business can do that, I believe that shares have limited intrinsic upside.

Final Verdict

McDonald’s is a strong, high moat business with limited downside to its fundamentals. I think that the company has the ability to expand its margins with targeted data.

But shares are trading at an expensive valuation compared to McDonald’s growth prospects. I think income investors should watch this company. Shares have low volatility, limited downside, and a stable, growing dividend. For more traditional value investors, I’d wait for a pullback before I’d buy or hold shares.