AMM Dividend Letter Vol 8 ~ Super Size My Income

This is from the AMM Dividend Letter released May 31, 2014. If you want to see the latest “Dividend Stock in Focus” as soon as it’s released then join our mailing list here.

Every year living expenses rise. Whether you’re retired now or planning to retire in 20 years you need income that can grow faster than inflation. This is one of the main goals of our Dividend Strategy: to build a meaningful future income stream via the investment in high quality dividend paying stocks.

We’re not interested in the highest yielding dividend stocks today. The weighted average yield for the dividend portfolio is currently a modest 2.5%. Our goal is to generate more money in the future by investing in a portfolio of companies that can grow their dividend, your income, faster than the rate of inflation.

Keep in mind that dividend growth is separate and apart from the growth in the portfolio value; which we would expect to be much more volatile over time due to the ups and downs of the stock market. While we expect our clients’ portfolio values to trend higher over the long run, focusing on dividend growth provides a more stable estimate of what matters most in retirement: Portfolio Income.

Dividend Growth in Action

A $100,000 account fully invested today in our dividend strategy with a current portfolio yield of 2.5% would produce approximately $2,500 in yearly income. If we grow the income stream at 12% per year then the portfolio income would double in 6 years, triple in 10 years, and quadruple in 12 years. In 12 years the original $2,500 per year has turned into $10,000 per year.

What if 12% income growth is too high of a growth rate to reasonably maintain? What if portfolio income grew at a rate of 7%? The same $100,000 account with a 2.5% yield would double its income stream in 10 years, triple in 16 years, and quadruple in 20 years.

Obviously we would desire the highest possible income growth, but even a 7% yearly portfolio “salary raise” should be more than sufficient to outpace inflation over time. Additionally, saving and investing more provides you a way to grow your income even faster. The more money you can save and invest now, the more fuel your portfolio has to grow your future income stream.

A $100,000 portfolio with a 2.5% yield and 12% annual income growth rate would produce an income stream of $24,115.73 in 20 years. What if you were able to save and add $5,500 (the maximum Roth IRA contribution limit) every year for the next 20 years to this portfolio? At the end of 20 years the income produced is $35,211.

With a 7% annual income growth rate and a 2.5% dividend yield a $100,000 portfolio would have an income stream of $9,674.21 in 20 years. If you were to save and add $5,500 each year for the next 20 years to this portfolio the income stream grows to $15,705.67.

A high dividend growth rate plus a high savings rate is the right formula for building a meaningful future income stream. We will focus on finding the companies that can grow their dividend the most over time. It is up to you to fill in the rest of the equation.

Dividend Stock in Focus

McDonald’s Corp. (MCD): $101.43*
*price as of the close May 30, 2014

The Birth of a New Industry

From Hollywood to surfing, California has long been a cultural trend setter. Perhaps the largest cultural export from California, the one still finding new parts of the world to influence, is fast food.

In the 1940s, as the United States was turning into a nation dependent on its cars, a new dining phenomenon was taking advantage of a mobile nation, the Drive-in. The customer drove up in their car and placed their order with a server or later into a two-way speaker. Then the food was delivered to their car, often by the iconic “young woman on roller skates”.

Car Hop on Roller Skates
Drive-in restaurants were the newest and coolest thing. The problem with being the newest and coolest thing?

Teenagers.

A large gathering of teenagers is like a modern day plague of locusts. They wreaked havoc on the drive-ins’ china and flatware and, even worse, scared away the larger economic market of families looking for a low-priced meal. Drive-ins were also burdened by a high-cost, labor-intensive format. The drive-in model was essentially broken.

Richard (Dick) and Maurice (Mac) McDonald operated the most successful drive-in in San Bernardino. The brothers recognizing that the golden age of the drive-in was over were ready to sell everything and start a new restaurant named “The Dimer” (where everything in the restaurant would be sold for a dime or two). Instead the brothers shut down their drive-in for 3 months, and completely revamped their menu and overhauled the building. In the process the McDonald brothers created a whole new category of dining.

They removed the BBQ pit and focused their menu on the item that drove 80% of their sales, hamburgers. Gone were the drive-in parking spots and car hops. Customers would serve themselves by ordering at one window and picking up their food at another. The limited seating encouraged people to leave and make room for other patrons. The brothers replaced the china and the flatware with paper bags, wrappings, and cups. The focus of the new McDonald’s would be the “Speedee Service System”. High volume sales through lower prices, a focused menu, speed, speed, and more speed.

The original McDonald's after converting from a drive-in
The original McDonald’s after converting from a drive-in

The new McDonald’s lost its teenage appeal but gained a more important clientele, the family market. The new business model was so successful, copy cats popped up all over Southern California and the fast food industry was born.

Dividend History:

McDonald’s started paying a dividend in 1976 and has raised its dividend every year since. 38 years of dividend growth. Over the last ten years McDonald’s dividend per share has grown at a compound annual rate of 18.95%. Over the last five years that growth rate has dropped to 8.76%.

Data from S&P Capital IQ
Data from S&P Capital IQ

Increased capital expenditures to open new stores plus declining same store sales slowed recent dividend growth. Free cash flow has tightened and ROIIC (Return on Incremental Invested Capital) has dipped.

Catalysts for Dividend Growth and Price Appreciation

Better Franchise Mix

When Ray Kroc obtained the franchising rights from Mac and Dick McDonald he didn’t invent franchising. Ray created a better system. The then current franchising systems focused on short-term profits and gouging its franchisees. Ray’s new system focused on the long-term success of its franchisees. Ray made his franchisees his partners. Instead of gouging them for short-term profits, Ray did everything he could to help them succeed. Ray Kroc also focused on selling single store franchises to owner operators. People whose livelihood depended on the success of their McDonald’s franchise store. Franchisees also had to adhere to Ray’s strict rules for quality, speed, and cleanliness. The franchisees that dedicated themselves to their store and followed Ray’s system succeeded. In turn McDonald’s succeeded. Ray rewarded his top operators with more stores and many became wealthy beyond their wildest dreams.

It is with a little irony that McDonald’s, the pioneer of the modern franchise system, currently has one of the lowest mixes of franchise restaurants.

Chart courtesy of Deustche Bank
Chart courtesy of Deustche Bank

Company owned stores generate higher revenue per store for McDonald’s than franchised stores. However, a company owned store comes with higher expenses. Re-franchising company owned stores reduces operational overhead allowing McDonald’s to offset the lower revenue through lowered expenses. A higher franchise mix should improve margins, ROIC, and free cash flow. The market seems to agree, as it is currently awarding higher multiples to companies with more franchised stores.

Fix the Menu

McDonald’s largest markets are U.S, Germany, Japan, and Australia. These same four markets are most troublesome regarding same store sales growth. One issue is the current menu sprawl.

This was the menu for McDonald’s when Ray Kroc got started.

McDonald's Amazing Menu Smaller

The focused menu insured each McDonald’s consistently delivered high quality food. Compare the old menu to the list below of the new menu items McDonald’s added in 2013 alone.

1. Mighty Wings
2. Premium McWraps
3. Steak & Egg Burrito
4. Fish McBites
5. Steak Breakfast Sandwiches
6. New Quarter Pounders
7. Grilled Onion Cheddar Burger
8. Hot’n Spicy McChicken
9. The Dollar Menu & More (with five new burgers)

Now add in all the smoothies and espresso drinks from McCafe.

McDonald’s is creating a speed and service problem with its sprawling menu. Even with all the new choices and discounted menu options, 5 items account for 40% of all McDonald’s sales. When the McDonald brothers shut down their original drive-in they decided to focus their menu on the one item that accounted for 80% of their sales, hamburgers. The brothers built the McDonald’s “Speedee Service System” to improve quality, consistency, and speed. The main goal was to increase sales.

Franchisees have complained repeatedly about the expanded menu. Finally management is admitting that the current kitchen is over burdened. All the new offerings and discounted menu items have made the kitchen inefficient. Management is trying to fix the problem with new “high density” kitchens. The new kitchens should reduce the amount of “time and motion” needed to complete an order. However, the new kitchens do not address the vast number of menu items that do not sell. Current management needs to take a lesson from the McDonald brothers and focus their menu offerings to drive the sales of their most popular and profitable items.

Leverage Recap

McDonald’s has the balance sheet to add more debt and use the proceeds to buyback more shares and/or pay a special dividend. According to a J.P. Morgan analyst, McDonald’s can take on $11 billion in debt and maintain a BBB rating. McDonald’s could buyback almost 11% of its shares outstanding with $11 billion. However, management has remained steadfast in their desire to maintain an A rating. The same J.P. Morgan analyst says $5 billion more in debt added would keep McDonald’s A rating. McDonald’s will take on even less than this according to management’s latest presentation.

CEO Don Thompson stated McDonald’s would return another $18-20 Billion to shareholders. The capital return will be share buybacks and dividend increases over the next 3 years. An increase of $1.6-3.6 billion through the combination of debt and existing cash flow.

Chart from the Sanford C. Bernstein Thirtieth Annual Strategic Decisions Conference 2014
Chart from the Sanford C. Bernstein Thirtieth Annual Strategic Decisions Conference 2014

Conclusion:

McDonald’s global brand, scale, and infrastructure are unmatched in the quick serve restaurant category. Yet CEO Don Thompson says McDonald’s only has a 10% share of the global market. There are opportunities for McDonald’s to increase sales and gain market share. We discussed a short-term, shareholder friendly move like borrowing more to boost buybacks and dividends. We also discussed two long-term options to improve results, re-franchising and focusing the menu. Ray Kroc focused on the long-term profitability and success of McDonald’s. The current management team earns a slight applause for keeping with Ray’s philosophy and not rushing into any short-term fixes. However, Ray Kroc built McDonald’s on the backs of the owner/operator franchisee. Ray did everything he could to make sure they were successful. When the franchisees succeed, McDonald’s succeeds. The current sprawling menu is hindering the franchisees.

We estimate a fair value of $103 for McDonald’s. Currently, we can’t justify a higher valuation unless we see improvements in the menu and same store sales growth. Given the current issues McDonald’s is still a high-quality, high return on capital company. McDonald’s has rewarded its owners with a growing income stream for 38 years and we don’t see an end to this. We are happy to hold onto our position at the current price. On any price weakness we’ll look to add McDonald’s to accounts that may not own it yet.

Chart courtesy of Stockcharts.com
Chart courtesy of Stockcharts.com

Links of Interest

What is “the Cheapest, most nutritious and bountiful food that has ever existed in human history”? (NY Post)

The movie “Super Size Me” was more about over-eating than eating fast food as an Iowa teacher goes on a 90 day all McDonald’s diet and loses weight. (YouTube)

The conjuring of The Mirage. 25 Years ago, Steve Wynn created a new kind of resort. Why we like investing in Steve Wynn. (Vegas Seven)

Drive-throughs are second nature to us here in the U.S. but people in China are having some trouble adapting. (Now I Know)

The complete do-it-yourself guide to making all your favorite McDonald’s food. (Epic Constructions)

The burger-making robot that could revolutionize fast food. (Business Insider)

A Q&A with the Author of Dream Big. The book on 3G Capital and praised by Warren Buffett. (DealBook)

All past letters are archived here.

Books of Interest

A great book on the rise of the Anheuser-Busch InBev’s Brazilian management team and their start from humble beginnings to creating the world’s largest brewer.
Dream Big

For an excellent and independent history on McDonald’s read
McDonald’s: Behind The Arches

For a look at the darker side of today’s fast food industry read
Fast Food Nation: The Dark Side of the All-American Meal

The opinions expressed in “The AMM Dividend Letter” are those of Gabriel Wisdom, Michael Moore and Glenn Busch and do not necessarily reflect the opinions of American Money Management, LLC (AMM), an SEC registered investment advisor who serves as a portfolio manager to private accounts as well as to mutual funds. Clients of AMM, Mr. Wisdom, Mr. Moore, Mr. Busch, employees of AMM, and mutual funds AMM manages may buy or sell investments mentioned without prior notice. This newsletter should not be considered investment advice and is for educational purposes only. The opinions expressed do not constitute a recommendation to buy or sell securities. Investing involves risks, and you should consult your own investment advisor, attorney, or accountant before investing in anything. Current stock quotes are obtained at http://finance.yahoo.com. Prices are as of the close of the market on the date for which the price is referenced.