McDonalds is quite the interesting company at this point in time. Obviously, with hindsight and knowing what I know now, they were 1) quite undervalued and 2) a great activist target, but you really don’t get that feel from reading the financials.
To start, management is clearly focused on creating shareholder value. The fact that they are measuring themselves on incremental ROIC (this measures the amout of profit created for each new dollar invested in the business. It’s very similar to several of Buffett’s favorite metrics) speaks wonders, and that they’re considering spinning off the non-core brands is pretty instructive. Cash is consistently returned to shareholders instead of squandered on crazy acquisitions.
And this chart is pretty mind blowing.
Revenues, profits, and store count are all on a consistent upward march.
However, deliberate practice is all about trying to recreate why an investor made their investment. And, in this case, I don’t think strong profit numbers alone will tell the story.
Consider this. MCD breaks down their revenues and costs by division (but not assets).
We can use this to come up w/ a “gross profit” for each of the two divisions. We come up with $2.1B for company owned stores (14.2 less 12.1) and $3.8B for the franchised stores. Of course, this is a bit unfair, as there are way more franchised stores. Dividing the profit by the store count at year end, we find that MCD earns ~$231k in gross profit per company owned store and $172K for a franchised store. We can also use this chart and the first chart to figure out revenue per company owned store ($1.54m per year) versus franchised ($1.66m per year).
Forget about all of the PPE, management headache, etc associated with the stores for a second. MCD frachises sell for at least one times revenue to frachisees, so owning all of these stores is literally costing MCD $14B+ in cash if they were to sell it off. So, in exchange for that literal $14B investment, MCD is netting $60k more in profit per store than it would be if it just sold them off the franchisees. And their stores are doing over $100k less per year in sales than a franchise.
In other words, MCD is simply not recouping their investment in company owned stores. Their stores are underperforming, and MCD could basically sell the stores to franchisees and still realize the same profit per store!!!
Then there’s the issue of PP&E. MCD has taken to buying the property underneath a bunch of their franchises and renting them out. These are effectively triple net leased properties, which are incredibly valuable leases that generally trade for cap rates of 12x or so (all revenue is effectively cash flow in a triple net lease, so revenue = profit) that are most effective when levered to the hilt. MCD does over $1B in revenue from their franchisees from this rental revenue, and it’s on their books for over $10B (see footnotes for that- this does NOT include their company owned stores PPE). Now, this is a bit double counting, because I’m sure some of this revenue makes its way into profit from franchisees, but I have almost no doubt that all of this property would be better owned outside of McDonalds.
Why? McDonalds is in a difficult situation acting as both landlord and franchisor. Are they really going to risk upsetting an important franchisee in rent negotiations? Add to that the fact that the real estate really should be levered much more highly than MCD is willing to, and it probably makes the most sense for someone else to own them. Again, it’s a bit double counted because I’m sure they get some profit from franchisees in here, but I would bet MCD could create $10B in value simply by selling the land off piecemeal or levering it up, keeping the excess cash and spinning it off.
So, with all that in mind, let’s take a stab at valuing them.
In their current form, I would think of MCD as a pretty high quality growth company. Excellent economics, strong management, moat from strong brand and years of “goodwill” (they may not be loved, but they do have a place in consumer’s minds), decent growth, relatively inflation protected, etc etc.
I generally wouldn’t pay more than 15x EBIT for a company, and that 15x is only reserved for top flight companies with excellent economics and a strong history. MCD certainly qualifies there. Given that, I’d consider the company relatively fairly valued the $3.541B x 15 = $53B. Back out about $8B in net debt, and you get a target market cap of $45B. With 1.26B shares out, that would work out to a target share price of $35.70 or so.
However, that’s in its current form. If they sell out their company owned stores at 1x sales (which actually might be low), they’d lose $550m in profits. At 15x multiple, that’s ~$8.3B in value lost. However, they’d be selling for $14.6B, so net they’d have created just under $6B in value. That’s another $5 per share, which would give us a target share price a bit over $40.
There’s also some value to be found in the PP&E (at least there is if you believe me!), so arriving at a target share price of $45 doesn’t take too much effort.
MCD spent almost all of 2004 and most of the first half of 2005 in the mid to high $20s per share, so you could have bought them at a decent discount to fair value and gotten upside from restructuring and realigning for free.
To start, management is clearly focused on creating shareholder value. The fact that they are measuring themselves on incremental ROIC (this measures the amout of profit created for each new dollar invested in the business. It’s very similar to several of Buffett’s favorite metrics) speaks wonders, and that they’re considering spinning off the non-core brands is pretty instructive. Cash is consistently returned to shareholders instead of squandered on crazy acquisitions.
And this chart is pretty mind blowing.
Revenues, profits, and store count are all on a consistent upward march.
However, deliberate practice is all about trying to recreate why an investor made their investment. And, in this case, I don’t think strong profit numbers alone will tell the story.
Consider this. MCD breaks down their revenues and costs by division (but not assets).
We can use this to come up w/ a “gross profit” for each of the two divisions. We come up with $2.1B for company owned stores (14.2 less 12.1) and $3.8B for the franchised stores. Of course, this is a bit unfair, as there are way more franchised stores. Dividing the profit by the store count at year end, we find that MCD earns ~$231k in gross profit per company owned store and $172K for a franchised store. We can also use this chart and the first chart to figure out revenue per company owned store ($1.54m per year) versus franchised ($1.66m per year).
Forget about all of the PPE, management headache, etc associated with the stores for a second. MCD frachises sell for at least one times revenue to frachisees, so owning all of these stores is literally costing MCD $14B+ in cash if they were to sell it off. So, in exchange for that literal $14B investment, MCD is netting $60k more in profit per store than it would be if it just sold them off the franchisees. And their stores are doing over $100k less per year in sales than a franchise.
In other words, MCD is simply not recouping their investment in company owned stores. Their stores are underperforming, and MCD could basically sell the stores to franchisees and still realize the same profit per store!!!
Then there’s the issue of PP&E. MCD has taken to buying the property underneath a bunch of their franchises and renting them out. These are effectively triple net leased properties, which are incredibly valuable leases that generally trade for cap rates of 12x or so (all revenue is effectively cash flow in a triple net lease, so revenue = profit) that are most effective when levered to the hilt. MCD does over $1B in revenue from their franchisees from this rental revenue, and it’s on their books for over $10B (see footnotes for that- this does NOT include their company owned stores PPE). Now, this is a bit double counting, because I’m sure some of this revenue makes its way into profit from franchisees, but I have almost no doubt that all of this property would be better owned outside of McDonalds.
Why? McDonalds is in a difficult situation acting as both landlord and franchisor. Are they really going to risk upsetting an important franchisee in rent negotiations? Add to that the fact that the real estate really should be levered much more highly than MCD is willing to, and it probably makes the most sense for someone else to own them. Again, it’s a bit double counted because I’m sure they get some profit from franchisees in here, but I would bet MCD could create $10B in value simply by selling the land off piecemeal or levering it up, keeping the excess cash and spinning it off.
So, with all that in mind, let’s take a stab at valuing them.
In their current form, I would think of MCD as a pretty high quality growth company. Excellent economics, strong management, moat from strong brand and years of “goodwill” (they may not be loved, but they do have a place in consumer’s minds), decent growth, relatively inflation protected, etc etc.
I generally wouldn’t pay more than 15x EBIT for a company, and that 15x is only reserved for top flight companies with excellent economics and a strong history. MCD certainly qualifies there. Given that, I’d consider the company relatively fairly valued the $3.541B x 15 = $53B. Back out about $8B in net debt, and you get a target market cap of $45B. With 1.26B shares out, that would work out to a target share price of $35.70 or so.
However, that’s in its current form. If they sell out their company owned stores at 1x sales (which actually might be low), they’d lose $550m in profits. At 15x multiple, that’s ~$8.3B in value lost. However, they’d be selling for $14.6B, so net they’d have created just under $6B in value. That’s another $5 per share, which would give us a target share price a bit over $40.
There’s also some value to be found in the PP&E (at least there is if you believe me!), so arriving at a target share price of $45 doesn’t take too much effort.
MCD spent almost all of 2004 and most of the first half of 2005 in the mid to high $20s per share, so you could have bought them at a decent discount to fair value and gotten upside from restructuring and realigning for free.
