McDonald’s The Fund purchased McDonald’s (MCD) in 2002 at an average price of approximately $17.50 a share. MCD last sold at about $17.50 a share in 1995 and reached a peak in the high 40’s in 1999. We were able to purchase MCD at the same price it had sold seven years earlier, despite the fact that over the sevenyear period earnings increased from $0.99 a share to $1.32 a share, sales increased from $10 billion to approximately $15 billion and book value moved from $5.36 a share to $8.11 a share.
Analysts were disillusioned by the fact that the growth rate was slowing and that the company, in attempting to meet analyst’s growth expectations, was constructing new stores which cannibalized the sales of existing stores. We calculated that MCD had the potential to generate in excess of $2 billion of free cash flow by cutting back capital expenditures (and thus revenue growth), especially where new stores were being constructed too close to existing stores. The increased free cash flow generated from cutting back capital expenditures could be used to buy back shares which, in turn, would accelerate earnings per share growth. As significant shareholders, we wrote management with detailed recommendations, urging the company to cut back capital expenditures on new stores and use the excess cash to modernize existing stores, change menus and return capital to shareholders in the form of share buy backs. We calculated that the share buy backs at the low price earnings ratio MCD was selling for at the time would produce higher earnings growth than opening new stores with low returns on invested capital. We were fortunate that the new president installed in early 2003 followed our formula to the letter, and the earnings potential we believed existed was realized. The apathy and disillusionment that surrounded the stock in 2002 began to vanish as MCD’s earnings and same store sales turned upward. MCD is expected to earn $2.40 a share in 2007. Same store sales in the United States are now growing at 3-4 % per year and the European operations are beginning to turn around. We continue to hold a position in MCD at the current price of about $42.00 a share, which continues to meet our valuation parameters, although we have sold some stock along the way at material capital gains.