McDonald's (MCD, Financial) is one of the best companies in the world and, if it were not for the negative connotations of fast food, it could be a top-five holding for Warren Buffett (Trades, Portfolio) (he already vists for breakfast everday).
Indeed, the company has many of the qualities Buffett looks for before investing. It has a global presence reinforced by a strong brand reputation built up over many decades as customers have come to trust the Golden Arches to give them the same quality of food as they expect at home, anywhere around the world.
It is this reputation that has helped the company get to where it is today, and maintain its dominance over the global fast food market. Its status is stronger than almost every other global fast food brand thanks in part to its franchise model. Using this model, McDonald's has been able to take over the global fast food market as local managers meet the changing tastes of local customers. This model has also proved to be extremely effective for shareholders.
Capital return
As the majority of Mcdonald's outlets are virtually independent businesses, the holding company does not have to worry about trivial day-to-day business problems, such as staffing issues and stocking. Instead, management can concentrate on the business of marketing and improving products as well as returning cash to investors. Specifically, over the past six years, the company has returned $46 billion to investors via buybacks and dividends, around 50% of its current market value of $96 billion.
Debt has funded a large percentage of this capital return. Over the past six years, the company's net debt has ballooned from $11.1 billion to $27.1 billion, pushing book value per share down from $15.3 to -$6. At the end of the last interim period (March 31), net shareholder equity had slumped to -$4.7 billion.
If it were not for this negative value, shares in McDonald's might seem like an attractive buy. A return on capital employed of 31.3% more than justifies the current valuation of 20.9 times forward earnings, and a dividend yield of 2.5% is slightly above the market average. A free cash flow of approximately $5 billion per annum indicates to me that the firm certainly has lots of room to maintain or increase shareholder returns in the years ahead.
So, is the negative equity value that bad?
Assessing negative equity
According to Travis Fairchild, CFA of O'Shaughnessy Asset Management, McDonald's shareholder deficit might not be as bad as it first appears, and there could even be hidden value on the balance sheet.
Two factors support this conclusion. First of all, the McDonald's brand. Currently, the company has this brand valued at $2.4 billion on the balance sheet. However, according to Statista, the value of the brand is probably closer to $98 billion, implying there's one ginormous hidden asset on the McDonald's balance sheet, which is not currently factored into financials.
That said, brand value is, in reality, difficult to place an accurate value on. In fact, the only time this value would be realized is if another company came to bid for the McDonald's business, or if the company sold the brand name -- both of which are unlikely.
Nonetheless, the second factor implying that the company is significantly understating the value of assets on its balance sheet is a lot more tangible.
Fairchild noted that McDonald's owns a lot of valuable real estate, where its franchisees operate their restaurants. As stated above, the company is a real estate business that sells franchise rights. This real estate is the company's most valuable asset. However, the company depreciates its properties using the straight-line method of depreciation over the shorter of the lease term or 40 years.
Fairchild noted that the average lease term for the company is 20 years, which implies that much of the property bought and leased before 1998 is now worth zero, on the balance sheet at least. In other words, there are billions of dollars of valuable real estate sitting on the company's balance sheet that is unrecognized. For example, at the end of 2017, the company recorded $14.2 billion in accumulated depreciation on its balance sheet.
Some rough math gives an idea of how large the real scale of the deficit could be. At the end of 2017, the firm owned 15% or 37,241 of its restaurants around the world. Franchisees operated the rest with the company owning a large percentage of the real estate. In 2015 estimates by Janney Capital Markets put the average total sales per franchise at $2.7 million. Assuming the company could sell the property at each location for a similar amount (1x sales) the absolute value of the property on its balance sheet could be in excess of $85 billion, based on this back of the envelope calculation. At the end of 2017, the balance sheet reflected just under $37 billion of property.
So overall, while McDonald's might not look like an expensive stock with a weak balance sheet at first glance, there are billions in hidden value on the balance sheet, which most investors might overlook.
Disclosure: The author owns no shares mentioned.
