Deliberate Practice: McDonald’s 2005 Follow-Up

While I did peak at Bill Ackman’s Burger King presentation while doing the McDonald’s (NYSE:MCD) deliberate practice, I did not peak forward to the section on McDonald’s in Ackman’s profile in the recently published book The Alpha Masters by Maneet Ahuja.

In The Alpha Masters, Ahuja comments that Ackman’s principal goal was to convince MCD to sell or spin off the company-operated stores to the more entrepreneurial franchisees.  He goes on to say,

This would have the additional benefit of improving the quality of McDonald’s earnings and cash flow as the assets that remained at McDonald’s would generate cash from rent and a franchise royalty stream from the franchisees.

After reading the book Confidence Game where I learned that one of Ackman’s favorite books was Quality of Earnings, it would be easy to believe that Ackman’s core thesis was that re-franchising the company-operated stores would increase the quality of MCD’s earnings and therefore the value of the shares.  My reading of Ackman’s Burger King presentation lead me in that direction at first but as I worked out the numbers of shifting revenues from company-operated stores to franchise stores, I wasn’t seeing how that would dramatically improve the value.  I completely agree with Whopper at Whopper Investments when he said in his MCD post,

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.

As I went back working through my numbers, I found myself uncovering something I had not seen before.  This is precisely why deliberate practice is exciting even though it can be difficult.

Since I am obsessed with the time value of money, I would have a difficult time putting a $14 billion valuation on the company-operated stores like Whopper does.  I agree that at 1x revenue that the stores would bring in $14 billion if they were all sold to the franchisees at once.  However, these are illiquid assets.  It takes time to sell 9,412 restaurants.  Perhaps I am splitting hairs but one can fall into an overvaluation trap if not careful.  To be fair, Whopper is probably being conservative with 1x sales valuation on the company-operated restaurants so the 1x sales multiple could be considered to be a discounted multiple.

If all the restaurants are sold in a linear fashion over a five year time horizon, my 2009 EPS estimate would drop to $2.05 from $2.74.  However, MCD would collect close to $14 billion in cash over that time.  At a 10% discount rate, the proceeds would have a present value of approximately $11 billion.  Not chump change to be sure.  This would increase my intrinsic value estimate to $40.10 from $28.60.

However, I would have to be more conservative than assuming that all of the value of the company-operated stores could be realized in five years.  Assuming the company were to sell 500 company-operated restaurants per year, then my intrinsic value would only increase to $31.40 from $28.60.  I think this is where Ackman’s missing long-term estimate process would be of interest.  What would the valuation be if MCD was able to convert 2,777 stores from the end of 2004 to the end of 2011?  That’s the difference between the company-operated stores in 2004 versus in 2011.  The MCD story since Ackman’s investment has changed.  The more things change, the more they stay the same.  McDonald’s is described as annuity In The Alpha Masters,

Owning 13 to 14 percent of the gross revenues of every McDonald’s in the world is one of the greatest annuity streams of all time,” says Ackman.  ”Every time someone buys a Coke, McDonald’s get 14 cents right off the top.  It’s an even better business than Coke.”

It’s a little odd that Ackman makes the argument that the company is a great annuity stream while implementing his position through options instead of buying the common shares directly.  Its good to remember that he is known as an activist investor so he is looking for an event to drive his thesis.  It’s going to happen pretty quickly or not at all.  It’s no wonder he took his profits after the stock doubled over two years.  The stock price probably caught up with his long-term valuation.

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5 Responses to Deliberate Practice: McDonald’s 2005 Follow-Up

  1. red. says:

    George, I think a lot more people would side with your interpretation of MOS than they would with mine.

    Interestingly, your qualitative approach to MOS is similar to the approach that I use. My investing universe is quite small, maybe 250 stocks whose businesses I can honestly say I understand.

    Re: when does one sell? Price-to-value has an implied ROI built into it; sell is when actual (after-tax) return exceeds that ROI.

  2. George Pica says:

    Red, I view the discount rate as the opportunity cost of capital. I am trying to conservatively estimate the value of the company. This conservative estimate is my base case scenario. I am trying to look at the different paths that the valuation of the company could take in the future. My base case is my best estimate of what is most likely to happen. I often have a bear case and a bull case also so behind my single point estimate of intrinsic value is a range of valuation that I think the company is worth. This could be thought of as a confidence interval. The wider the confidence interval, the more of a margin of safety I would require. I do not set the margin of safety in a quantitative manner but it is a way to look at the data in order to make a good judgment. I would rather keep my opportunity cost a constant since I would be extremely happy to consistently receive a consistent 10% annual return on my capital year after year and it is one less variable to worry about. Since these are equity investments where returns are lumpy and there is analytical risk in my estimates of future cash flows, I require a discount to my intrinsic value estimate.

    I don’t have a problem calling the discount to intrinsic value a haircut. Yes, I am taking a haircut to my conservative estimate of intrinsic value. I think that haircut is one way to achieve a margin of safety. Another way that I am hopefully achieving a margin of safety is that I am using my conservative estimate of intrinsic value.

    I agree, another way to build a margin of safety would be to estimate the value of MCD assuming their is no growth. In that case you might not need a discount to purchase shares if the price of the stock was the same as your intrinsic value estimate. However, if you buy at the no-growth intrinsic value, how do you know when to sell?

    I’m not sure if I would say that value investing is about getting something for free. However, I think that estimating the intrinsic value of the company and only purchasing the shares when you can buy them at a discount to that price is getting something for free. After all, if I am right about the intrinsic value of the company and I bought the shares at a 25% discount to the intrinsic value, then I just got 25% of the company for free.

    I really appreciate getting your feedback on how you approach investing. One of things I love about value investing is that there are a lot of rational ways to approach it. Buffett does a wonderful job in “The Superinvestors of Graham-and-Doddsville” laying out how the “Graham and Dodd ‘look for values with a significant margin of safety relative to price’ approach to security analysis” is a valid and robust investment process. He goes on to show the performance of nine different managers that were all intellectual descendants of Ben Graham. Each manager applied the theory set forth by Graham differently but they were all value investors: http://www7.gsb.columbia.edu/alumni/news/hermes/print-archive/superinvestors.

  3. red. says:

    Sorry for the late response.

    I see where you’re coming from on all the points you make.

    On 7x/8 x rent, if the business is a going concern and is in retail or air transport or some other line that requires a set ratio of fixed assets to revenue, using the above multiples will work well.

    Remember, what one is trying to do, in equity analysis, is, first and foremost, to approximate the value of the assets that are being used: 7x or 8x rent (in the current interest rate environment) does that accurately enough. And if the implied value of the assets being leased is $1 million, then, the value of debt-equivalent should be the same. I’ve seen a lot of nonsense re: operating leases that management tries to sell in their 10-k’s and so some my insistence on capitalizing leases properly comes from that. (And I note that there are plenty of people claiming 70+% ROICs for restaurant businesses, which is an impossibility but ony possible because they are either not capitalizing leases or doing so at management’s misleading “minimum lease commitment” figure.)

    And yes, in the case of liquidation, 2x or 3x rent is more appropriate.

    Why use a 10% return as your dscount rate if you’re also insisting on a “margin of safety”? Why not use a 20% discount rate and be done with it?

    In my view, no investment principle has been more distorted over time than Graham’s original margin of safety concept. It has now come to mean pick a number you think it might be worth, halve it, and that’s you’re buy price. I think that’s not only not what he meant, nor what he intended, but that it makes no real sense even in casual contemplation. Margin of safety is about valuing a stock using the most pessimistic scenario that is is reasonable to contemplate. If one buys McDonalds at a price that implies that it won’t ever grow at more than the rate of inflation, that is a margin of safety price regardless of whether it is 50% or 20% of the “true value” of MCD.

    Value investing is not about haircuts. It’s about getting something valuable for free. You’ll notice that in every deliberate practice example, Buffett is buying a free option rather than pricing a haircut. (I’m ignoring Ackman etc — poseurs and speculators rather than value investors proper)

    That’s my imho 2 cents.

  4. George Pica says:

    Red, I see what you are doing with the operating leases. It looks like using 7x or 8x rent might be a good shortcut. However, using the present value of the minimum lease obligations is a sound method. A lot of accounting is game able and I don’t see how using a multiple of the previous year’s rent produces a more realistic result. For example, if a company had leases expiring that they were not going to renew, then taking a multiple of the previous year’s rent would overstate the company’s debt. Aswath Damodaran has a good paper on operating leases at http://people.stern.nyu.edu/adamodar/pdfiles/papers/newlease.pdf.

    My estimates of MCD’s future cash flows were in nominal terms and therefore using a nominal risk free rate is the most appropriate risk free rate to use in my opinion.

    You bring up some interesting points regarding WACC.

    Regarding the time value of money, I prefer to think more in terms of how much am I going to charge for my capital? I want a 10% return so that is the return that I require. If I purchase a stock at a discount to that intrinsic value, then I have a margin of safety.

  5. red. says:

    continued from http://www.whopperinvestments.com/deliberate-practice-mcdonalds-mcd-2005#comment-10740

    Operating leases: page 38, 2004 rent = 1,253 million

    I encourage you not to use the PV of reported minimum lease obligations: I know that the textbooks recommend it but it’s gameable & therefore unrealistic. Use 7x or 8x rent. In this case, MCD decided to be honest, so it comes out to about the same.

    TIPS: yes, TIPS is the real rate. If you think that MCD has a strong competitive position and can therefore pass on inflation to its customers, then its future cash flows should be denominated in real dollars.

    WACC:

    Forget the corp fin textbooks for a second and contemplate three questions:

    1. Do you see the circularity in using market cap for the equity weighting? Is market cap a function of WACC or is WACC the function of market cap?

    2. MCD stock rises to a hundred. Debt stays the same. Are the cash flows now more risky than they were when MCD was at 35? If not, why has the WACC gone up?

    3. Does a private (i.e. non-public) business have no cost of equity?

    Time value of money:

    I still think it makes sense to separate out fair value from the price that you, personally, would pay. If long term stock returns ~6.8% in real terms, that’s the long-term equity yield, which is the long-term cost of equity. The question, then, is whether MCD’s cash flows are safer than average or less safe than average. Most investors would say safer. Therefore the required rate of return on MCD’s cash flows should be lower than 6.8%.

    I don’t think there’s anything unusual about your obsession with the time value of money. TVOM is what investing (not just in stocks but in anything) is all about.

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