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.