This week’s deliberate practice challenge from Whopper Investments was McDonald’s (NYSE:MCD) in 2005. Well known value investor Bill Ackman of Pershing Square took a large and successful position in MCD in 2005. The challenge was to analyze and value MCD at the beginning of 2005 using the company’s 2004 10-K Annual Report, Proxy statement and a handful of exhibits and company press releases.
I think it is safe to assume that we are all quite familiar with MCD so an overview might not be necessary. However, after peaking at Ackman’s 2012 presentation on Burger King, an overview of MCD in 2005 provides an interesting perspective. In 2004, MCD was the largest quick-service hamburger chain in the world. MCD had 31,561 stores in over 100 countries around the world with approximately 58% of systemwide restaurants franchised and $51 billion in systemwide sales. This compares to Burger King’s much smaller numbers seven years later in 2012 where the king of burgers has 12,512 stores in 80 countries with approximately 92% of systemwide restaurants franchised and $15.3 billion in systemwide sales. MCD’s massive scale in 2004 gives the company a competitive advantage through their economies of scale and brand recognition.
What did Bill Ackman see in MCD in 2005?
Putting myself in Bill Ackman’s shoes is a daunting task as they are pretty big shoes to fill. Stumbling around at first, I think I’m starting to get a sense of how he thinks.
I think he saw a company being overlooked because they were changing their strategy. MCD was shifting from a store growth story to a capital allocation story. On page 10 of the 2004 10-K the company states:
Strategic direction and financial performance
In 2002, the Company’s results reflected a focus on growth through adding new restaurants, with associated high levels of capital expenditures and debt financing. This strategy, combined with challenging economic conditions and increased competition in certain key markets, adversely affected results and returns on investment.
In 2003, the Company introduced a comprehensive revitalization plan to increase McDonald’s relevance to today’s consumers as well as improve our financial discipline. We redefined our strategy to emphasize growth through adding more customers to existing restaurants and aligned the System around our customer-focused Plan to Win. Designed to deliver operational excellence and leadership marketing, this Plan focuses on the five drivers of exceptional customer experiences—people, products, place, price and promotion.
What is amazing is that the numbers look very good in 2004 yet investors were so stuck on the old story that they weren’t interested in them. I have not looked back at the numbers but it would not surprise me that MCD might have had a growing store base while same store sales were weakening. The combination of investors focusing on store openings slowing while same store sales growth became weak probably made investors disinterested in MCD.
The impressive Returns On Incremental Invested Capital (ROIIC) is evidence that management’s restaurant refreshment strategy was working. The 2004 ROIIC was an impressive 41% which far outperformed the company’s ROA of 8.5% and ROE of 17.4% for 2004. This indicates that the best capital allocation strategy is to direct capital toward refreshing stores over opening new stores.
Using Ackman’s 2012 Burger King presentation, I am going to value MCD in a similar manner. Ackman shows a near-term valuation and mid-term valuation. The near term is using one year estimates and the mid-term is using EPS estimates five years out. What is interesting to me is what Ackman leaves out. Where is the long-term estimate? I have to imagine he has one and it would be fascinating to see a long-term estimate by Ackman that goes out seven to ten years. In his mid-term estimate, he gives his five year price target. That gives us an expected return but not his intrinsic value estimate. I need an intrinsic value estimate in order to know where to buy or sell. That is a core aspect of my investment process.
Both my near-term and mid-term valuation assume the company hits the high end of their targets as the company states in the 2004 10-K:
The long-term goal of our revitalization plan was to create a differentiated customer experience—one that builds brand loyalty and delivers sustainable, profitable growth for shareholders. Looking forward, consistent with that goal, we are targeting average annual Systemwide sales and revenue growth of 3% to 5%, average annual operating income growth of 6% to 7%, and annual returns on incremental invested capital in the high teens. These targets exclude the impact of foreign currency translation.
The near-term valuation uses a multiple of EBITDA – Capex. Ackman uses a sensitivity analysis to present a range for the near-term valuation. My 2005 EBITDA – Capex estimate is in the range of $3.3 billion to $3.8 billion and using a multiple of 13.5x to 15.5x EBITDA – Capex gives a per share equity valuation range of $29.15 to $40.55 as seen in the table below.
My mid-term valuation uses an adjusted EPS and terminal multiple estimate in 2009. If management hits the high end of their targets I would estimate 2009 EPS at $2.74 assuming management repurchases enough stock to get shares outstanding down to approximately 1.18 billion. Using a 15x terminal multiple, the target price is $41.
What is left out by Ackman’s Burger King presentation is the valuation of dividend payments. He is assuming no dividend payments in his upside. A target price is not sufficient in my opinion since MCD pays a dividend and had raised its dividend every year for nearly 30 years and they are embarking on a capital allocation strategy. Assuming a 35% payout ratio in 2009 and a 10% required return, I get an intrinsic value of $28.60. Ackman uses a 20 multiple in his Burger King valuation so if I apply that multiple, I get an intrinsic value of $37.10. That gives a mid-term valuation range of $28.60 to $37.10. Based on the information I have, I don’t have a valid reason to assign a 20 terminal multiple so I would estimate my intrinsic value at $28.60. I would require a margin of safety of a 20% discount to intrinsic value before purchasing shares so I would consider purchasing shares at prices below $22.90.
Since Whopper requested we estimate the Enterprise Value (EV) of the company for the exercise, I would estimate the equity value of the company at $36.4 billion. Adding net debt of $7.8 billion, I get an EV of $44.2 billion.