How McDonald's 4-Bagged

The year is 2003, and the bear market is in full force. You're eyeing McDonald's (NYSE: MCD  ) stock, which has plummeted from $45 per share to around $15 per share, a decade-low. Anybody who bought shares in early 2003 would've tripled or quadrupled their money. Using only information prior to early 2003, we try to reverse-engineer the situation to find the clues that Mickey D's shares were a screaming buy.

Mickey D's moat
Although selling hamburgers and french fries doesn't sound like the greatest business in the world, McDonald's nonetheless boasts a very secure moat. That's because the company makes the bulk of its income from franchising and real estate.

That's a HUGE difference from operating a company-owned restaurant. Why? McDonald's charges franchisees a percentage of sales for services and real estate provided. If sales fall 3%, then the franchise revenue will fall around 3% as well.

On the other hand, if a company-owned store experiences a 3% decline in sales, this can severely impact profit, because a portion of expenses are fixed. For a restaurant, up to 50% of sales might be spent on payroll, occupancy, depreciation, and other fixed costs. Thus, a 3% decline in sales might cause profits to fall 8%-10%.

In 2002, McDonald's earned about $3 billion in operating profit (before selling, general, and administrative costs) from franchise income, and only $1.6 billion from company-owned stores.

Such a heavy proportion of income from stable, high-margin franchisee fees would effectively insulate the company from the vagaries of negative same-store sales, the economic environment, and other potential pitfalls.

The opportunity
So, clearly, McDonald's should almost always trade at a healthy multiple because its cash flows are extremely stable. However, this was not the case in early 2003.

In 2002, McDonald's took about $850 million worth of charges. This consisted of $266 million relating to restaurants in Latin America and the Middle East, $402 million to close 751 underperforming restaurants, and $184 million for a technology write-off when a technology project was terminated.

However, the key was that none of the charges were indicative of recurring problems. For example, although the technology write-off was disappointing, it didn't impair McDonald's ability to continue earning a lucrative stream of cash flow from its franchisees.

Similarly, although closing 751 stores sounds bad, the company noted that most of those stores had negative cash flows and low sales volumes. Thus, closing those stores would actually have a beneficial effect on future results.

Other factors
McDonald's had a couple of other things going for it. It owned the fast-growing Motley Fool Rule Breakers pick Chipotle (NYSE: CMG  ) concept. In addition, other fast-food restaurants, including Wendy's (NYSE: WEN  ) , CKE Restaurants (NYSE: CKR  ) , and Jack in the Box (NYSE: JBX  ) , were also bottoming (as well as the general market). This indicated that McDonald's problems were part of an industry and market downturn, and not specific to the company.

Valuation
In 2002, McDonald's generated $2.9 billion in operating cash flow. Excluding the $850 million charge, the company earned about $1.5 billion. Based on a share price of $15 in early 2003, McDonald's market cap was about $19 billion, which means shares traded at roughly 13 times earnings and 6.6 times cash flow.

If investors conservatively assumed McDonald's could increase earnings 10% for the next three years, and that shares traded at a more realistic 16 multiple to earnings, then shares would appreciate to around $25 per share, for a 22% annualized return. In fact, shares did much better and soared to $35 per share by the end of 2005, for a 33% annualized return. To date, shares have more than tripled since early 2003.

In a nutshell, in 2003, due to an industry downturn and nonrecurring problems, McDonald's shares simply got too cheap for a wide-moat company, and subsequently rewarded shareholders smart enough to capitalize on the opportunity. Hopefully we Fools can be ready the next time such an opportunity comes around.

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