This week, I had the pleasure of meeting Bill Ackman, head of Pershing Square Capital Management, when we spoke at the Value Investing Congress in New York. Bill used the forum to discuss Pershing's proposal to unlock value at McDonald's (NYSE:MCD) by spinning off company-owned stores ("McOpCo") into a separate company, so that McDonald's proper can be what Ray Kroc said it was from the outset: a real estate company that happens to sell hamburgers.
Let me make a pitch. I have no financial interest in the Value Investing Congress, but I simply thought that the process of listening to some of the greatest investing minds in rapid succession was as accretive to my knowledge base as anything I've ever done. They're holding another Value Investing Congress in Pasadena, California, in May, just before the Wesco (AMEX:WSC) annual meeting. If you can afford to go, go.
Back to the issue at hand, Ackman laid out a thesis that values McDonald's real estate at about $46 billion, roughly equal to the company's current enterprise value of $47 billion ($41 billion market capitalization plus net debt of roughly $6 billion). His proposal is based on a substantial disconnect between what most investors view McDonald's to be, and what it actually is.
McDonald's generates 54% of its earnings before interest, taxes, depreciation, and amortization from its real estate and franchising royalties and another 46% from its company-owned restaurants. However, Ackman estimates that the actual amount of profits from its restaurants is far lower, as the company fails to charge -- even as a bookkeeping item -- a market rate for rent or franchise fees to these properties. If one made an adjustment for them, actual EBITDA from restaurant operations is about 22% rather than 46%. Subtract out maintenance capital expenditures and it's more like 14%. Furthermore, unlike rent and franchise fees, the latter of which are based on a percentage of store-level revenues, restaurant operation profits are extremely variable and beholden to the price vagaries of commodities like beef. I addressed the ongoing issues facing McDonald's during one of the lowest points of the company, back in April 2003. That turned out pretty well.
It's important to note that McDonald's doesn't particularly question Ackman's assumptions. Further, McDonald's, unlike many corporations, welcomed the input of an informed shareholder, to its ultimate credit. Also, this thesis has further credibility in the fact that Vornado Realty Trust (NYSE:VNO) had taken a 1.2% position in McDonald's.
How to unlock value?
Ackman's solution to close the gap between McDonald's private market value and its public one is for the company to spin off 65% of its 9,000-unit corporate restaurant operations division into a separate corporation through an IPO, raising more than $3.3 billion. McDonald's could then focus on its high-margin real estate and franchise business, while the new "McOpCo" could set about maximizing returns on the more variable restaurant business on equal ground with other franchisers. Ackman then wants McDonald's Classic to sell some $14.7 billion in mortgage-backed securities on its properties to refinance its current $5 billion in debt and buy back more than 300 million shares at $40 apiece.
At the end of the day, Ackman believes that the market will recognize the remaining McDonald's as having a much higher-quality stream of cash flows, and value it much higher per share as a result -- about $45 to $50. McDonald's calls the proposal "an exercise in financial engineering," but only after it expended substantial resources evaluating it. Again, as a shareholder, it's nice to see that McDonald's isn't simply dismissing outside proposals as "not invented here."
The core of Ackman's proposal isn't necessarily the refinancing or a desire to restructure, though were McDonald's entirely in private hands, it would likely increase its leverage to increase return on investment, probably to a level even beyond where Ackman's proposal suggests. His proposal focuses on the underperformance of McDonald's company-owned restaurants, the fact that it had historically eschewed owning stores rather than franchising, and that McDonald's would better align itself with its franchisees if it didn't have company stores.
Why not just refranchise?
As part of the Pershing proposal, McOpCo, following its spinoff, would be in a position to optimize the value of its restaurants, by, among other things, refranchising them. So, rather than going through an IPO of McOpCo so that it could sell company restaurants to franchisees, would McDonald's be just as well off simply selling many of the company's 9,000 restaurants itself? Ackman estimates that the IPO of the 65% of McOpCo would net McDonald's $3.27 billion. That values each company-owned store at about $700,000, including net debt.
At present, the company generates royalties and rent payments that roughly average 13% of franchisee sales, plus it also would garner substantial revenues from the act of selling up-and-running, profitable restaurants. These revenues, by the way, are extremely high-margin. What would the company be able to generate by simply selling these stores to franchisees? After all, at the end of the day, if all McOpCo does is aggressively refranchises its stores out, then the end result of the IPO would be simply to speed up the process at the cost of some of the full value of the properties for McDonald's proper.
All of this said, I am convinced that McDonald's needs to divest itself of much of its company-owned restaurants. Given the beauty of McDonald's franchise economics for the parent company, and given the relative underperformance of company stores vs. those run by entrepreneurs, McDonald's investors should be hopeful that pressure by Ackman and ostensibly Vornado will help foment further creativity at the corporation.
Bill Mann is the co-advisor of the Motley Fool Hidden Gems newsletter. He owns shares in McDonald's. The Motley Fool is investors writing for investors.
