In Glenview Capital Management’s 4th quarter letter they break down their investment thesis in McDonald’s (MCD) and the steps they think the company can take to reach a value of $169 per share.
1) Operational turnaround. While the broader category continued to generate positive same store sales in 2013 and 2014, McDonald’s same store sales turned negative as a result of strategic misdirection, operational inefficiencies and disenfranchised franchisees. We believe each of these three components is a solvable problem, and our proprietary research in the channel and conversations with management suggest they are already being addresses, which should in time allow for a return to positive same store sales growth. We expect the strategy pivot to become more customer focused as evidenced by recent food quality improvements and the reduction in regional layer of organization, which will allow for greater localized decision making closer to the customer. A simplified menu and product innovation calendar should drive operational efficiencies as well as improve the customer experience. Importantly, we also believe the change in management has catalyzed renewed enthusiasm among the franchisees that will result in better execution in the field. Franchisees may find further motivation to improve execution should management take a carrot and stick to offering top performing franchisees company owned stores as part of potential refranchising efforts or stores operated by underperforming franchisees that are pruned from the system.
2) SG&A expense rationalization. McDonald’s spends $2.5 billion per year on SG&A which equates to $69,000/store and compares to best in class peers that spend merely 25% that amount on a per store basis. While the company does not provide high level of visibility into this $2.5 billion annual spend bucket, we find the current spend level difficult to justify. Even after adjusting for real estate ownership expenses, higher company owned mix and higher average unit volumes, we think there is roo for at least $500M of cost savings especially given the size of the company which should drive material economies of scale.
3) Refranchising. McDonald’s continues to operate 19% of its stores but, particularly as growth slows, there are increasingly fewer business reasons to own and operate this many company stores, especially when it can serve as a distraction or even stunt consolidated profit growth during tough times. Currently, McDonald’s mix is below almost all major peers despite some having demonstrated the viability of a nearly 100% franchise model. Refranchising has a minimal impact on EPS when consummated in a rent-adjusted leverage neutral basis, but the improved quality of the less capital intensive and more stable earnings stream has been consistently and appropriately rewarded in the market via improved valuation. Multiple case studies point to both an immediate recognition upon announcement as well as over time as the plan is executed, and McDonald’s stagnant franchise mix over the past five years has contributed to a valuation that was at the high end of its peers five years ago but now ranks as the cheapest in the group as others have capitalized on the opportunity while McDonald’s has not.
4) Balance sheet optimization. At 2.6x rent adjusted leverage, the company’s current capital structure is inefficiently conservative when considering the high quality, stable and defensive nature of the business and a material real estate portfolio that is still presently owned. With accommodating credit markets providing access to generationally low interest rates, as evidenced by McDonald’s 30 year debt yielding slightly below 4% pre-tax or 2.6% after tax, we believe McDonald’s could return approximately 25% of the market cap to shareholders through the end of 2016 while still maintaining investment grade rating and as much as 50% of the market cap if they choose to match the leverage of burger peers, QSR and WEN.
5) Real estate monetization. Unique to the industry, McDonald’s owns 45% of the land and 70% of the buildings for its restaurants. using the current rental rates McDonald’s charges its franchisees, we believe the earnings power of these real estate assets as a standalone entity would be equivalent to approximately 50% of current consolidated EBITDA. Given that REITs are trading at almost 20 x EBITDA, we do not believe this is reflected in McDonald’s current 12x EBITDA valuation, and we believe management efforts to monetize or illuminate this could unlock at least $20 billion of value.
While operational changes may not result in an instantaneous inflection as it may take time to get credit from consumers and the CEO, who just officially assumed his post less than two weeks agao, may want a short learning period before taking action, we think the shape of events will continue to strengthen over the course of the year. Operationally, comparisons will ease and headwinds from supply chain issues should fade followed by fundamental traction from new initiatives. Increased investor interaction with the CEO should help build confidence in the present and will hopefully be soon followed by a public articulation of management’s vision for the company. Given the exceedingly large potential for value creation from a playbook that has been successfully implemented at peer companies, a CEO who did a good job running the U.K. business and appears to embrace change and a Board that ahs recently moved to an annually elected schedule, we would be surprised to not see material progress made on the initiatives we outlined above, which we believe could support a $169 price target, making shares of the purveyor of the dollar menu even cheaper as we see them as 57c dollar bills.
Glenview Capital Management Q4 2014 Letter (Link)