This note was originally published November 18, 2014 at 07:19 in Restaurants
With the news of a large activist buying into MCD, we find it prudent to ask, “Will shareholders be saved?”
We think it’s going to be a long road. The last activist that was involved in MCD was successful, but not because they had an impact on management thought process.
What did Pershing see in late 2005?
- A concept squarely in the midst of a significant turnaround that resulted in over 110 months of positive global same-store sales growth
- MCD had a market cap of $42 billion and $20 billion in system-wide sales
- A real estate portfolio that was undervalued by $16 billion ($30 billion versus Pershing Square’s $46 billion estimate)
- A stock that was unnecessarily trading at a discount to its peers
- Three different businesses: franchise operations, company-owned operations and real estate
What did Pershing propose?
- Spin 65% of the McOpCo stores
- Spin out the real estate
- Use the proceeds and increase leverage to repurchase stock
What was McDonald’s response?
- They called it a mere exercise in financial engineering
- Claimed they had a unique business model
- Suggested it would disrupt the relationships it had with customers, franchisees and suppliers
- Management said friction costs would make a REIT cost prohibitive
- Pointed to potential unintended consequences
- Feared it would lose its “A” credit rating
In the end, the company never implemented any of Pershing's bold plans. Pershing's investment in MCD was successful, not because of the their ideas, but because the business was going in the right direction.
Here we are, ten years later, with another activist prepared to potentially knock on the door of MCD. In some ways, it’s a very different McDonald’s this time around. In others, it’s the same old story.
Last week, Jana Partners took a stake in MCD by accumulating 1.042 million shares, inclusive of calls. According to the investment manager’s website, “Jana typically applies a fundamental value discipline to identify undervalued companies that have one or more specific catalysts to unlock value. Jana can be the instrument for value creation by becoming an actively engaged shareholder.”
We understand why an activist would be attracted to MCD today:
- McDonald’s needs to undergo a significant restructuring
- McDonald's has approximately 6,500 company-operated restaurants that could be re-franchised
- Global same-store sales are declining and have been for quite some time
- The stock has under-performed the SPX by 14.5% over the past year
- Chipotle has grown from approximately 440 restaurants in 2005 to approximately 1,785 restaurants today and is leading a significant shift in consumer eating patterns.
- McDonald's must be pushed to aggressively adapt to the changes in the market place
The activist playbook in the restaurant space is generally confined to a couple of key moves. Get control of the board and do one, or all, of the following:
- Sell real-estate
- Cut SG&A
- Sell company-owned stores
- Sell other non-core assets
- Increase leverage and repurchase stock
In the case of MCD, we believe it will be very difficult to achieve any of these moves.
First, we don’t think the board is ready to give up on CEO Don Thompson (for now, at least). Second, selling real-estate will never happen at MCD; there is a chance, however, that the company sells some McOpCo stores. All told, we believe the latter is too small of a change and would not move the needle on profitability. Third, McDonald’s doesn’t have any non-core assets. And, fourth, we believe it is unlikely management will increase leverage because they like their credit rating where it is. This would likely be a unwise move, to be frank, because increasing leverage in a declining sales and margin environment is unlikely to create shareholder value.
Now, either Jana’s investment is just the beginning of a bigger position or they are making the call on a short-term improvement in the operating performance of the company.
We’re not sure what the play is here.
What we are sure of is that McDonald’s is unlikely to see a notable, short-term improvement in trends and that Jana’s position is too small to agitate for change. The truth is, none of the typical moves in the activist playbook will generate much value in this environment.
The biggest upside in MCD will come from fixing the core operations. With no disrespect to Jana, there is likely little they can do in this regard. If they did come up with a silver bullet it would take 12-18 months for it to be approved and executed. Lastly, we doubt the franchisee base will look kindly upon a hedge fund telling them how to run their business.
For this reason, we still think there is risk to the numbers in 2015 and remain bearish on MCD. We normally side with activists in the restaurant space, but we don’t see how one can make money in MCD right now.