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    MARKET EDGES

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The basic premise of wanting to be long MCD is a good one; but for us, it comes down to a matter of timing.  From where we sit, with an abundance of unknowns, it’s still too early.

McDonald’s is a great company with strong margins, significant free cash flow, and unmatched global scale.  It’s an iconic brand, but its image is tarnished and in need of a major overhaul that can only be led by an overhaul of the menu and the food it serves.  This is precisely why the company is trading at $97 today.  Despite this, there is one shareholder that thinks the stock is worth $169.  We love the bold thinking, but it’s unlikely to happen anytime soon.

Three of the top fifteen shareholders that own MCD can be classified as activists.  Given that the new CEO has taken the initiative to classify himself as an internal activist, or a constructive agitator, will the company be better managed?

We’re working under the assumption that these shareholders are directing the company to pull some levers to create shareholder value.  This was confirmed by yesterday’s meet and greet with management in NYC.

Glenview Capital Management recently put forward a very aggressive case for what MCD can do to unlock value.  No matter what they put forward, turning this company around will ultimately come down to fixing its operations.  Importantly, this is the part of the story that cannot and should not be influenced by an activist.  It will also force the CEO to make difficult, strategic decisions that will be disruptive to how the company operates today.

The Glenview (and consensus) bull thesis goes something like this:

OPERATIONAL TURNAROUND

Glenview Capital Management: “McDonald’s same-store sales turned negative due to strategic misdirection, operational inefficiencies and disenfranchised franchisee.  We believe that each one of these is a solvable problem and our proprietary research in the channel and conversations with management suggest they are already being addressed, which should allow for a return to positive same-store sales.”

Hedgeye: We agree MCD can be fixed operationally.  The bigger question is how long it will take and what will it take to return to positive same-store sales?  How deep are the operational issues?  Will management address the health of its franchisees?  Our proprietary check into McDonald’s franchisees suggests that these issues are much deeper than most think.  The bigger issue revolves around how much blood management can extract from the proverbial stone.  At this point, the franchise system is not seeing “renewed enthusiasm” in the field and, in fact, franchisees are still very concerned about what the recovery will look like.  Consumer perception of the brand remains a huge issue.

Verdict: Glenview target price reduced by $11.  There is little evidence of a turnaround.  At the very least, it will not manifest into increased profitability until late 2016.

SG&A EXPENSE RATIONALIZATION

Glenview Capital Management: “The bull case says that MCD can cut $500 million of the $2.5 billion in SG&A spending.” 

Hedgeye: Once again, we agree that MCD is a bloated company relative to its peer group and there is a significant opportunity to cut costs.  Given the current management team and construct of the Board of Directors, MCD likely won’t come close to realizing the potential G&A cuts.  This type of change would require running the company with a significantly different mentality than anyone at McDonald’s is used to.  For this reason, we don’t believe this is in the cards anytime soon.  Additionally, a sizeable part of any G&A savings will need to be reinvested in the business to help improve assets and the quality of the food.

Verdict: Glenview target price reduced by $11.

REFRANCHISING

Glenview Capital Management: “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 overtime 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 McDonalds has not.”

Hedgeye: Management has disclosed their intentions on refranchising, a position we believe they are unlikely to shift from.  The premise of the thesis here is that refranchising will lead to a higher multiple, given the more asset-light nature of the business.  For the most part, MCD U.S. is already an asset-light business model and, unfortunately, it’s not the right time for MCD to be refranchising its company-operated store base.  The company needs the store base right now, because it needs to prove to franchisees that the investments they are making to improve operations will result in the intended lift in sales and profitability.  It’s clear from our discussions with the McDonald’s franchise community that the system is very reluctant to incur incremental costs to fix the asset base until management proves the ROI.  Lastly, even the new CEO will have a difficult time getting the Board to approve this radical change in direction for the company.

Verdict: Glenview target price reduced by $14.

BALANCE SHEET OPTIMIZATION

Glenview Capital Management: “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 an investment grade rating and as much as 50% of the market cap if they choose to match the leverage levels of burger peers, QSR and WEN.”

Hedgeye: The potential for balance sheet optimization can be lumped into the same category as SG&A cuts and refranchising.  All three are real opportunities, but all three are highly unlikely given the current Board of Directors.  We don’t believe the new CEO and current Board will leverage the company to the degree that other asset-light companies have done.  That’s simply not the McDonald’s way.  It would represent a major shift in thinking at the company and there are no signs it will move in this direction.

Verdict: Glenview target price reduced by $12.

REAL ESTATE MONETIZATION

Glenview Capital Management: “Given that REITs are trading at almost 20x 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.”

Hedgeye: We believe this entire topic of McDonald’s potential real estate opportunity is overblown and, on some level, flawed.  The Glenview letter is short on details and ignores some very important issues.  If those doing the analysis spent more time studying McDonald’s business model, they would better understand how the real estate and franchise sides of the business work together.

First, it appears that people believe McDonald’s is charging below market rents to franchisees.  This is simply not true – actual rent payments are far above market rates.  This would not be allowed under a publicly traded REIT.  If MCD gets a significant chunk of their revenues from rent paid by franchisees, how will a REIT further monetize real estate?  Raise the rent to franchisees?  They can’t.

Second, many properties are already encumbered by the franchise agreements in place at each and every location.  McDonald’s has no power to modify or force a renegotiation of these terms.  They can certainly sell the underlying properties into a REIT, but we fail to see how they can monetize this without charging higher rent.  And if they sell this underlying property, McDonald’s is still responsible to the franchisee for the remainder of the franchise term.  They can sell or assign their rights, but not their responsibilities.

The dirty little secret that no one talks about is ongoing rumors that there is a “secret MCREIT” that MCD set up with six of their suppliers 20 years ago.  According to industry insiders, the suppliers bought real estate and leased it back to MCD with zero transparency to shareholders.  How much of the leased land and buildings are already owned by this “secret MCREIT?”

Verdict: Glenview target price reduced by $25.

UPSHOT

Our target price is closer to $96, a far cry from the $169 target put forth by Glenview Capital Management.  We see downside/upside potential to $83/$112 per share, respectively.

MCD: Putting the Activist Thesis to the Test - 1