McDonald’s (MCD) is on our Hedgeye Restaurants Best Ideas list as a LONG.
Our long standing view has been that the inflection point for the MCD turnaround will be 3Q15. We are now two days away from that event and the confidence in our call remains very strong. McDonald’s is a resilient company and its new leadership team is making some significant changes to how the company is being run.
The company will also be hosting an analyst meeting in NYC on 11/10/15. On the earnings call, I believe the company will defer questions about the long-term strategy to the analyst meeting. Importantly, at the analyst meeting the company will outline the decision on what to do with the company’s real estate holdings. I now believe that there is a greater than 50% chance the company will likely create a more efficient tax structure with its rental revenue stream.
WHAT THE STREET IS LOOKING FOR IN 3Q15
THE BULL CASE FOR MCD
Optimize the menu to offer customers their favorite food & drinks more effectively
- Shrink the menu, improve existing products, develop new products, adjust pricing, create more excitement about the food
- All Day Breakfast
- Improve the value message: At the analyst meeting the company will discuss a national value platform in the U.S.
Transformation of the customer service experience
- Modernizing the interaction between MCD and the customer to create a memorable experience. Self-ordering kiosks are a great experience for the customer, and they allow the kitchen to operate more efficiently.
Refranchise and close stores
- Eliminate underperforming stores to cut costs and improve profitability, leading to improved industry metrics.
Manage complexity of restaurant operations
- With everything management has added to the restaurants, it was getting too complex, keep it simple.
- New training programs for employees to improve accuracy and experience for the customer and employee.
- The company has completed the installation of smaller drive-thru menu’s
Financial strings to pull
- Refranchising and store closures must lead to sizeable SG&A savings at corporate
- Financial engineering, potential to lever up and buy back more shares or increase the dividend
- Reduce capital spending to improve ROIIC. (We should begin to see the impact of this in 3Q15)
HEDGEYE ESTIMATES FOR 2016 & 2017
MCD EPS peaked at $5.55 in FY13, and will earn $4.75 in FY15, down 15% from the peak. Street estimates have MCD earning $5.15 in FY16. As it stands today, our estimates are for MCD to post a near record tying EPS in FY16 of $5.40-$5.60 with $6.00 being a real possibility. The potential for $6.00 is dependent on how aggressive the company gets with any additional G&A cost cutting to be announced at the upcoming analyst meeting.
THE NYC ANALYST DAY ON NOVEMBER 10TH
I expect the mood at the analyst day in NYC will be very upbeat (following the better than expected 3Q15 performance) and the momentum being experienced internally given the major changes that are taking place at MCD. In addition, the tone of how CEO, Steve Easterbrook will manage the business going forward was set in his first 100 days as CEO of MCD:
- “everything is in play”
- "constructive agitator"
- “internal activist”
- “I’m honest and fair and don’t dispense forced kindness”
- “We will try new things, move fast with what works and even faster from what doesn’t”
- “We’re making the business more responsive to market conditions by using our scale advantage more effectively, we cannot afford to carry legacy attitudes and legacy thinking, and we won’t”
Some of the themes we expect to hear at the NYC Analyst day
AWARENESS – The new corporate structure is changing the way McDonald’s does business around the world for the better. What to look for:
- We are expecting MCD to make additional SG&A cuts. There are significant opportunities to cut from the estimated FY15 $2.3 billion spent in this line item.
- The new structure is accelerating the innovation pipeline. Leaders are more in touch with their regions than ever before, giving them greater ability to share best practices across like markets.
RATIONALIZATION/SIMPLIFICATION – There are parts of this that MCD has already talked about but there is so much more to focus on.
- Stores – store closings (already announced)
- McCafé – Please no espresso drinks (should be addressed)
- Cost Cutting – as per above there will be more G&A cuts
- Changes to the Menu – In addition to McCafé, management will talk about regional simplification to its menu
SUSTAINABILITY – Will McDonald’s compete effectively in the consumer centric world of sustainable food?
- We think so, McDonald’s is improving their food, from the source to how it is prepared. They have committed to using cage free eggs by 2025 and they pledged to move towards antibiotic free chicken within two years.
REAL ESTATE – Could this be the year!
The big news coming from this year’s analyst meeting will be what the company has decided to do with the company’s massive real estate holdings.
If the current pattern of behavior holds true the company will be looking to alter its real estate holdings. For over 50 years many people including myself said MCD can’t sell breakfast all day. I have also said they will never do anything with their real estate. I was wrong about and breakfast and chances are I will be wrong about the real estate too.
I imagine there are others who are working overtime to help the company see the value that can be created by changing the structure of the real estate. According to FactSet, there are two large shareholders of McDonald’s who are classified as “activism threat level is high.” I assume both of them want MCD to think differently about the real estate.
I also found it out of character that a McDonald’s Board member would give a quote to the WSJ about the review process. McDonald’s Board member Miles D. White said on Thursday, “McDonald’s board and management haven’t made a decision yet, but we have had a lot of review and a lot of debate.” Mr. White is chief executive of Abbott Laboratories and head of the corporate-governance committee for the McDonald’s board. Why was he speaking on behalf of the company one week before they report earnings?
Between 2008 and 2011 there has never been a need for the company to do anything with the real estate, because the business was strong. Since the business began to decelerate in 2012, the real estate rumors have become more pronounced. The CEO at the time, Don Thompson, did not have the internal mandate to make those types of changes. Under CEO Steve “everything is in play” Easterbrook, the odds of the company changing the structure of the real estate have gone up significantly.
The issue at hand is the company’s ability to re-arrange royalty rates with franchisees. The company generates over $6.0 billion a year in rental income with operating margins running north of 75%. This is all taxable at the effective tax rate of 32%. If the company can structure an internal REIT to own the rental stream the company could save billions in taxes, creating substantial shareholder value. As a general rule, for every $500 million the company can save in taxes (at 22x) it creates an $11 increase per share in shareholder value.
Objections to altering the real estate structure in the past have centered on giving up control of the real estate and preservation of its credit rating. If the company can establish a REIT to shelter its rental income, while controlling the real estate and maintaining its credit profile everybody wins!
Please call or e-mail with any questions.
Howard Penney
Managing Director
Shayne Laidlaw
Analyst
