Why McDonald's Still Has Some Pep In Its Step: Part 1

Mar.25.14 | About: McDonald's Corporation (MCD)

Summary

McDonald's stock has not been doing well for the past year.

Through analyzing its fundamentals, it seems that McDonald's is undervalued by at least 20%.

McDonald's implied value is supported with extremely conservative assumptions regarding its top line growth, margins and capital expenditures.

This article will be split into 2 parts. The first part of the article will consist of my analysis of McDonald's (NYSE:MCD) using a DCF model. The second part of the article will consist of my analysis of McDonald's using an LBO model.

Background

Click to enlarge

Source: Google Finance

As seen in the above chart, McDonald's is down 4.21% in the past year, and approximately 10% from its 52-week high of $103.70.

In a low-interest rate environment, this should not happen. Due to low interest rates, companies should theoretically be able to finance their operations more cheaply, thus earning a higher return on invested capital.

Of course, many would cite other factors causing the stock's price to fall, however we should not stray from the fundamentals, which is that a stock should be valued according to the underlying company's future earning potential.

This brings us to the discounted-cash flow analysis.

DCF

The DCF is premised on the fact that a company should be valued according to the sum of its future free cash flows ("FCF"), discounted to the present with an appropriate discount rate.

How do we do this? It's actually very simple.

First, we need to define what free cash flow is.

Free cash flow is defined as the real cash that a company has on hand, obtained from its core operations, minus its mandatory reinvestment required to continue its operations.

Mathematically speaking, FCF = EBIAT + Non-cash charges (D&A, etc) + Changes in working capital - CapEx

Historical financials

Now, in order to predict a company's future FCF accurately, we need to analyze its historical financials in order to obtain a gauge for our forward assumptions.

First, we need to arrive at EBIAT, or Earnings Before Interest After Taxes.

The reason why it is before interest is due to the fact that we are valuing the company on an unlevered basis. The reason why it is after taxes is due to the fact that taxes are a mandatory payment if a business wishes to operate.

All figures are in millions of USD, except for per share data.

The below picture shows the revenue McDonald's has generated in the past three years.

Source: McDonald's SEC Filings

As shown above, McDonald's has had minimal growth in revenue during the past few years.

The below pictures shows McDonald's expenses, and how I arrived at EBIAT.

Source: McDonald's SEC Filings

As shown above, McDonald's expenses have remained quite stable in the past years.

From 2011 to 2013, food & paper has lingered around 22% - 23% of sales. Payroll & employee benefits is relatively stagnant at 17% of sales.

Occupancy expenses seems to be increasing by a small margin, from 15% to 15.6% of sales. This could be due to the recovery of the real estate market, hence pushing rental prices up. Franchised restaurant-occupancy expenses have similarly increased from 5.5% to 5.8% of sales.

Selling, general & administrative expenses have fallen a tad bit from 8.9% to 8.5% of sales.

Other operating income / (expense) has remained stagnant at 0.9% of sales.

This gives us a total operating cost & expense of about 69% of sales, resulting in an operating income of approximately 31% of sales as Operating Income = Revenue - Operating expense

Given that the line items above operating income have yet to include interest and taxes, Operating Income, in this case, will equal EBIT, or earnings before interest & taxes.

Next, we subtract taxes from earnings, to arrive at EBIAT, which is about 21% of sales.

Recalling our FCF formula of FCF = EBIAT + Non-cash expense + Changes in Working Capital - CapEx, next we have to add back non-cash expenses.

The reason why we add back non-cash expenses is due to the fact that these expenses that have been incurred, does not actually reduce a company's cash.

Let me give an example. Say a company purchases a property that is depreciating. It pays the upfront cost, and depreciates it over a period of time. During that period of time, the depreciation expense is continually incurred, due to the accrual rules of accounting, however, in actuality, the company's cash is not actually reduced. Thus, we add back non-cash expenses.

In the case of McDonald's, non-cash expenses are merely depreciation & amortization, deferred income taxes, share-based compensation, and other expenses.

The below picture shows these line items.

Source: McDonald's SEC Filings

As seen above, from 2011 to 2013, D&A has increased steadily from 5.2% to 5.6% of sales, probably due to the recovery of the housing market.

Deferred income taxes have decreased from 0.7% to 0.1% of sales.

Share-based compensation has remained stagnant at 0.3% of sales.

Other non-cash charges have hovered around -0.3% and 0.1% of sales.

Next, we need to adjust for changes in working capital.

The reason why we adjust for changes in working capital is simple. Working capital reflects the cash needed by the business to continue its operations, hence it is mandatory and needs to be accounted for.

Source: McDonald's SEC Filings

As seen above, accounts receivables have hovered between -1% of sales and 1% of sales.

Inventories, prepaid expenses and other current assets have remained relatively stable, merely moving 10bps in either direction.

Accounts payables, similarly to accounts receivables, is hovering around -1% and 1% of sales.

Income taxes and other accrued liabilities have similarly remained a tad above 0% of sales and below.

Now that we have accounted for changes in working capital, we are at our final step to calculate free cash flow, which is subtracting capital expenditures.

The reason why capital expenditures is subtracted to obtain FCF is because, capital expenditures are a mandatory expense of a business as most if not all businesses need to continually replace its property, plants and equipment ("PP&E") due to wear and tear.

Source: McDonald's SEC Filings

As seen above, after accounting for EBIAT, non-cash expenses, changes in working capital and capital expenditures, we arrive at a FCF value of $4.9 billion, $4.3 billion and $4.6 billion for the years 2011, 2012 and 2013 respectively.

Projections

Now that we have established a base platform for McDonald's historical financials, we can use that to project its future earning potential.

The below picture shows the revenue projections I have assumed for McDonald's 5 years into the future.

The reason for merely projecting 5 years into the future is due to the fact that beyond that, it becomes extremely difficult to predict future revenue growth and earnings.

Click to enlarge

Source: McDonald's SEC Filings

As seen above, I have assumed an extremely conservative growth rate of 3%, declining 0.5% year-to-year, for McDonald's, for the years 2014 to 2018.

The below pictures shows the cost projections I have assumed for McDonald's 5 years into the future.

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Click to enlarge

Source: McDonald's SEC Filings

In the above, I have assumed that McDonald's costs and expenses remain relatively stable 5 years into the future by taking the average cost & expenses of the previous 3 years, due to their relative stability.

Click to enlarge

Source: McDonald's SEC Filings

In the above picture, I have arrived at my EBIAT projections for McDonald's, based on my previous assumptions.

Click to enlarge

Source: McDonald's SEC Filings

Similar to my previous projections, I have assumed the average of the previous years due to stability for changes to working capital and capital expenditures, to arrive at an unlevered free cash flow value, which increases from $4.5b to $4.9b from the years 2014 to 2018.

Discounting free cash flow to its present value

Now that we have arrived at FCF values, we need to discount them back to the present using an appropriate discount rate.

Since this analysis is an unlevered free cash flow analysis, it is before the payments of interest, thus both equity and debt holders have a claim to the company's cash flow.

Thus, the discount rate is split into two parts, the cost of equity, and the cost of debt.

To calculate the cost of equity, I will be using the capital-asset pricing model ("CAPM"), the most widely-used formula in the industry.

Cost of equity = risk-free rate + (equity risk premium * beta)

For the risk-free rate, I will be using the US 30y bond as a proxy, sourced from Google Finance on 22/3/2014.

For the equity risk premium, I will be using a value sourced from Ibbotson, who measured the equity risk premium from 1926-2002.

McDonald's beta is sourced from Google Finance on 22/3/2014.

Source: McDonald's SEC Filings

As seen above, I arrive at a cost of equity of 6%.

Regarding cost of debt, I calculated it by taking the weighted average interest rate of all McDonald's outstanding debt, as shown below.

Source: McDonald's SEC Filings

As seen above, I have arrived at a cost of debt of 4.3%. Since debt requires periodic interest payments, and interest expenses are tax-deductible, I have obtained the after-tax cost of debt of 2.9% by taking the cost of debt * (1- tax rate).

Source: McDonald's SEC Filings

As seen in the above, I have calculated a weighted average cost of capital ("WACC") of 4.54% for McDonald's.

Click to enlarge

Source: McDonald's SEC Filings

As seen above, I have discounted McDonald's unlevered free cash flow for the years 2014 to 2018 to obtain the present value of FCF and summed them together.

Due to the fact that a company does not simply cease to exist after 5 years, we need to approximate its earnings growth after 5 years, into perpetuity, to arrive at a value known as the Terminal Value ("TV") where TV = FCF / (WACC - G)

G = Long-Term Growth Rate

To do this, I have selected the number 3.2% as the long-term growth rate, which is similar to the long-term GDP growth rate.

Thus, I have arrived at a terminal value of $108b. As this is a future value, there is a need to discount it to the present, which I have, thus arriving at a present value of TV of $104b.

Summing the present value of TV and present value of the sum of unlevered free cash flows, we arrive at an Enterprise Value of $125b.

Arriving at an implied share price

As a company's share price reflects the value of the company to equity holders, there is need to remove debt holders from the equation.

To do this, we subtract net debt, preferred stock and non-controlling interests, to arrive at an equity value of $136b. Dividing this by McDonald's fully diluted shares outstanding, we arrive at an implied share price of $126, which represents approximately a 25% potential upside.

Are my numbers realistic?

You may be wondering that it is impossible for such a popular company like McDonald's to be undervalued by such a large margin.

However, consider this. In my assumptions, I have assumed very conservative growth rates, (3%, declining by 0.5% year-to-year) no improvements to operating margins (taking the average costs as a % of sales) and no reduction in capital expenditures, but in fact an increase, due to sales growing and capital expenditures remaining a stable % of sales.

These three key drivers account for a large amount of a company's value and hence play the most important role.

Conclusion

From this analysis, I conclude that McDonald's is undervalued by about 25% and has a lot of upside potential.

In the next part of my coverage on McDonald's, I will value McDonald's using a different valuation methodology, known as a leveraged buyout ("LBO") model.

Will my valuation of MCD using an LBO model support the DCF model? Or will they contradict each other? Stay tuned to find out more.

My analysis of McDonald's using Excel can be found here.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.