Seeking Alpha
Long/short equity, deep value, value
Profile| Send Message|
( followers)  

Summary

  • McDonald's stock has been steadily declining for the past year.
  • Through analyzing its fundamentals, it seems highly likely that McDonald's may be acquired by a financial sponsor.
  • The likelihood of McDonald's being bought out by a financial sponsor is supported with conservative assumptions regarding its top line growth, margins and capital expenditures.

Background

In the first part of my analysis on McDonald's (NYSE:MCD), I analyzed the company using a discounted cash-flow analysis and came to the conclusion that it was undervalued by at least 20%.

Now, I will be moving on to the second part of my analysis of McDonald's, where I will be analyzing the company using a leveraged buyout ("LBO") model.

First off, what is a leveraged buyout?

A leveraged buyout is a situation where a financial sponsor, purchases a company whole, using a mixture of cash and debt. In this scenario, the financial sponsor, usually a private equity firm, is able to earn a suitable return on its equity contribution (the cash it has contributed to the deal) by taking on a disproportionately high amount of debt. A financial sponsor usually measures the financial attractiveness of an investment using a metric known as the internal rate of return ("IRR"). Most financial sponsors seek a 20%+ IRR.

Why does this concern the individual investor? You may ask.

Well, the reason is simple. When a financial sponsor seeks to acquire a target company, it has to offer the target company a control premium over its current trading price. The reason for this is simply because, no company would ever sell itself whole at its current trading price - there simply is no incentive to do so.

Thus, when a financial sponsor announces it is acquiring a target company, the target company's share price will jump to the financial sponsor's offer price, reflecting the fact that a deal may go through. Hence, the individual investor can earn a decent return by identifying companies that would be suitable LBO candidates.

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

LBO

So how do we model out an LBO scenario? Well, first let us think about what happens during an LBO.

In an LBO situation, all of the target company's outstanding shares are being acquired by the financial sponsor, using debt to finance a large portion of the purchase price.

Thus, there is a need to account for the interest expense originating from new debt.

When a target company is acquired, its balance sheet changes dramatically. Goodwill gets created, new debt is issued, old debt is retired, and the cash the company has on hand may be used in the transaction. Thus, there is need to account for these balance sheet adjustments too.

Furthermore, in order to balance the balance sheet, there is need to project the company's cash-flow statement, as cash at the end of year is frequently used as a "plug" to balance the balance sheet. In other words, without modeling out the cash-flow statement, we would not be able to balance the balance sheet, thus affecting our analysis of it.

So, what do we have to do?

A target company is being acquired, and for that to happen, a financial sponsor would require funds. Hence, there is a need to model out the sources & uses of funds so that one can clearly see where the funds came from, and what purpose do they have in the transaction.

The sources & uses of funds will also be used to make balance sheet adjustments to reflect the LBO transaction.

Next, due to the target company taking on new debt, there is need to account for this. To do this, we need to model out a debt schedule, with reasonable assumptions regarding the amount of debt, type of debt, interest rate, LIBOR spread, et cetera.

After that, we would need to include this new interest expense in the target company's income statement projections so as to calculate EBITDA. The reason we need to calculate EBITDA is due to the fact that most financial sponsors use EBITDA as their preferred valuation metric in the context of an LBO transaction.

Next, we would need to model out and project the cash-flow statement to balance the balance sheet, and also to project the balance sheet itself to analyze how the target company's assets and liabilities change over time.

Lastly, we would need to model out a returns analysis in order to conclude whether the transaction is financially attractive to a financial sponsor, to determine the likelihood an LBO occurring. The higher the potential returns, the more likely an LBO will occur and the higher the likelihood that an individual investor can earn a decent return by "arbitraging" between the target company's current share price, and the purchase price the financial sponsor has offered to acquire the target company.

(click to enlarge)

Source: SEC Filings

As seen above, we have calculated McDonald's current equity value, enterprise value, its trailing twelve months ("TTM") EBITDA, funds required, et cetera.

The reason why we need to calculate McDonald's equity value and enterprise value is so that we can determine an appropriate offer price. I have assumed a reasonable control premium that a financial sponsor would be willing to pay (20% over the current trading price).

By calculating a company's TTM EBITDA, we can arrive at a Enterprise Value / EBITDA ("EV/EBITDA") entry and exit multiple. For this analysis, I have conservatively assumed that the entry and exit multiple is the same. The reason why there is a need for an exit multiple is because, in order to realize a return on their investment, a financial sponsor would sell the acquired company after a few years, thus with an exit multiple, we can gauge what that selling price would be.

As an LBO transaction is an extremely complex transaction, which involves lawyers, investment bankers and financiers, there a need to pay these people for their work, and hence I have assumed their fees as a percentage of the purchase price.

Moving on to the sources & uses of funds, the above picture clearly shows where the funds are coming from (sources), and how they are going to be utilized (uses).

As an LBO transaction involves a disproportionate amount of debt compared to the equity contribution, I have assumed that the purchase price would be financed using 75% debt. This is a reasonable assumption as due to the current state of the capital markets where interest rates are low, it is relatively easy to obtain the required debt financing. As McDonald's has some cash on hand on its balance sheet, I have assumed that this cash would also be used to finance the LBO transaction.

As for the debt portion, I have assumed that McDonald's would take out a revolving credit facility (a facility that acts as a credit card for a company to finance its ongoing operations, if the need arises), an amortizing term loan ("Term Loan A"), an institutional term loan ("Term Loan B"), and a subordinated note.

I have also assumed that term loan A would comprise of 50% of the total debt raised, term loan B, 30%, and subordinated note, 20%. The reason for this assumption is due to the fact that term loan A is usually secured by the target company's long-term assets, usually property, plants & equipment ("PP&E") and has first lien priority in an event of a liquidation. Thus, due to the collateralized nature of term loan A, it would result in a higher demand by debt investors (usually banks). Term loan B, in comparison, is also secured by collateral, but has a second lien priority in a liquidation scenario. Hence it has a lower demand amongst debt investors. Subordinated note as a portion of total debt raised is the lowest due to the fact that it is a high-risk / high-return security, and most debt investors would not be comfortable allocating a large portion of their funds to such a high-risk instrument.

The cash proceeds from McDonald's cash on hand, term loan A and B and the subordinated note, is used to finance the equity purchase price, refinance existing debt, and pay legal & miscellaneous fees, financing fees, and advisory fees.

Although the numbers for the debt may be pretty alarming, keep in mind that the debt financing portion of the purchase price is syndicated to many banks, hence risk is spread over a large number of banks.

(click to enlarge)

(click to enlarge)

(click to enlarge)

Source: SEC Filings

As seen above, I have modeled out McDonald's debt schedule, using the assumptions I have outlined previously.

First, I start out with projecting the forward LIBOR curve, quoted in 3-month LIBOR terms, as most bank loans are quoted on a LIBOR + a reasonable spread basis.

I have assumed that LIBOR is 0.25% in 2014, and increases by 0.25% each year after that. This assumption is supported by the fact that the Federal Reserve has hinted that it would raise interest rates soon.

As for calculating cash flow available for debt repayment and cash flow available for optional debt repayment, there is a need to calculate this to clearly show whether McDonald's is able to sustain interest and principal repayments of its debt. Cash flow available for debt repayment is calculated by taking the sum of cash flow from operations and investing. Cash flow available for optional debt repayment is simply calculated by subtracting mandatory repayment from cash flow available for debt repayment.

As for the revolving credit facility ("revolver"), I have assumed it to be 25% of the total funds required. The revolver would have a small spread of 1%, a LIBOR floor of 1%, a commitment fee of 0.5% of its total, an administrative agent fee of 0.25% of its total, a tenor of 9 years, and it will mature in 2022.

The reason for the small spread assumption is due to the fact that the revolver has the highest priority in the capital structure, thus has the lowest risk. The reason for a LIBOR floor is due to the fact that banks do not want the risk of their return below a certain number (usually 1-3%), thus a LIBOR floor would prevent that. If LIBOR is below 1%, McDonald's would still pay 1% + spread on its bank debt.

The reason for commitment fees and administrative agent fees is due to the fact that when a bank offers a company a revolving credit facility, there is a chance that the company does not use said facility, but banks still need to provide that commitment, hence tying up its capital. Thus, in order to compensate banks for promising to provide capital, McDonald's would have to pay a commitment fee on the unused portion of the revolver. An administrative agent fee is required as banks require agents to handle administrative matters regarding the use of the revolver.

In our analysis, McDonald's barely uses the revolver (it draws $216mln in 2014, and repays that in 2016).

As for term loan A, I have assumed a spread of 2%, LIBOR floor of 1%, mandatory yearly amortization of 5%, a tenor of 6 years, and a maturity year of 2019.

The reason for a mandatory yearly amortization is due to the fact that banks want to reduce their risk and hence issue amortizing term loan, which as their name suggests, amortize yearly.

In our analysis, McDonald's will pay off about $13bn of its term loan A, and supposedly refinances after the maturity of the loan.

As for term loan B, I have assumed a spread of 3%, LIBOR floor of 1%, mandatory yearly amortization of 1%, a tenor of 7 years, and a maturity year of 2020.

The reason for a higher spread compared to term loan A is due to the fact that term loan A is more senior than term loan B in terms of the capital structure and priority in liquidation scenarios. The reason for a tenor of 7 years instead of the 6 years term loan A is due to the fact that banks are much more comfortable if their loans are the first to be repaid.

In our analysis, McDonald's pays off approximately $6bn of its term loan B, and supposedly refinances after the maturity of the loan.

As for the subordinated note, I have assumed a spread of 7%, no LIBOR floor, a tenor of 9 years, and a maturity date of 2022. The reason for the high spread is due to the fact that debt investors needs to be compensated for the high-risk they are taking by investing in the subordinated note issued by McDonald's. Subordinated notes are inherently riskier compared to term loan A as they have a junior claim to a company's assets in the event of a liquidation.

In our analysis, McDonald's solely pays interest on the subordinated note as investors who invest in subordinated notes do not want their capital repaid over time, only at maturity. The reason for this is because they do not want to face reinvestment risk, the risk of not being able to find a suitable investment to allocate capital to.

Now that we have modeled out the deal assumptions, sources & uses and debt schedules, we move on to projecting our income statement, balance sheet and cash flow statement.

(click to enlarge)

Source: SEC Filings

As seen above, I have projected McDonald's income statement for 10 years into the future, using assumptions from my previous article, and then freezing the values after year 5. The reasoning is also further elaborated in my previous article.

Total revenues are projected to grow from $28bn in 2013 to $31bn in 2023.

Total costs & operating expenses are projected to increase from $19bn in 2013 to $22bn in 2023.

Total interest expense is projected to decrease from $4.6bn in 2014 as a result of taking on new debt to finance the LBO, to $2.1bn in 2022, reflecting the decreasing interest payments as the principals of term loans A and B are amortized over time.

Commitment and administrative agent fees are also accounted for.

By subtracting costs & operating expenses, interest expense and commitment and administrative agent fees from total revenues, we arrive at operating income, which is projected to decrease from $8.7bn in 2013 to $4.2bn in 2014, to reflect the large debt repayments as a result of taking on new debt. Operating income then increases from $4.2bn in 2014 to $10bn in 2023.

Net income, obtained by subtracting taxes from operating income, is projected to fall from $5.5bn in 2013 to $2.8bn in 2014, reflecting debt repayments, and increase from $2.8bn in 2014 to $6.7bn in 2023.

(click to enlarge)

(click to enlarge)

Source: SEC Filings

As seen above, I have adjusted the balance sheet to reflect the LBO transaction, projected the balance sheet line items, and balanced the balance sheet. The underlying assumptions and reasoning regarding several line items are elaborated on in my previous article.

McDonald's pro forma 2013 cash balance is zero, reflecting the entire use of cash on hand to finance the LBO transaction. It remains zero in 2014, and increases to $17bn in 2023.

Accounts and notes receivable, inventories, prepaid expenses and other current assets do not have any pro forma adjustments as they are not affected by the LBO transaction.

Accounts and notes receivable are projected to increase from $1.3bn in 2013 to $1.5bn in 2023.

Inventories are projected to increase from $124mln in 2013 to $162mln in 2023.

Prepaid expenses and other current assets, and capitalized financing fees remain flat in future years as they are not reflected in McDonald's cash flow statement, and the same goes for other assets.

New goodwill is created as a result of the LBO transaction. The value is calculated by taking the premium of the equity purchase price over the current book value of equity, giving us $119bn in goodwill.

As for long-term assets, mainly PP&E, I have simply assumed depreciation and capital expenditures to be equal so as to not achieve a negative net PP&E balance.

Total assets are hence projected to increase from $154bn in 2013 to $171bn in 2023.

Accounts payable, income taxes, other taxes, accrued interest, accrued payroll and other liabilities, other long-term liabilities, deferred income taxes, et cetera are not affected in an LBO scenario and hence remain unchanged in pro forma 2013.

Accounts payable are projected to grow from $1bn in 2013 to $1.2bn in 2023.

Income taxes are projected to increase from $216mln in 2013 to $279mln in 2023.

Other taxes and accrued interest remain flat in future years as they are not reflected in McDonald's historical cash flow statements.

Accrued payroll and other liabilities are projected to increase from $1.2bn in 2013 to $1.4bn in 2023.

As we are assuming McDonald's debt pre-LBO is refinanced, we subtract its total, giving us a debt balance of zero in pro forma 2013. Term loan A, B and the subordinated note are adjusted in pro forma 2013 to reflect the fact that McDonald's is taking on new debt to finance the LBO.

Shareholder's equity is adjusted to reflect the wiping out of shareholder's equity pre-LBO (as McDonald's is assumed to be acquired in full by a financial sponsor) and replenished with the financial sponsor's equity contribution.

Total liabilities and shareholder's equity are projected to be the same amounts as total assets, thus balancing the balance sheet.

(click to enlarge)

(click to enlarge)

Source: SEC Filings

As seen above, McDonald's cash flow statement is projected 10 years into the future to arrive at an ending cash balance which will be linked to the company's balance sheet in the respectively years, "plugging" the gap and balancing the balance sheet.

Deferred income taxes, share-based compensation, other items, purchases of restaurant businesses, et cetera are not reflected as they are difficult to predict.

(click to enlarge)

Source: SEC Filings

As seen above, I have calculated the multiple of invested capital ("MOIC") and IRR for the financial sponsor, the two preferred return metrics of financial sponsors.

The reason why equity value is calculated is due to the fact that the financial sponsor would only own equity in McDonald's post-LBO, and this equity value increases as EBITDA increases, as prices are quoted on a EV / EBITDA basis.

As for MOIC, a financial sponsor would earn 1.4 times its invested capital if it exits 1 year after acquiring McDonald's and 2.6 times its invested capital if its exits after 10 years.

Regarding IRR, a financial sponsor would earn 40% IRR if it exits in the first year, which decreases over time to 10% in year 10.

Conclusion

From my analysis, I conclude that it is highly likely that a financial sponsor would acquire McDonald's as its projected returns, supported by conservative assumptions, exceed the returns requirements of financial sponsors in the first few years. Furthermore, such financial sponsors, mostly private equity firms would exit their investment after a few years to realize a return on their investment. Thus, this theoretical LBO is financially attractive to a financial sponsor if it exits its investment in the first 3 year, assuming that McDonald's achieve projected financial results.

This would then provide a decent return to an individual investor if they purchase McDonald's stock before the announcement of the LBO.

Some naysayers might disagree and argue that it is unlikely McDonald's would be acquired by a financial sponsor as it is such a large company. To that I say that M&A activity has been roaring since the start of the year with many large deals taking place (Vodafone-Verizon $130bn deal being one example). Hence, it is very likely that equally large deals would take place in the future.

My analysis on Excel can be found here.

Source: Why McDonald's Still Has Some Pep In Its Step: Part 2