McDonald's Has Powerful Hidden Free Cash Flow

 |  About: McDonald's Corporation (MCD)
by: The Dumb Money

I do not own a ton of McDonald's (NYSE:MCD) stock. I wish I owned more. McDonald's has been an American institution since the Eisenhower Administration, and it famously reinvented itself in the last decade. It spun off Chipotle (NYSE:CMG) in 2006. (CMG has proven to be a very powerful investment in its own right.) McDonald's decided in 2004-2006 to focus on its core brand. It introduced new coffee drinks, spruced up its stores, focused on international expansion, changed its thematic color scheme in its restaurants and elsewhere from bright red-and-yellow, to a more muted and of-its-time yellow-and-creme/beige. And this has succeeded: McDonald's has grown like crazy and has expanded its margins.

The question now is whether McDonald's remains a good buy. The answer is a qualified "yes." McDonald's is generating a lot free cash flow that is disguised by its investments in new growth.

For me, a discounted free cash flow analysis is the cornerstone of all of my corporate valuation analyses. I combine that with a more qualitative analysis of a company's corporate strategy, its competitive prospects, etc. And I only tend to get to these analyses at all if I have concluded previously that the company has above-average returns on equity and assets and low or sustainable debt loads. (It is important to look beyond returns on equity, using a Dupont Analysis, because financial leverage can sometimes disguise a fundamentally weak competitive position.)

So anyway, here is my most up-to-date discounted free cash flow analysis spreadsheet for McDonald's:

As the sheet shows, McDonald's historical free cash flow, from 2002 through 2011, was 33% annualized. 33%? Wait a minute.... From 2007 through 2011 the sheet shows is it only about 4% annualized growth? What is going on? Why that much slowing? Run for the hills. What should we use for our growth assumptions going forward?

Hold the phone, ladies and gentlemen. What you are seeing here are two things: 1) you are seeing the result of McDonal'ds turnaround in the mid-aughts, and 2) you are seeing a company that was investing in growth, and for which the standard free cash flow calculation is likely inaccurate.

The standard free cash flow calculation looks at all cash from operations and deducts capital expenditures. These are numbers on any standard cash flow sheet reported by the company. The problem is that the capital expenditures line on any company's cash flow statement does not distinguish between maintenance spending versus spending for new growth. Here's the thing: spending for new growth should not logically count against this year's net income for the purpose of reducing this year's free cash flow. One of the best explanations of this, though it's getting to be an old post at this point, is here.

McDonald's is a perfect example of this paradox. The alternative way to calculate free cash flow, popularized by hedge fund manager Joel Greenblatt, is to take cash flows from operations, just like normal, but then subtract the lesser of depreciation, or capital expenditures. The theory behind this is simple: one way of thinking about depreciation is that it represents the portion of the company's pre-existing equipment that becomes obsolete or otherwise inoperable every year. Thus, all things being equal, the portion of capital expenditures that is mere maintenance spending should equal the depreciation allowance. Now, it is true that companies can fudge this to a certain extent in either direction in the short term; but in the long term, it is generally thought to even out.

If you use this alternative measure of free cash flow for McDonald's, a very different picture emerges. Rather than seeing 33% annualized cash flow reduced to 4% annualized growth in the past few years, you see "only" 13.47% annualized free cash flow growth from 2002 through 2011. But you see a much larger 11.87% annualized growth from 2007 though 2011. McDonald's has been and is still investing for growth.

This makes a big difference. I assume a discount rate of 9% for McDonald's, which is based on one decent estimate of its WACC. If you look at the first calculation, you will think McDonald's is only growing its free cash flow at 4% annualized. At that rate (assuming no slowing), McDonald's is only worth about $68.75/share. That seems amazing. But if you use the Greenblatt method, to account for investments in new growth, assume a slight slowing of growth to 8% annualized, and the stock is worth $115.85, and is 15% undervalued. The sheet is currently set up to reflect this set of assumptions.

I don't know how fast McDonald's will grow. I think it's prudent to assume its growth will slow down now that it has had its recent productivity burst. But I'm willing to bet it can grow at an 8% annualized for ten years, net of new investments in growth. At that rate, since I like a 20% margin of safety, it is a buy at anything under about $92.50/share. Thus, sadly, it's not quite a screaming buy right now, under these assumptions, but it's not far off, and in fact, there is an excellent argument that even after all of the share price appreciation McDonald's has experienced in the past three years, it remains a great buy.

Disclosure: I am long (MCD). I have no plans to add or sell within the next 72 hours