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Lester Goh's  Instablog

Lester Goh
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I am a polytechnic student based in Singapore, looking to break into investment banking. Email: lester_py@hotmail.com
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  • Microsoft: Right Strategy, Right Implementation

    In this article, Peter Kastner, a fellow contributor talks about how Steve Ballmer's announcement of transforming Microsoft (NASDAQ:MSFT) into a devices and services company is a bad move. Though this is not explicitly stated, it is implied.

    He first raises the point that Microsoft is not a "devices" company, saying that the company "gets credit for Xbox game consoles, mass-market mice and keyboards… nothing more."

    This is clearly incorrect as apart from the aforementioned products, Microsoft also sells its laptop/tablet hybrid, Surface, and Windows Phone.

    (click to enlarge)

    Source: SEC Filings

    As seen above, Surface and Phone accounts for approximately $5b of Microsoft's revenue, or about 5% of its total revenue. Though small, it has only been a short period of time since Microsoft have entered these markets. Given that the tech mammoth did not have first mover's advantage, I'd say that a few billion a year in revenue for is pretty impressive given its circumstances. It is true that these devices have hardly made a dent in their respective markets, amongst the likes of their substitutes. However, the company is gaining traction in those markets given the continuous increase in revenues.

    The next point Peter brings up is regarding the Nokia acquisition. In one of my articles, I examined the acquisition based on ROIC, a metric that I believe does a decent job of measuring core operating profitability, and concluded that in tech industry, acquisitions take time to bear fruit and that simply not enough time has passed to conclude that the Nokia acquisition was a failure.

    Finally, he talks about how Microsoft's IT services, which I presume is referring to cloud services is minuscule. That is also true. However, this segment is growing fast. In 2012, cloud revenue was $700m, 2013 $1.3b, 2014 $2.8b. Given the fact that the segment have been doubling its revenue every year, I'd say that it still has a lot of potential and is here to stay.

    Furthermore, given that Microsoft controls the cash cow which is Office that generates tens of billions in free cash flow for Microsoft every year, Microsoft clearly has a strong margin of safety to invest in new markets in an effort to expand growth. Contrary to what Peter suggests, this strategy of expanding product lines is clearly the right move for Microsoft as Office revenue growth have been slowing in recent years. However, the segment has provided Microsoft with the capital to invest in new projects, products and devices such as Surface and Cloud which are slowly growing the company's top line. Investors should rest easy knowing that management is doing a good job of improving the company's prospects

    Tags: MSFT, long-ideas
    Oct 07 4:54 PM | Link | Comment!
  • Why I Am Still Bullish On Apple Inc.

    In this article, I will value Apple Inc.(NASDAQ:AAPL), one of the world's most valuable companies, using a discounted-cash flow analysis.

    Background

    (click to enlarge)

    Source: Google Finance

    As seen above, Apple Inc.'s stock price has fallen from its all-time high of $700, and has been hovering around the $500-$550 range for about a year.

    There are many reasons why this is the case. Most cite Apple Inc.'s loss of the smartphone market share to Samsung. Others argue that the smartphone market is getting more saturated and hence there are lesser opportunities for Apple Inc. to increase its profits.

    However, no matter the case, we should not stray from the fundamentals of value investing, which is that a stock should be valued according to the ability of the underlying company to generate profits.

    Hence, the question is, how do we value a stock based on its future earning potential?

    This brings us to the discounted-cash flow analysis ("DCF").

    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.

    The reason why a company's future cash flows are discounted to the present is due to the time value of money.

    Let me use an example to explain. Suppose you are given a scenario in which you can choose to accept a dollar today, and a dollar a year from now.

    Obviously, you would accept the dollar today, right now, as it has more utility and is less risky. If you were to consider the option of accepting a dollar a year from now, instead of a dollar now, you would be facing inflation risk.

    Hence, the reason for discounting cash flows back to the present.

    This sounds a little complicated, but it is actually very simple.

    First, we need to define what FCF actually is.

    FCF is defined as the real cash that a company generates on a recurring basis, from its core operations, minus the mandatory reinvestment required to continue its operations.

    To illustrate this mathematically, FCF = EBIAT + Non-cash expenses (D&A, etc) + Changes in working capital - CapEx

    Historical Financials

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

    Recalling the FCF formula, we first need to obtain EBIAT, or earnings before interest, after taxes.

    The reason why we are using a metric that excludes the effect of interest is due to the fact that we are valuing Apple Inc. on an unlevered basis, which is to say, before the payments of interest.

    The reason why the metric we have chosen includes the effect of taxes is due to the fact that taxes are a mandatory business expense - you cannot operate a business without paying taxes to the government.

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

    The below picture shows the revenue Apple Inc. has generated, the cost of sales it has incurred, and its gross margin for the past 4 years fiscal years.

    Source: SEC Filings

    As seen in the above picture, Apple Inc.'s has had unstable growth in its past years - it had a spurt of growth in 2012 where its sales went up by 44.6%, and in 2013, its sales went up by a mere 9.2%.

    Its cost of sales has increased from 59.5% of sales in the year 2011 to 62.4% of sales in the year 2013.

    Its gross margin has been similarly unstable, increasing from 40.5% of sales to 43.9% of sales in 2012, and falling to 37.6% of sales in 2013.

    Most of you would have realized that I have included 2014 as a historical year when Apple Inc.'s 2014 fiscal year has not ended. In fact, SEC filings only reveal Apple Inc.'s 2014 first quarter results.

    However, from Apple Inc.'s 2014 1Q results, I have projected its financials for the remaining quarters.

    (click to enlarge)

    Source: SEC Filings

    As seen above, Apple Inc.'s net sales increased 5.7% from 1Q FY2012 to 1Q FY2013.

    From this information, I projected Apple Inc.'s net sales to grow 4% quarter-to-quarter. I feel that this growth in sales can be easily achieved from its recent deal with China Mobile(NYSE:CHL) as Apple Inc. is just entering the smartphone market in China.

    As for its cost of sales and gross margins, I have assumed them to be about to same as the previous quarters.

    (click to enlarge)

    Source: SEC Filings

    As seen above, Apple Inc.'s R&D expenses has remained relatively stable at 1.9% to 2.3% of sales.

    Its SG&A expenses have remained steady at 5.2% to 5.3% of sales.

    Thus, due to its stability, I have projected both Apple Inc.'s R&D and SG&A expenses for its future FY2014 quarters to be the average of the previous 2 1Q.

    Summing up R&D expenses and SG&A expenses, we arrive at total operating expenses, which have remained at about 7%.

    Subtracting total operating expenses from gross margin, we arrive at Apple Inc.'s operating income for each quarter, which appears to be approximately 31% of sales.

    (click to enlarge)

    Source: SEC Filings

    As seen above, besides operating income from its core business operations, Apple Inc. also has non-operating income, which is not generated from its core businesses (smartphone/tablet/laptop sales).

    Interest and dividend income seems to be steady at 0.7% to 0.8% of sales.

    Interest expense seems to be close to 0, at -0.1% of sales.

    Other expenses, net seems also to close to 0, at -0.2% to 0.1% of sales.

    Summing these three line items up, we arrive at other income / (expense), net, which seems to hover between 0.4% and 0.8% of sales.

    (click to enlarge) Source: SEC Filings

    As seen above, Apple Inc.'s income before taxes for its FY2014 quarters is steady at about 31.4% to 32.4% of sales.

    Apple Inc.'s EBIT, which excludes the effects of interest, is also steady at the same amount, due to its minimal interest expense.

    Apple Inc.'s tax rate appears to hover around 26% for its previous quarters, hence I have assumed an average of its previous quarters' tax rate to arrive at its projected tax rate, which is 26.1%.

    By subtracting taxes from EBIT, we arrive at EBIAT, which is about 23.2% to 23.3% of sales in Apple Inc.'s future FY2014 quarters.

    Thus, to arrive at Apple Inc.'s "historical" financials for FY2014, I have projected them using conservative assumptions, and used its actual historical financials as a basis.

    Source: SEC Filings

    As seen above, Apple Inc.'s R&D expenses seems to remain steady at about 2% of sales.

    Its SG&A expenses seems to be decreasing year-to-year, from 7% in 2011 to 5.3% in 2014.

    Summing these expenses together, we arrive at total operating expenses, which seems to hover at about 8.6% to 9.3% of sales, before decreasing to about 7.4% of sales in 2014.

    By subtracting total operating expenses from gross margin, we arrive at operating income, which is about 30% of sales.

    Source: SEC Filings

    As seen above, Apple Inc.'s interest and dividend income seems to be about 1% of sales in recent years.

    Interest expense are near-zero due to the fact that Apple Inc. is financed with very little debt.

    Other expenses are also near-zero, hovering around -0.1% to 0.4% of sales.

    Summing these three line items, we arrive at other income / (expense), which seems to be around 0.3% to 0.7% of sales.

    Source: SEC Filings

    As seen above, Apple Inc.'s pre-tax income seems to be around the 30% to 35% of sales range in its historic years.

    Its EBIT, obtained by excluding the effects of interest expense, is hovering at around 29.3% to 35.6% of sales.

    Apple Inc.'s tax rate has historically been about 24.2% to 26.2% of sales.

    By subtracting income taxes from EBIT, we arrive at EBIAT, which is about 23.1% to 26.7% of sales.

    Recalling our FCF, once we have arrived at EBIAT, we have to add back non-cash expenses.

    The reason why we are adding back Apple Inc.'s non-cash expenses is due to the fact that these expenses are not cash expenses, hence the name. Due to its non-cash nature, it does not reduce a company's FCF. As we have subtracted a company's non-cash expenses in the income statement, we have to add them back to reflect a company's actual cash.

    In Apple Inc.'s case, its non-cash expenses are depreciation & amortization, share-based compensation and deferred income taxes.

    Source: SEC Filings

    As seen above, historically, Apple Inc.'s depreciation & amortization expense has been about 1.7% to 4% of sales.

    Its share-based compensation has been around 1.1% to 1.3% of sales.

    Its deferred income tax expense has been about 0.7% to 2.8% of sales.

    After adding back non-cash expenses, we have to add back changes to working capital.

    The reason for adding back changes to working capital is due to the fact that working capital is mandatory for a business's core operations.

    Source: SEC Filings

    As seen above, Apple Inc.'s changes to accounts receivable has hovered between -3.5% to 0.1% of sales.

    Inventories has remained relatively stable, hovering between -0.6% and 0.3% of sales.

    Vendor non-trade receivables are about -1.8% to 0.1% of sales.

    Other current and non-current assets are about -2% to 0.6% of sales.

    Accounts payable are about 1.4% to 2.9% of sales.

    Source: SEC Filings

    As seen above, Apple Inc.'s deferred revenue has hovered between 0.9% and 1.8% of sales.

    Its other current and non-current liabilities has decreased from 4.2% in 2011 to 2.8% in 2014.

    Now that we have accounted for changes in working capital, we move on to capital expenditures.

    The reason why we have to account for capital expenditures in our FCF calculation is due to the fact that it is mandatory for businesses to continually spend cash on more property, plants and equipment ("PP&E"). PP&E depreciates over time, hence there is a need to replace it. Thus, it is a mandatory expense which needs to be accounted for.

    Source: SEC Filings

    As seen above, Apple Inc.'s capital expenditures has increased from 3.9% of sales in 2011 to 4.7% of sales in 2014.

    Recalling our FCF formula, by adding non-cash expenses and changes to working capital, and subtracting capital expenditures from EBIAT, we arrive at FCF values for Apple Inc., which has increased from $33bn in 2011 to $67bn in 2014.

    Projections

    Now that we have established a base line for Apple Inc.'s historical financials, we can use this as a platform to project its future financials.

    The below picture shows Apple Inc.'s projected net sales, cost of sales, gross margin, R&D, SG&A and total operating expenses.

    (click to enlarge)

    Source: SEC Filings

    As seen above, I have conservatively projected Apple Inc.'s net sales growth rate for the next 5 years. Starting with 2015, I have projected a 5% increase in net sales, which decreases by 1% year-over-year. This is because I suspect that Apple Inc.'s deal with China Mobile will allow it to increase its net sales in the short-term, but over a period of 5 years, its growth in net sales will begin to slow as the smartphone market in China becomes more saturated.

    As for cost of sales, I have assumed it to be 65% of sales for the next 5 years, up from 62% it has been hovering at as I suspect that with more price competition from other smartphone/laptop/tablets makers, Apple Inc. would have to lower the price of its products to be able to compete more effectively.

    Furthermore, the smartphone market, Apple Inc.'s largest cash cow, globally, is beginning to become saturated. Thus in order to extract as much cash as possible from that market, Apple Inc. would have to lower its prices of its smartphones, either through wireless-carrier deals or direct discounting.

    For Apple Inc.'s gross margin, it is obtained through subtracting cost of sales from net sales. Its gross margin is projected to decrease from over 40% of sales, to 35% of sales in future years.

    As for R&D expenses, I have assumed that Apple Inc. would double its R&D spending on a percentage of sales basis, from 2% of sales to 4%. The reason for this assumption is due to the fact that most of Apple Inc. revenue markets are beginning to become saturated and hence in order to keep up, Apple Inc. would have to divert more resources to R&D and continuously innovate.

    As for SG&A expenses, due to its stability in previous years, I have assumed an average of the previous years' SG&A expenses going forward, arriving at about 6.3% of sales.

    By summing R&D and SG&A expenses, I arrive at total operating expense, which is 10.3% of sales.

    (click to enlarge)

    Source: SEC Filings

    As seen above, by subtracting total operating expenses from gross margin, I have arrived at Apple Inc.'s operating income for the next 5 years, which are steady at 24.7% of sales.

    As for its non-operating income, I have simply assumed them to be the average of the previous years, due to its relative stability historically.

    Interest and dividend income are assumed to remain steady at 0.7%.

    Interest expense is assumed to be near-zero.

    Other expenses are assumed to be at 0.2% of sales.

    By summing these three line items, I arrive at other income / (expense), which is about 0.5% of sales.

    By adding other income / (expense) to operating income, I arrive at pre-tax income, which is about 25.2% of sales.

    (click to enlarge)

    Source: SEC Filings

    As seen above, I have calculated EBIT by excluding the effect of interest expenses. As a result, EBIT is about 25.2% of sales, due to Apple Inc.'s minimal interest expense.

    As for its tax rate, I have assumed an average of the previous years' tax rate, due to its stability in previous years, and have arrived at a 25.4% tax rate going forward.

    By subtracting income taxes from EBIT, I arrive at EBIAT, which is about 18.8% of sales.

    As for depreciation & amortization, I have assumed an average of the previous years' D&A, due to its stability in previous years, and have arrived at 2.6% of sales going forward.

    Share-based compensation are projected at 1.2% of sales going forward, also due to its stability in previous years.

    (click to enlarge)

    Source: SEC Filings

    As for deferred income tax, I have also assumed an average of the previous years' numbers due to its stability, and arrived at 2% of sales going forward.

    As for changes to working capital, due to its stability in previous years, I have assumed an average of the previous years' numbers for all working capital line items.

    For accounts receivable, I projected it to be 1.6% of sales going forward.

    For inventories, I projected it to be 0.1% of sales going forward.

    For vendor non-trade receivables, I projected it to be 0.9% of sales going forward.

    For other current and non-current assets, I projected it to 0.9% of sales going forward.

    (click to enlarge)

    Source: SEC Filings

    As seen above, for accounts payable, I have projected it to be 2.2% of sales going forward.

    For deferred revenue, I projected it to be 1.4% of sales going forward.

    As for other current and non-current liabilities, I have projected it to be 2.8% of sales going forward.

    As for capital expenditures, I have projected it to be 4.7% of sales going forward, as it seems to hover between 3.9% and 5.3% of sales in its historic years.

    By summing EBIAT, non-cash expenses, changes to working capital, and subtracting capital expenditures, I arrive at Apple Inc.'s 5-year projection of its FCF, which increases from $59bn in 2015 to $65bn in 2019.

    Discounting free cash flow to its present value

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

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

    Thus, the discount rate is divided into two sections, 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-utilized 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 31/3/2014.

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

    Apple Inc.'s beta is sourced from Google Finance, dated 31/3/2014.

    (click to enlarge)

    Source: Google Finance

    As seen above, Apple Inc. beta is 1.06.

    Source: SEC Filings

    As seen above, I arrive at a cost of equity of 12.4%

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

    Source: SEC Filings

    As seen above, I have arrived at a weighted-average interest rate of 1.94%.

    As interest is tax-deductible, I have obtained the after-tax cost of debt by multiplying the weighted-average interest rate by (1 - tax rate), to arrive at an after-tax cost of debt of 1.45%.

    Source: SEC Filings

    As seen above, I have computed Apple Inc.'s capital structure, which is largely equity.

    To obtain the amount of equity, I have taken Apple Inc. closing share price of $536.86 on 31/3/2014, multiplied by its fully diluted shares outstanding of 901.5M, sourced from Apple Inc.'s latest 10Q. This amounts to approximately $483bn

    To obtain the amount of debt, I have summed Apple Inc.'s total outstanding debt, sourced from its latest 10Q. This amounts to $17bn.

    To obtain the weighted-average cost of capital ("WACC"), I have multiplied the cost of equity by the percentage of equity in the capital structure, and multiplied the after-tax cost of debt by the percentage of debt in the capital structure.

    To illustrate this mathematically, I have calculated it using the following formula:

    WACC = cost of equity * % equity + cost of debt * % debt

    Thus, I have arrived at a WACC of 12.1%.

    (click to enlarge)

    Source: SEC Filings

    As seen above, I have discounted Apple Inc.'s unlevered FCF for the years 2015 to 2019 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 account for 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 used the world's long-term GDP growth rate of 3.2% as a proxy for Apple Inc.'s long-term earnings growth rate.

    Thus, I arrive at a TV of $741bn. As this is a future value, there is a need to discount it to the present, which I have, hence arriving at a present value of TV of $374bn.

    Arriving at an implied share price

    By summing the sum of present values of FCF projected 5 years into the future, and the present value of TV, I arrive at an Enterprise Value ("EV") of $598bn.

    I have subtracted out net debt, preferred stock and non-controlling interests, to arrive at an equity value of $601bn.

    Dividing the equity value by Apple Inc.'s fully diluted shares outstanding, I arrive at an implied share price of $667.10, about a 20% discount to its current share price.

    Are my numbers realistic?

    You may be thinking right now, that a company of Apple Inc.'s size, is impossible to be undervalued by such a large margin.

    However, consider this.

    In my projections, I have used extremely conservative revenue growth rates, (5%, declining 1% year-over-year), a large increase in cost of sales (62% to 65% of sales) and a large increase in R&D expenses (2% to 4% of sales).

    If I assume that Apple has a 5% growth in revenue in 2015, and zero revenue growth in the later years, I arrive at an implied share price of $611.32, still a 13% discount to its current share price.

    Furthermore, I have not included Apple Inc.'s planned share buybacks in my analysis, which could further prop up its price.

    Thus, I feel that my analysis and assumptions fairly reflect Apple Inc.'s future earning potential.

    Conclusion

    From this analysis, I conclude that Apple Inc. is undervalued by about 20%, and even in harsher scenarios, Apple Inc. is still undervalued by about 10%, at the very least.

    My analysis of Apple Inc. 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.

    Tags: CHL, AAPL, long-ideas
    Mar 31 8:42 AM | Link | Comment!
  • Why McDonalds Still Has Some Pep In Its Step: Part 1

    This article will be split into 2 parts. The first part of the article will consist of my analysis of McDonalds using a DCF model. The second part of the article will consist of my analysis of McDonalds using an LBO model.

    Background

    (click to enlarge)

    As seen in the above chart, McDonalds 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 that 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 a 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 McDonalds has generated in the past three years.

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

    The below pictures shows McDonalds expenses, and how I arrived at EBIAT.

    \

    As shown above, McDonalds' expenses has 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 has 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 McDonalds, non-cash expenses are merely Depreciation & Amortization, Deferred Income Taxes, Share-Based Compensation, and Other.

    The below picture shows these line items.

    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 has 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.

    As seen above, Accounts Receivables has hovered between -1% of sales and 1% of sales.

    Inventories, prepaid expenses and other current assets has 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 has 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 CapEx 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.

    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 McDonalds' historical financials, we can use that to project its future earning potential.

    The below picture shows the revenue projections I have assumed for McDonalds 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)

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

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

    (click to enlarge)

    (click to enlarge)

    In the above, I have assumed that McDonalds 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)

    In the above picture, I have arrived at my EBIAT projections for McDonalds, based my previous assumptions.

    (click to enlarge)

    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 the Present

    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 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.

    McDonalds' Beta is sourced from Google Finance on 22/3/2014.

    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 McDonalds' outstanding debt, as shown below.

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

    As seen in the above, I have calculated a Weighted Average Cost of Capital ("WACC") of 4.54% for McDonalds.

    (click to enlarge)

    As seen above, I have discounted McDonalds 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 reflect 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 McDonalds' 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 McDonalds 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 CapEx 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

    So, am I right, and the market wrong? Or alternatively, is the market right, and I wrong?

    Well, I'll leave that to you to decide.

    In the next part of my coverage on McDonalds, I will value McDonalds using a different valuation methodology, known as an 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 McDonalds using Excel can be found here: onedrive.live.com/redir?resid=5A0DE9664C...

    Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

    Tags: MCD
    Mar 23 12:24 PM | Link | Comment!
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