In Grinding It Out, the story of McDonald’s, Ray Kroc explained the financial engineering that drove the company to prosperity in its early days: “The formation of Franchise Realty Corporation, was to my mind, a stroke of financial genius. Franchise Realty was the supreme example of a guy putting his money where his mouth is. We started Franchise Realty Corporation with $1,000 paid-in capital, and Harry parlayed that cash investment into something like $170 million worth of real estate. His idea, simply put, was that we would induce a property owner to lease us his land on a subordinated basis. That is, he would take back a second mortgage so that we could go to a lending institution (in the early days it was a bank) and arrange a first mortgage on the building; the landlord would subordinate his land to the building. I must admit that I was a bit skeptical: Why would a landlord want to do that?
One of the reasons his subordinated lease idea worked so well was that in the late fifties we didn’t have the proliferation of franchise operations and the fierce competition for commercial fringe property that developed in the course of the next twenty years. Another reason was that both Harry and I were pretty good salesmen, and we could romance a property owner with the notion of earning at least a little something from his vacant land.
This was the beginning of real income for McDonald’s. Harry devised a formula for the monthly payments being made by our operators that paid our own mortgage and other expenses plus a profit. We received this set monthly minimum or a percentage of the volume the operator did, whichever was greater. After a time we began realizing substantial revenues from the formula, and we could see that we were merely nibbling around the edges of this huge hamburger frontier we were exploring.
It was then that Harry’s view of the corporation as just a real estate business, rather than a hamburger business, began to crystalize. As he had set it up, we would not take a mortgage for more than ten years, even on a subordinated basis. We had twenty-year leases on all the property. This meant, of course, that after ten years when our mortgages were paid off, we would have all the income from a store free and clear to the corporation.”
The Harry mentioned in the passage refers to Harry Sonneborn, the man who left his corporate position at Tastee Freez to secure a loan for Ray Kroc to buy out Dick and Maurice McDonald and both the proprietary technology for their industry-leading milkshake mixers as well as the intellectual property behind the McDonald’s Franchise.
I included that lengthy passage because it helps explain McDonald’s beginnings that still affect the company to this day. In many ways, McDonald’s is a real estate company that sells hamburgers and fries. That is because 81% of the 35,864 locations are franchised and the franchisees pay McDonald’s an 8% fee to use the McDonald’s name in addition to a monthly rent that varies significantly by location. That is an important distinguishing characteristic that separates McDonald’s from many of the other fast food companies you might analyze.
Usually, there is some kind of sale and leaseback operation afoot—at some point in time, yeah, the company owned the property but it then needed a huge amount of cash at some point in time so the real estate gets sold to a bank or insurance company and then they become the landlords. That isn’t what has happened at McDonald’s. It’s not just a percentage of hamburger, fries, and coffee sales that you receive when you collect a McDonald’s dividend check, but you are also collecting a dividend from the rent checks that the McDonald’s franchisees sent to Oak Brook headquarters.
If McDonald’s were to ever spin-off its REIT business, I would imagine it would be a very lucrative long-term event for shareholders, just like Abbott Labs spinning off Abbvie or ConocoPhillips spinning off Phillips 66. Judging by the quality of the real estate portfolio—the real estate locations are in some prime spots immediately off highways and the likelihood of collecting the rent checks would be very high since you don’t see too many McDonald’s closing up shop—I would guess an independent McDonald’s REIT would trade at 20x funds from operations.
That would put it at the high end of valuation for most real estate companies, but it would be deserved. Last year, McDonald’s had 36,104 locations. This year, it is down to 35,864. Only 240 locations went under, for a default rate of 0.6%. If you can own a REIT with 99.4% of your tenants paying the bills, you know that you have found a lifelong holding.
If there was a spinoff, you would have a situation where there would be $3.50 of funds from real estate operations trading at a multiple of 20 for a price of $70. The remaining McDonald’s would generate $3.30 as buying a share of McDonald’s post-REIT spinoff would mean you’d be collecting percentage-of-sales fees from the franchisees that are selling burgers, salads, fries, coffee, and milkshakes. I would peg the value of that at 18x earnings for a price of $59.
My sum of the parts analysis leads me to the conclusion that McDonald’s currently has value of $70+$59=$129 if McDonald’s were to spin off its real estate holdings into a REIT. My guess is that you’d see a 30% pop towards fair value if that happened.
The reason why McDonald’s resists such a move is that owning the real estate has been a lucrative source of profit growth and has been closely intertwined to the company’s story of becoming an empire. It is part of the company’s identity of what makes it different from other fast food giants. Just like Google’s culture is based partially on funding far-flung, seemingly irrelevant projects that do not immediately contribute to the bottom line, McDonald’s executives know that they are running a company that is different from others in the fast food industry because McDonald’s has complete ownership control of the company’s operations that you don’t get anywhere else. Spinning off the real estate division would make the company just like everyone else in fast food, albeit with greater brand-name strength.
I do think, at some point, you will see a spinoff of the real estate holdings into a REIT because it represents low-hanging fruit for spurring growth. Don Thompson had to step down as McDonald’s CEO because earnings per share didn’t do anything over his time at the helm—McDonald’s made $5.27 per share in 2011, and will make $5.10 per share this year. And that actually understates the issue because McDonald’s has been repurchasing its own shares. It makes $4.8 billion now, and made $4.9 billion in 2010.
I am more forgiving of the stagnant growth than others because I recognize that McDonald’s generates about a fourth of its revenues from Europe—when Spain has a 25% employment rate and half the college graduates can’t even get coffeehouse jobs, can you really get upset at McDonald’s for failing to grow profits there? And, in the United States, food costs are rising which is typical in good and ordinary economic times. The problem, though, is that McDonald’s can’t easily pass along 4%, 5%, or 6% input costs along to the customers because the primary appeal is cheapness. People want a McChicken for a $1. They don’t want it for $1.25. They don’t want it for $1.49. They don’t want it for $1.79. They want it for a dollar.
The stickiness of the prices can make growth difficult during good economic years. McDonald’s tries to disintermediate itself from this issue by collecting a percentage of sales rather than profits from its franchisees, but it still operates a fifth of the stores and has some franchisee agreements based on profits in the 27 countries where it is illegal for a franchisor that operates more than 99 locations to charge its franchisees based on sales (it has to be based on profits in these countries to avoid the “squeezing” that occurs during periods of rising input costs).
In the long run, McDonald’s will be fine. Shareholders are going to collect at least $20 per share from the company in total dividends over the next five years, and that works out well if you use the $90s stock price as an opportunity to reinvest and accelerate your income growth from the company. The dedication of the client base is something to behold—have you ever seen the way someone drives to McDonald’s? Customers get that glint in their eye, go 35 in a 25, and attack would-be competitors for a spot in the drive thru line with a zeal you would expect to see if they were racing to save their first-born from peril.
It is not only a recession-resistant stock, but it excels during such periods. The profits grow from $2.8 billion in 2006 to $5.5 billion in 2011 as input costs stay low during recessions and the company gains customers because 2009 is the kind of year when you say, “No Chipotle tonight honey, let’s do McDonald’s.” That kind of thinking happens on a widespread basis in bad economies, and that is why it is worth holding in a defensive portfolio. The hidden real estate assets may also provide a kick sometime down the road when Steve Easterbrook finds it difficult to grow overall organic profits and then decides he wants to do something to avoid the fate of his predecessor.