Last week, McDonald’s shares jumped 1.5%, amid speculation that the fast-food giant might spin-off its massive real-estate holdings. That looks increasingly likely under the activist-like new CEO, Steve Easterbrook. It’s another welcome development and a broader sign that McDonald’s is finally turning the corner. Our prediction: This year will be the last time McDonald’s stock sees a price below $100.
Let’s be clear. A lot has changed at McDonald’s in the past year. Within the first two months of becoming CEO earlier this year, Easterbrook announced $300 million in cost cutting measures, a move that includes refranchising 3,500 stores of its 36,290 stores globally and shutting down an additional 700. McDonald’s (MCD) will soon use technology, such as self-ordering kiosks, to change the customer experience while rejiggering its menu, dropping some, adding others and improving its existing products. In October, for instance, McDonald’s announced that it would take “All-Day Breakfast” nationwide. Meanwhile, we think the wide-ranging menu of options at McCafe will soon be addressed.
Shareholders are obviously pleased with the shift in strategy and tone. Since Easterbrook took over in March, McDonald’s stock is up 5.5%. The new CEO has gone so far as to call himself an “activist” CEO and a “constructive agitator.”
It appears that Easterbrook is going all-in on this “activist” message. I now believe there is a greater than 50% chance that McDonald’s will create a more efficient tax structure, such as a REIT, for its real estate rental revenue stream. Since McDonald’s business began to decelerate in 2012, the real estate rumors have become more pronounced. The CEO at the time, Don Thompson, did not have the internal mandate to make those types of changes. Under CEO Steve “everything is in play” Easterbrook, the odds of the company changing the structure of its real estate holdings have gone up significantly.
The issue at hand is the company’s ability to re-arrange royalty rates with franchisees. McDonald’s generates over $6 billion a year in rental income with operating margins running north of 75%. This is all taxable at the effective tax rate of 32%. If the company can structure an internal REIT to own the rental stream, the company could save billions in taxes, creating substantial shareholder value. As a general rule, for every $500 million the company can save in taxes (at 22 times) it creates an additional $11 per share in shareholder value.
Objections to altering the real estate structure, in the past, have centered on giving up control of the real estate and preservation of its credit rating. If the company can establish a REIT to shelter its rental income, while controlling the real estate and maintaining its credit profile everybody wins.
Our long-standing view has been that on Thursday, when the company reports third quarter earnings, McDonald’s will have reached an inflection point in its turnaround. That in mind, we added McDonald’s to the long side of Hedgeye’s “Best Ideas List,” in August, well before the real estate speculation peaked and it was trading for $99. My team and I see significant upside. And regardless of whether McDonald’s spins-off its real estate holdings or not, at a recent price of $104, the stock could go up 20% to 30%.
How do we get there? We think McDonald’s earnings per share will be down 15% in 2015 from the previous peak of $5.55 in 2013. As it stands today, our estimates are for McDonald’s to post a near record-tying earnings per share number in 2016 of $5.40 to $5.60 with $6 being a real possibility. The potential for $6 is dependent on how aggressive the company gets with any additional cost cutting to be announced at the upcoming analyst meeting on November 10th. Applying today’s earnings per share multiple of 22 times on $6.00 in earnings and the stock could be worth $130.
Meanwhile, All Day Breakfast could be another game changer for McDonald’s. Our survey of 2,000 customers shows that 33.3% of people would go to McDonald’s more often if they could get breakfast for lunch. Management has also brought back the “value message” in its advertising, with the return of the $2.50 Double Cheese Burger and Fries deal.
McDonald’s has a long history of returning value to shareholders. The company has a 3.25% dividend yield. To put that in perspective, adding in buybacks, the company should return $8 billion to $9 billion to shareholders in 2015. In all, between 2014 and 2016, the company will have returned close to $20 billion to investors.
It’s probably not on most investor’s radars, but a longer-term catalyst for the stock is the looming crash in beef prices. Each year, McDonald’s buys roughly $1 billion of beef. Our analysis of historical beef prices suggests that prices peaked, in 2014, at $2.42 per pound, as heifers for slaughter continue to weigh more than ever and herd sizes have been swelling in recent years. We think 50% decline in price is well within the realm of possibilities. As one of the largest commercial purchasers of beef in the U.S., lower commodity prices will continue to be a strong tailwind for McDonald’s through 2018.
Everything seems to be lining up for McDonald’s.
Howard Penney is a managing director and restaurants analyst for Hedgeye, an independent investment research and financial media firm based in Stamford, Connecticut. Neither Penney nor Hedgeye are investors of McDonald’s.
