Description

Investment Thesis

1. MCD is a high quality business (mid 30s EBITDA margin, 16% ROIC) trading at a discount, with a margin of safety provided by its significant scale advantages and strong brand value in a defensive, growing end market

1. Largest restaurant with one of the most recognizable, iconic brands in the world.  MCD restaurants generate $2.5mm of sales / unit (2x competition) and $450k of profit / unit (4x competition).  MCD has significant scale advantages i.e. MCD spends more on advertising (~$5bn) than rest of industry combined

2. Predictable, stable cash flow stream given franchised business model and real estate ownership.  75% of EBITDA from royalty and rent. MCD owns 45% of the land underneath its restaurants and 70% of the buildings for its 36K restaurants.  Owns best real estate in the business given first mover advantage in most markets

2. Disappointing operational execution and a suboptimal company structure over the past two years have led to material underperformance compared to peers (stock down 3% in LTM vs. +15% for S&P) and a sector-low valuation (11x 2016 EBITDA vs. 14x for peer group), but these issues are self-inflicted and fixable.  A fresh, experienced new CEO and cooperative Board is now leading the company with a sense of urgency and is both willing and able to enhance shareholder value through a operational turnaround.  He has referred to himself as an “internal activist” and is committed to moving faster and keeping all value creation options on the table.

1. Value Creation Levers.  There are a number of levers that management could easily pull to drive profitability, cash returns and a multiple rerating.  These include (in order of value creation): (i) refranchising à moving franchise mix from 81% to 90% or 95%, (ii) leveraging balance sheet (currently 1.3x vs. franchised peer group at 2x to 5x) and (iii) SG&A cuts (spends $70k / systemwide restaurant vs. peer group at $12k to $40k).  Finally, MCD could potentially monetize its real estate through a REIT structure, shielding taxes and benefiting from a multiple bump on a meaningful portion of its earnings.  However, I believe this is highly unlikely and  last resort.

2. Operating Turnaround.  I also believe there is a reasonable probability of an operating turnaround in the next 12 to 18 months given upgraded leadership (plus shareholder pressure) and excited franchisee base.  In the coming year, I expect MCD to eliminate fringe menu items to improve service time and accuracy, address its price architecture, improve ingredient quality in very public way, advertise ingredient quality and food prep (i.e. crack eggs for breakfast vs. peers that reheat frozen food), innovate in core burger category and test customized burgers, improve labor relations and perception of MCD as an employer and create a more decentralized organization to enable local product development.  Comps get very easy in June.

1. Important to keep in mind that Burger King, Wendy’s, Sonic, Jack in the Box, Taco Bell, KFC, Domino’s, Papa John’s, Dunkin Donuts, etc. are all generated at least +LSD comps

3. Attractive up / down asymmetry

1. Under a conservative base case scenario, MCD should trade at 12.5x FY17 EV/EBITDA in line with higher-franchised peers, which represents a $113 price target at the end of FY15 (18% upside from today’s $96 share price)

   1. While a mid/high teens return may not seem compelling to those on VIC, I believe it is a very compelling risk/reward considering the minimal downside / large margin of safety, combined with various value creation levers and an increasingly engaged shareholder base which can drive significantly more upside beyond my $113 target
2. Downside based on 10x EBITDA (significant discount to peer group) results in $88 stock price, or < 10% downside.  Realistically, downside protected by enthusiasm for new management and understanding that turnaround will take at least a year.  Also, weak operating results will increase pressure to pull value creation levers.

3. I believe one can earn a good return if MCD simply pulls refranchising / leverage / SG&A levers and can earn a great return if coupled with an operating turnaround.

Company Overview

Mcdonald’s Corporation (MCD) is the world’s largest franchisor and operator of fast-food restaurants.

• Market-share leading quick service restaurant (QSR) with over 36,000 restaurants, $88bn systemwide sales, and $27bn revenue globally

• Dominant player in largest QSR sub-category: burgers

• Geographically diversified – in terms of EBIT:

• 44% U.S.

• 41% Europe

• 15% Asia

• Majority (~82%) of MCD’s restaurants are operated by franchisees which pay MCD via two earnings streams:

• Brand royalty = ~4% of sales

• Rent = ~9% of sales (in cases where MCD owns the underlying real estate)

• Royalties and rent contribute to ~75% of total EBITDA

Why is MCD a Good Business?

MCD is a very high quality business with a irreplaceable brand, market leading position in a growing, defensive category, significant scale advantages and a highly stable business model that generates > 75% of its earnings from royalties and rent.

Highly Recognized, Iconic Brand with Market Leading Position

• Decades of heritage and billions of dollars of advertising spend have created one of the most valuable brands in the world

• Enables MCD to attract the best franchisees and partners around the globe

• Brand recognition contributes to strong unit economics and productivity per store at roughly twice the level of peers

Market Leader in Stable, Defensive QSR Industry

• MCD has 5% market share in the United States restaurant industry and 15% share in the QSR segment

• Restaurant sales grow at ~ 4% p.a.

• MCD achieved strong SSS through the downturn (7% in 07, 7% in 08, 4% in 09)

Scale Advantages

• McDonalds spends more on advertising than rest of industry.  While not a guarantee of success, advertising muscle amplifies an on-target, trend right message.

• Best real estate in industry given scale, unit economics and first mover advantage in most markets

• Supply chain that is unrivaled; global reach and capabilities

Franchised Business Model + Real Estate Ownership Create Stable Earnings Profile

• 80% franchised business model creates stability through royalty stream and enables Company to grow in capital light manner.  Limited exposure to commodities, labor costs, etc. as that risk and volatility is borne by franchise base

• Owns 45% of land and 70% of buildings for its 36K restaurants.  The Company is the landlord for its franchising, charging ~ 9% of sales.  Again, creates a stable, low-risk cash flow stream and attracts great franchisees.  

Recent Underperformance

• Over the past decade, MCD has generated 6% system sales growth (2% stores, 4% SSS) and 8% EBIT growth

• Coupled with share buybacks, total EPS growth has compounded at a low teens rate before dividends (currently 3.5% yield)

• However, after a fantastic decade long run, MCD sales growth and profit margins began to decline in 2013 / 2014

• See Valuation and Risk/Reward section for historical financials

Industry Growth and MCD Performance

• The United States restaurant industry is expected to grow at ~ 3% going forward (vs. ~ 4% over last four years).  While fast casual is experiencing explosive growth, it currently only accounts for 4% of US foodservice

• MCD has substantially underperformed the peer group in the last two years after a period of outperformance.  Other legacy QSR companies with a reputation for unhealthy food have been able to generate positive low to high single digit SSS growth

Historical Market Share (United States)

• MCD has ceded market share after a period of strong market share gains

What is Driving Growth at Peer Group?

• While it varies across companies, other “unhealthy” QSR chains have done a much better job at executing around their core, menu innovation and marketing improvement

• They have also focused on upgrading their asset base

• BKW (#4 QSR chain) à under new management team, upgraded the menu, revamped marketing (no more King character, advertised the food and compelling value), invested in asset base

• WEN (#5 QSR chain) à under new CEO, WEN returned to focusing on premium sandwiches with successful items such as the Bacon Pretzel Cheeseburger.  Focused on unique buns and cheeses that were differentiated in the marketplace.  Invested in remodel program.

• DPZ (#15 QSR chain) à under new CEO, admitted that food quality and service had become problems, made a public mea culpa and advertised their improvement with great success.

• Taco Bell (#6 QSR chain) à menu innovation (Doritos taco) + improved customer perception of ingredients (cantina bell) + new breakfast day part

• Jack (#17 QSR chain) à menu innovation (Siracha burger) and memorable, unique advertising

• Sonic (#12 QSR chain) à menu innovation + unique, memorable marketing (two guys sitting in a car) with more of an emphasis to national TV (64% in 2014 vs. 48% in 2012)

But What About Fast Casual?

• Fast casual is certainly a headwind for McDonald’s and other legacy fast food players.  But fast casual only accounts for 4% of the industry and is expected to compound at a HSD rate (vs. +LSD for traditional QSR concepts)

• It is also important to keep in mind that MCD and Five Guys are not truly substitutes for most MCD customers given significant price point differential:

Operational Diagnosis

McDonald’s challenges are mostly self-inflicted due to disappoint operational execution – relative lack of innovation, less effective advertising, declining quality scores, and weakening value proposition.

• While the broader burger category continued to generate positive same store sales (SSS) in 2013-2014, MCD’s SSS turned negative as a result of strategic misdirection, operational inefficiencies, and disenfranchised franchisees

• These issues are self-inflicted, as MCD customers have not stopped eating burgers – they are just looking elsewhere within the traditional fast food category

• Conversations with franchisees and former MCD executives suggest that these issues are already being addressed, which should allow for a return to positive SSS over time

Relative Lack of Innovation

• After nearly a decade of sales building through new products – culminating in the McCafe launch – McDonald’s innovation pipeline seems to have dried up

• The single biggest product introduction in the last two years – the Mighty Wings limited time offer (LTO) in 2013 – had disappointing results, while flagship products from Burger King (e.g. Chicken Fries) and Wendy’s (e.g. Pretzel Bacon Cheeseburger) were massively successful

Less Effective Advertising

• National advertising campaigns, such as the “Our Food, Your Questions” initiative, have been largely reactive to consumer concerns about MCD’s health and food quality, rather than being proactive in promoting the steps the company is taking toward healthier, higher-quality ingredients

• Menu marketing has been centralized at the national level, rather than allowing localized decisions to be made by franchisees closer to the end customer

Declining Quality Scores

• MCD’s food quality scores have been on the decline, as its complicated menu and lack of proper employee training have weakened food prep quality.  Menu proliferation (100 items added over last decade) has hurt order speed (doubled order time in many stores) and order accuracy

• Asian meat supplier scandals and MCD’s historical sourcing of preservative-filled ingredients have driven negative perceptions about its food quality

• People are not eating fewer burgers – they’re eating exceedingly higher quality burgers, caring more about ingredient sourcing and food preparation

Weakening Value Proposition

• Customers have historically anchored to MCD’s Dollar Menu, and as Food Away from Home Inflation (FAFH) has risen, MCD has had to raise prices on most of its premium burgers and other menu items to offset the higher costs without losing its large Dollar Menu-focused customer base

Turnaround Plan

New CEO Steve Easterbrook and his team have a clear plan to turn around the company’s operations, the components of which are already being implemented.  There is significant overlap with his highly successful turnaround plan at MCD UK.  

Menu simplification and innovation

• Reduce menu board complexity.  There are too many items (have added 100 items in last decade), which is creating customer confusion and kitchen complexity, hurting service time, order accuracy and employee morale.  Many of these items are low turning (i.e. complex variations of snack wraps) and have easy substitutes on the menu.  Approximately 80% of sales come from a handful of core and value items.

• At the same time, get back to innovating, particularly around burgers.   MCD has ceded this ground to WEN.  Company plans to launch third pound sirloin burgers soon and also introduce premium toppings (i.e. guacamole) later this year.  Innovation has been borderline non-existent over last two years

• Create Your Taste – higher price point, customized burger platform based on in-restaurant kiosk ordering system.  Unclear if this makes sense and can generate returns as only 30% of sales is inside the restaurant.  In test mode and management has been non-committal.  Launching across Australia (800 store market) this year, which should provide valuable lessons.  Should improve brand perception.

• Decentralize the organization to enable faster and more regional approach to menu innovation.

Modify price architecture

• Reduce the price gap between Dollar Menu and More and core items (i.e. Big Mac).  This has already started and is part of the reason for weak compares in recent months.

Improve health and wellness perception

• Advertising campaign around the quality and integrity of the ingredients and kitchen prep

• High profile changes to supply chain (i.e. plan to eventually eliminate antibiotics in chicken).  MCD receivers a lot of free press for these types of changes though they can’t be implemented overnight given size of the supply chain

• Could MCD move to fresh beef or eliminate all preservatives?  Inventory turns 100x per year.  Opportunities to transition to “fresher” supply chain

Emphasis on improving customer experience

• Technology – will introduce their first mobile app by end of year, eventually enabling mobile ordering, mobile payment, loyalty program, customized marketing

• Emphasizing culture of hospitality

• Raising minimum wage and benefits at company owned stores.  Improves perception of company and helps them compete, motivate and retain talent

Decentralize the Organization

• Enables faster and more locally relevant innovation and improved marketing

• Empowers franchisees and incorporates their best ideas more rapidly and effectively

Background on New CEO

MCD’s new CEO Steve Easterbrook is credited with successfully turning around the McDonald’s UK business in the mid / late 2000s, an effort which entailed addressing many of the same issues that plague McDonald’s globally today.

Background

• On March 1st, 2015, the Board of Directors hired British-born Steve Easterbrook as President and CEO

• Since joining McDonald’s in 1993, Easterbrook has held numerous leadership roles, including CEO of McDonald’s UK, President of McDonald’s Europe, and most recently, Global Chief Brand Officer

• In addition to his more than 20 years with McDonald’s, Easterbrook’s time leading two UK-based restaurant chains in 2011-2013 – PizzaExpress and Wagamama – equips him with an outside perspective to make radical changes to issues that have fatigued MCD’s historical “promote from within” culture

McDonald’s UK Turnaround

• In the 2000s, McDonald’s faced a sales downturn in the UK, driven in part by concerns about its food quality and its treatment of employees

• Easterbrook, promoted to head that business in 2006, dealt with the brand’s battered image head on

• He boosted sales by modernizing restaurants with a cleaner look, revamping the menu, and working to portray McDonald’s as environmentally friendly

• He was also a fierce defender of the brand, starting a petition to change the dictionary definition of “McJob” as a dead-end job and installing a website to answer questions including its working conditions and animal welfare

• At the same time, Easterbrook showed an interest in adding healthier-menu options and an appreciation for the importance of marketing to moms as well as its core male consumers

• Easterbrook went on television channel BBC in 2006 to debate Eric Schlosser, an industry critic and author of “Fast Food Nation” – a debate which he won

• Under Easterbrook, McDonald’s UK market share, after declining to 12% in 2006, rose each year to 15.7% in 2013, despite continuing declines in global market share

Checks on Steve Easterbrook are unanimously positive and suggest that he is both willing and able to take the necessary steps to turn around the brand perception and company performance with a strong sense of urgency:

Feedback from Former MCD Executives

• “He was the best and only choice.  They did the right thing bringing him back.  He is an extremely bright, driven, exciting leader.  I loved working with him.  And he does listen, too.  He doesn’t surround himself with yes people.  He will surround himself with people that will challenge him, which I think is one of the things that had been a challenge for Don [former MCD CEO].”

• “He has shown a willingness to make some bold hiring choices from outside the organization.  Especially on the brand and marketing side.”

• Former Global HR Director at McDonald’s

• “From what I read and hear, Easterbrook is doing the right things, versus what I’ve heard in the past.  It’s all about the advertising; it’s all about the fundamentals; and it’s all about getting the consumer experience of the people who are coming into the store right.”

• Former Chief Marketing Officer at McDonald’s Germany

• “Easterbrook is good at simplifying complex situations by remaining focused and not impulsively taking action in many different directions.  He also is good at communicating his strategy to both management and store owners.”

• “The chief difference between Don Thompson’s strategy and that of Steve Easterbrook is that Thompson was very focused on a centralized  approach, which never worked globally.  By contrast, Easterbrook has seen the benefits of a decentralized approach and empowering local operators.  Easterbrook is likely to push for more decentralization at McDonald’s.”

• “He [Steve Easterbrook] was an instrumental part of the changeover of the British business, because the British business was sluggish and didn’t perform very well for six or seven years.  He took the job, and then they started to change, together with McDonald’s Germany.  He was Marketing VP at that moment.  His main focus was really on the execution in the restaurants, the revitalization of the brand, and very strongly in communication.”

• “I expect Steve to empower people around the globe.  He will empower more management and more people locally to do business better.  He’s a financial person, so if he can understand what is going on with franchising and re-franchising in the ailing markets, and then put in developmental licensing, that will have an impact.  Steve understands that they need to cut the centralized things first and then streamline.”

• Former President and CEO at McDonald’s Germany and West Division in Europe

• “The new CEO is a great leader and decision maker…he doesn’t wait to get everyone onboard before making decisions, he is very confident in his strategic views and moves swiftly to implement them, even if there’s tension.”

• “Steve stands up both internally and externally to defend and support his vision in a very smart way…which sometimes can be perceived as a little bit cold, but it is usually effective.  He is capable of this turnaround but it will be slower than his prior turnaround because of the scale of the global operations he is now dealing with and because he needs time to built and mold the new senior management team surrounding him.”

• Former SVP and Franchising Development Officer, McDonald’s Europe

Feedback from Former MCD Franchisees

• “Management has changed a lot over the last 35 years, and a lot of the company’s issues have been self-inflicted.  But I’m pretty positive on the new CEO Steve Easterbrook.  But his sense of urgency and ability to execute on a global scale has not yet had enough time to bee seen.”

• Current McDonald’s Franchisee (13 locations in Florida)

• “Steve Easterbrook did a turnaround in the UK which is pretty similar to what’s going on now.  But the learning curve may be steeper because the global franchisee structure is different than what he had to deal with in the UK.”

• “There is some low-hanging fruit over the next 12 months, like menu simplification and localization.  McDonald’s today can change much more quickly than it has been able to in the past because of the recent management changes.  There is finally some sense of urgency…in the next 90 days we’ll start to see changes.  60-75% of the strategic plan can take place within the next nine months.  Image perception will probably take longer to change.”

• Current McDonald’s Franchisee (12 locations in Illinois)

• “I’ve never met Steve Easterbrook or Mike Andres [President of McDonald’s USA] but I’ve heard good things given Steve’s UK experience.  McOpCo executives have been much more amenable to change and seeking franchisees’ perspectives lately.”

• “I think we are 9-18 months away from turning around the business.  Sales should get back to flattish within the next 12 months.  Given his branding experience, Steve can probably get advertising and marketing changes made pretty quickly, but product and supply chain changes will take more time.”

• Current McDonald’s Franchisee (9 locations in Pennsylvania and New Jersey)

Value Creation Opportunities

Three primary drivers of potential value creation indicate ~26% upside to MCD’s current $96 share price at a 12.5x EV/EBITDA multiple at the end of 2016, or a 17% two-year IRR.

1. Restaurant Refranchising

1. MCD is currently ~81% franchised

2. Plans to refranchise at least ~1,500 units by FY16 (~85% franchise mix)

3. Under new CEO’s plan, MCD could potentially move to ~90% franchised

4. I assume 90% franchise mix across all regions by end of 2017, with proceeds to fund $3bn share buyback

2. Increased Leverage / Share Buyback

1. MCD is currently under-levered

1. 1.3x Net Debt/FY14A EBITDA

2. 2.4x Adj. Net Debt/FY14A EBITDAR

2. Peers are levered at 2.3x Net Debt with a 90% franchise mix, suggesting that MCD can support higher leverage by increasing franchise mix (stable CF’s)

3. I assume an increase to ~2x net debt / FY15E EBITDA at 4% int. rate in 1Q16, with proceeds funding $4.6bn buyback

3. SG&A Reduction

1. MCD has ~2x more SG&A/store than peers

2. With 90% franchise mix + corporate G&A cuts, MCD should be able to cut more than its guided G&A savings of $100mm

3. I assume an SG&A reduction of 7.5% (~$200mm) in FY16

Restaurant Refranchising

MCD has an opportunity to become a more asset-light model by refranchising some of its nearly 7,000 company-owned units, which would likely result in both higher profit per unit and a higher earnings multiple.

• MCD considers itself primarily a franchisor with company-operated restaurants playing a smaller role in the McDonald’s system

• Of the three initiatives MCD said it was considering at a March 2014 conference (i.e. looking at capital structure, evaluating SG&A spend, and considering refranchising opportunities), the only one that it ended up making a meaningful change on was refranchising

• Announced plans in May 2014 to sell at least 1,500 stores in APMEA and Europe through 2016, taking its franchise mix up from 81% to ~85%

• The Street estimates that MCD would receive roughly ~$1.5bn in proceeds from selling the 1,500 international company-operated stores to franchisees, assuming conventional franchise deals

• Proceeds could be higher if the refranchising is done in developmental licensing deals in which MCD would sell any owned land and buildings along with the business

• However, more aggressive refranchising is a possibility

• MCD has a franchise mix of ~81% vs. larger-cap multi-national QSR peers at 92% and the overall peer average of 90%

• By refranchising more aggressively, MCD would create value from cutting SG&A and using the proceeds to buy back shares

• I assume ~3,000 restaurants are refranchised from 2014-2017, bringing MCD’s franchise mix to ~90%

• Assumes $350k EBITDA per store per year, each sold at a 5x multiple with the proceeds taxed at 32%

• Generates $3bn in proceeds from 3Q15 through 2017, which are used to buy back shares at an 8.5% cost of equity

WEN Case Study on Refranchising

• At the end of last year, WEN management indicated they were considering increasing their franchise mix.  In early February 2015, they officially announced their intention to move from an 85% franchised system to a 95% franchised system by middle 2016

• The Company also announced its intention to take balance sheet leverage from 3x to a target of 5x to 6x

• Finally, the Company announced cost cutting actions to reduce SG&A to $230mm (13% reduction relative to LTM levels of $265mm)

• The stock was up nearly 40% from initial hints about refranchising to the final announcement

• Given the new asset-light business model, the stock re-rated from 10x EBITDA to 13x EBITDA within four months

Capital Structure Optimization

MCD should be able to add leverage to its balance sheet and use the proceeds to repurchase stock while maintaining its investment grade credit rating.

• Management has expressed their desire to maintain the company’s current credit rating – “A” at S&P and “A2” at Moody’s – with the belief that its franchisees achieve a 100-150bps borrowing “halo” from having a franchisor in a strong financial position

• MCD initially explored its capital structure in March 2014 and concluded in May that there would be little change

• However, these views on leverage & maintaining the credit rating are likely due more to conservatism on the part of the company

• MCD can likely be more aggressive in adding leverage to capitalize on the current low interest rate environment and attractive financing rates

• MCD is under-leveraged relative to peers – 1.3x Net Debt/EBITDA (vs. peers at 2.3x) and 2.4x Adj. Net Debt/EBITDAR (vs. peers at ~3.0-3.5x)

• Assumes that MCD’s real estate leases are capitalized at 8x to calculate adjusted net debt

• Given how under-leveraged MCD is versus its peers, the company should be more aggressive with its debt

• Adding $10bn of incremental debt would bring MCD’s leverage ratios more in line with its peer set and would generate an additional +$0.30 FY16 EPS (+$5-6 per share at an 18x P/E)

• Adding $10bn of incremental debt would bring MCD’s leverage ratios more in line with its peer set

• For conservatism, I assume that in 1Q FY16, MCD only levers up to ~2.0x PF Net Debt / FY15E Adj. EBITDA, or +$4.6bn incremental debt (assumed at 4% interest rate)

• This implies 2.8x PF Adj. Net Debt / FY14 EBITDAR, a level at which MCD could still maintain its investment grade credit rating today

• My assumptions of $4.6bn incremental debt and after-tax refranchising proceeds of $3bn are used to buy back stock through FY17, with operating cash flow funding additional share repurchases in FY18-19

SG&A Reduction Opportunity

MCD management has communicated that they are beginning to review SG&A for cost cutting opportunities at both the store and corporate levels.

• There are several sources of potential SG&A reduction opportunities, all of which the new MCD management team has stated they are reviewing

• Refranchising

• MCD plans to refranchise at least 1,500 restaurants (more than 400 done in 2014)

• SG&A support for a franchised restaurant should be considerably less than for a company-operated restaurant

• ~$25,000 reduction in SG&A per store from refranchising (1)

• Applying this metric to MCD’s plans implies $35-40mm in potential G&A savings

• Potentially more if some of the refranchising is via developmental licensing (no capex / maintenance G&A required from MCD)

• Localization/Regionalization in U.S.

• New head of U.S. business, Mike Andres, is trying to localize/regionalize the business with less national input on menu, marketing and other matters

• SG&A in the U.S. ($772mm in 2014) could be reduced significantly by rationalizing certain growth initiatives (e.g. Create Your Taste) and focusing on simplification of menu/products

• Fewer Restaurant Openings

• MCD is planning to open fewer restaurants in 2015 (~1,000 vs. ~1,300 in 2014) and could open even fewer than planned

• This could be another area of SG&A reduction

• Management has already announced that they have identified $100mm of SG&A savings opportunities (4% reduction to FY14 SG&A of $2.5bn), which they plan to re-direct toward investment in their digital strategy and other growth initiatives

• I assume a 7.5% reduction in SG&A relative to FY15E levels, or ~$195mm

• Incremental savings to company’s $100mm likely achieved through higher franchise mix shift from refranchising (lower support costs required)

Valuation and Risk/Reward

Applying a discount-to-QSR peers multiple of 12.5x to my base case FY17 EBITDA, MCD represents an attractive long opportunity with 18% one-year upside, 15% three-year IRR, and 2.3x up/down asymmetry.  The downside price of $88 at year-end FY15 assumes a 10x multiple of consensus FY16 EBITDA, plus the $3.40 of dividends collected in FY15.  Note that this downside price implies a 4.0% dividend yield, well above the comps which yield 1.0-1.5%.

Comps

• On consensus FY16E estimates using a range of multiple valuations, MCD trades at a ~20-30% discount to peers

• Applying the larger-cap QSR peer average multiples to my estimates, MCD would trade at ~$125 (30% upside)

• SONC and WEN seem to be the best comps for MCD’s turnaround plan – similar margins and target franchise mix/leverage

• Similar restaurant margins of 16-17%; franchise mix of ~90% and leverage of 2-3x in line with my MCD targets

• At the low end of the 12.5-13.5x EV/EBITDA multiple range for SONC/WEN, MCD would be a ~$118 stock (22% upside)

• The market continues to reward highly-franchised or high-unit growth models with high EV/EBITDA multiples

Downside Analysis

MCD has limited downside due to its ample and steadily growing cash dividend as well as its current valuation relative to historical multiple ranges

• MCD’s annualized dividend is $3.40 per share, and the company has raised the dividend every year since it was initiated in 1976

• Annual dividend growth of between 5-15% since 2010, with the quarterly dividend being raised in Q4 of every year

• MCD has the highest dividend yield in QSR industry

• MCD’s current yield is 3.5% vs. peer average of 1.4%

• My downside price of $88 would be represent a 4.3% dividend yield

• More than 2x the 10-yr U.S. Treasury yield of ~2% for an investment-grade A-rated company with global scale and strong, consistent cash flow

• Over the last 1-, 5- and 10-year periods, MCD has traded as low as 9.8x, 9.1x, and 7.7x forward EV/EBITDA, respectively

• My downside case assumes that MCD achieves consensus FY16 EBITDA and gets valued at a 10x EV/EBITDA multiple at the end of 2015

• Over the last 1-, 5- and 10-year periods, MCD has traded as low as 16.0x, 14.4x, and 13.2x forward P/E, respectively

• My downside case assumes that MCD achieves consensus FY16 EBITDA and gets valued at a ~16x P/E multiple at the end of 2015

Investment Risks and Mitigants

1. Slowing economic activity

1. Restaurant meal occasions are highly discretionary in nature, and MCD customers may be influenced by various macro factors including employment, gas prices, personal savings, discretionary income, housing, consumer confidence, etc.

2. Mitigant: MCD has proven to be very defensive in prior recessions as customers trade down to QSR segment.  Generated  7% SSS in 2008 and 4% in 2009

2. Health and Wellness

1. Customers increasingly desire food that is perceived to be “healthier” with higher quality ingredients

2. Mitigant: Plenty of “bad for you” QSR chains are doing well, suggesting there is growth (albeit slower growth) in legacy QSR segment.  MCD is also in early innings of implementing a plan to advertise the integrity of its ingredients and improving “freshness” of the supply chain

3. Current trends remain challenging

1. MCD continues to struggle on multiple operating fronts (menu innovation, marketing efficacy, food quality, value) which will likely take time to turn around and which have yet to show any signs of improvement.  Checks universally suggest 12 to 18 month timeframe

2. Mitigant: I believe this is well understood by investors.  Some segment of investor base believes bad news is good news as it amplifies pressure on management on other issues (refranchising, leverage, SG&A and real estate)

4. Food and labor inflation

1. Food inflation has historically positively correlated to restaurant traffic, but restaurant margins may be pressured if such costs cannot be passed on to consumers; also, wage increases (either minimum wage or voluntary) would impact margins

2. Mitigant: Beef has been in highly inflationary period that should abate in 2016 / 2017.  Commodities inflation this year should be modest.  Labor inflation is real though mostly borne by franchisees.

5. Foreign currency risk

1. MCD owns or franchises more than 21,000 stores outside the U.S. and therefore has exposure to several different currencies; fluctuations in these currencies may continue to pressure earnings growth.  Approximately 54% of EBIT is outside US and FX movement is a 10% headwind to EPS growth in 2015

2. Mitigant: FX headwinds will eventually abate, and near-term impact has been incorporated into my FY15 projections

6. Valuation

1. Valuation is cheap relative to peer group but full on an absolute basis

2. Mitigant: pro forma for 2x leverage, 90% franchise mix and $200mm SG&A cut, the stock is trading at 10.5x EV/EBITDA and 16.9x P/E, a ~27% discount to peer group

Case Studies: Why MCD’s Turnaround Can Succeed

The turnaround stories of McDonald’s in the early 2000s (“Old MCD”), Burger King (BKW), and Darden (DRI) had many of the same diagnosed issues as today’s MCD and saw meaningful improvement in operations and market valuations within the first year of their turnarounds.  Their case studies provide helpful context for why I believe today’s McDonald’s can and will be turned around.

1. Old MCD

1. Diagnosis

1. Summary: MCD experience a significant downturn in sales and earnings in 1999-2002 across U.S. and Europe as the business transitioned from a robust growth story (1980s & early 1990s) to a mature, saturated brand, suffering a ~$47bn decline in market value in the process

2. Operational Issues:

1. Store saturation / cannibalization

1. MCD became domestically dominant and mature with a global presence yet softness in some of the best foreign markets

2. Too many units in too many markets caused cannibalization of SSS growth at existing restaurants

2. Mis-diagnosis of consumer preferences

1. Significant capital and management attention was invested in the “Made-For-You” system, designed to offer customized burgers, which created peak-hour bottlenecks that caused slowdown in service time

2. Management tried to be all things to all people -- offering too wide a menu (premium, wholesome, snack, and value items) to all demographics (young adults, families, and seniors)

3. Increasing competition

1. MCD’s new Dollar Menu had little differentiation on price and drove softer SSS and margins

2. Burger price wars intensified with competitors offering slim, Dollar Menu equivalents targeted at the $0.99 and $1.00 price points

3. Financial Issues:

1. MCD traded as low as 10-11x forward EPS in late 2002 / early 2003 driven by negative SSS and margin pressure across most regions

2. Turnaround Plan: Old MCD’s “Plan to Win”

1. Summary: Although several changes had already been implemented (e.g. CEO change, announced capex cuts), MCD’s management formally announced their turnaround plan, called “Plan to Win”, at an April 7th analyst meeting in 2003

2. Operations:

1. Change the senior management team

1. CEO Jack Greenberg was replaced by Jim Cantalupo in January 2003

2. Cantalupo was best known for being the chief architect of MCD’s international growth, building the international business from 2,350 units to >15,000 units and $9.5bn systemwide sales from 1987-1999

3. Cantalupo was very well known internally and highly regarded by the franchisee community which gave him early support to make structural changes

2. Rationalize the store footprint

1. In October 2002, MCD announced a surprising cut to its 2003 planned new restaurant openings to roughly half the levels of 2002

2. Plan was to reallocate resources to existing units in order to improve SSS, margins and cash flow

3. New unit expansion would be limited to a few strategic markets while rebuilding sales and margins at existing units

3. Review menu items and G&A spending

1. New management continued to support the Dollar Menu in the U.S., but re-evaluated which items were appropriate to offer at the $1 price point (e.g. the premium Big N’ Tasty sandwich came under review)

2. Potential corporate cost reductions came under internal review

3. Financials:

1. Quarterly guidance was discontinued -- new executive team felt that thinking quarterly was a distraction from the overall company strategy

3. Result:

1. Summary: Old MCD succeeded in its turnaround, driving significant improvement in sales, margins, and stock price, setting the stage for the following decade of growth and profitability

2. Operations:

1. Store growth

1. Despite concerns that his growth-oriented track record would not fit with the turnaround plan, Jim Cantalupo successfully cut back on new unit openings and improved existing store operations

2. SSS

1. Pullback in new store growth reduced cannibalization of existing stores’ SSS

2. Lower store saturation plus a more attractive, simplified menu drove a 1,300bps improvement in overall SSS from 1Q03 to 1Q04

3. G&A spending

1. Pared back corporate spending and eliminated duplicative costs by reducing the number of menu SKUs (resulting in SG&A cuts from 11.2% of rev in 1999 to 10.4% in 2004)

3. Financials:

1. Improved SSS and cost controls drove EBIT margins up more than 500bps within two years

2. MCD’s stock price more than doubled within one year of the turnaround launch, from $14 per share in 1Q 2003 to $30 during 1Q 2004

2. BKW / 3G Capital

1. Diagnosis

1. Summary: From the early 2000s until 2010, Burger King (BKW) lost significant market share to MCD and struggled operationally as it fell behind on menu innovation and marketing, lost consumer mindshare to competitors, and caused grievances among its franchisee base

2. Operational Issues:

1. Misalignment in menu and marketing

1. In early/mid 2000s, BKW doubled down on its historically core customer (young males with an appetite for burgers) without adding healthy alternatives to the menu

2. BKW effectively forfeited the lucrative female / family/ health-conscious consumer base to MCD which was developing healthier new items like salads and wraps

3. When the Great Recession hit in 2008, BKW struggled to capitalize on the “trade-down” phenomenon amongst consumers

2. Outdated stores and image

1. Old store base with cluttered menu boards and outdated fixtures

2. Lack of localization of menu and marketing messages

3. Increasing competition

1. New burger-centric concepts (e.g. Five Guys, Smashburger) began to take mindshare and market share from BKW

2. Competing QSR chains innovated on healthier menu items, attracting the family, female, and health-conscious consumers while BKW focused exclusively on young male customers

4. Unstable ownership

1. Burger King passed into different ownership several times and jumped on and off the public markets every few years

2. Franchisees publicly aired their grievances that the company did not give them sufficient input into the menu and store operations

2. Turnaround Plan: 3G’s Plan to Revive BKW

1. Summary: 3G Capital agreed to take BKW private in September 2010, and after nine months of intensive brainstorming sessions, they developed a four-pillar, $750mm turnaround strategy that was announced in April 2011

2. Operations:

1. Expand the menu

1. Sought to appeal beyond young males to include other demographics (e.g. women, families, the health-conscious consumer)

2. Focused on freshness and more in-house food prep

3. Featured new items like mango & strawberry smoothies, “Garden Fresh” salads, chicken wraps, and mocha & caramel frappes

2. Improve marketing communications

1. Shut down the old campaign which featured the now-retired King mascot and was aggressively geared toward young males

2. New marketing campaign replaced the mascot with broadly-appealing celebrities with recognizable faces (e.g. Mary J. Blige, Jay Leno)

3. Improve operations

1. Improved consistency across restaurants and cut unnecessary corporate overhead expenses

2. Settled long-standing legal dispute with franchisees and gave them more input on Value Menu pricing and length of limited-time offers

3. New management team went on a 58-city tour of BKW locations to introduce themselves and their new vision to franchisees

4. Created three committees - restaurant council, marketing council, and a people council - made up of franchisees and BKW corporate employees to facilitate cooperation between the two camps

4. Refresh the image

1. Promised location remodels at every one of its 7,200+ stores with various enhancements (e.g. digital menu boards, new packaging)

2. Offered royalty reductions and fee discounts to encourage franchisees to renovate their stores early

3. Created $250mm lending facility to give franchisees early access to funding for the reimaging and to pay for the $31,000 worth of equipment needed to prepare the new menu items

5. Change the senior management team

3. Result:

1. Summary: 3G Capital revitalized BKW’s U.S. & Canadian operations and achieved 3 consecutive quarters of SSS growth (and remains on track to achieve its 40% remodel target), while expanding the brand into ~100 countries with a fully franchised model generating QSR industry-leading EBITDA margins

3. DRI / Starboard Value

1. Diagnosis (from Starboard Value 9/14/2014 presentation):

2. Turnaround Plan: Starboard’s Plan to Revive DRI

1. Summary: On 9/14/2014, Starboard Value Fund released a 294-page presentation laying out its plan for value creation through an Olive Garden turnaround (rebound to +3% SSS in each of the next 3 years), operational improvements (primarily cost reductions), and value-enhancing transactions (asset sales / spin-offs)

2. Operations:

1. Infuse a major upgrade in leadership

1. Substantially improve the Board of Directors

2. Appoint a transformational new CEO

3. Align incentives with shareholders

2. Pursue domestic / international franchising

1. Opportunity to drive value via a broader domestic franchising program for Olive Garden and Longhorn Steakhouse

2. More aggressive push into international franchising for all brands

3. Achieve a major operational restructuring -- simplify the menu, optimize food preparation, tighten labor costs, and reduce marketing spend

3. Financials:

1. Sell real estate

1. DRI’s remaining real estate could be worth $2.5-3.0bn, and Starboard estimated that a separation of these assets could drive $1bn of shareholder value

2. Spin off the Specialty Restaurant Group (SRG)

1. SRG collection of higher-end niche brands has strategic value separate from DRI; as a stand-alone company, SRG could be worth $1.6-2.0bn

3. Maintain DRI’s investment grade rating and current dividend

3. Result:

1. Summary: The turnaround is well underway as DRI is executing on cost savings and operational improvements ahead of Street expectations, with two straight positive SSS quarters at Olive Garden (for first time in ~5 years), continuing cost declines, and early moves to monetize the real estate portfolio.  Since the release of its 294-page presentation, Starboard has had its entire 12-person nominee slate elected to DRI’s Board and has begun to catalyze its outlined turnaround.

4. Operations:

1. Management changes

1. DRI shareholders elected all 12 directors nominated by Starboard at the October 2014 DRI board meeting

2. On 2/23/15, DRI appointed Interim CEO Eugene Lee to remain permanently as CEO

2. Operational initiative yielding both sales and margin benefits

1. Olive Garden SSS have improved for four consecutive quarters and are now in positive territory, from a trough of -5.4% in 3Q14 to +2.4% in 3Q15 (quarter ended Feb 28)

2. Restaurant-level margin and EBIT margin improved yoy in 3Q15 for the first time since 2012 as SG&A % of sales declined 160bps

5. Financials:

1. Real estate sales

1. Sale-leaseback agreements have been reached for 31 properties with cap rates “well below” 6%, exceeding management’s internal expectations

2. Proceeds from monetization of real estate, along with excess cash, with be used to reduce debt and further enhance shareholder returns

2. Increase in FY15 guidance

1. Given strong results since Starboard’s turnaround plan launch, management raised its FY15 EPS guidance on much better domestic SSS and margin outlook

3. Stock performance

1. DRI’s stock has appreciated by 43% since Starboard’s presentation release (from $47 avg share price in 1Q15 to $67 as of 4/1/15)

2. Driven by market’s improving sentiment on earlier-than-expected magnitude and timing of turnaround in SSS and margins

Catalyst

• My checks indicate that MCD could experience a potential credit rating downgrade from Moody's or S&P after the company reports 1Q FY15 earnings on 4/22/15, due to continued weakness in U.S. McOpCo sales and margins. Such a downgrade would likely drive many institutional investors to sell the stock uneconomically given various credit rating mandates for their investments. This would create an buying opportunity for investors, as the U.S. weakness is likely in the process of being addressed by the new management team, and the credit rating would likely still remain investment grade, allowing MCD franchisees to still achieve solid terms on their leases.

• The next concrete announcement by new CEO Steve Easterbrook regarding specifics surrounding the value creation levers (e.g. target franchise mix, optimal leverage level, SG&A reduction opportunity) and/or turnaround plan (i.e. menu simplification, new advertising campaign, price architecture, etc.) will likely bode well for investor sentiment and thus the stock.  I would imagine such an announcement being made within the next 1-2 months (either on the 1Q15 earnings call, at the May 2015 annual shareholder meeting, or at one of the various investor conferences at which he will be speaking).