Pershing Unveils New Plan for McDonald's

The fund seeks to spin off 20% of the company-operated restaurant business.
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Updated from 4:23 p.m. EST

Activist hedge fund Pershing Square Capital on Wednesday released its revised plan to unlock shareholder value at

McDonald's

(MCD) - Get Report

, calling for the fast-food giant to spin off 20% of its company-operated restaurant business.

Pershing, which owns 4.5% of McDonald's through deep-in-the-money options, has already been

rejected once in its bid to enhance value at the Golden Arches. In his new plan, Pershing manager Bill Ackman also seeks to have McDonald's sell off 1,000 of its roughly 8,000 company-operated restaurants to franchisees and use the funds to boost expansion in China and Russia.

Assuming McDonald's were to adopt the moves, Pershing believes the company's stock would get a boost of $10 to $15 per share.

Pershing's previous plan called for McDonald's to sell off 65% of its company-operated restaurant business and take on $9.7 billion of incremental debt. Even though the new plan is less radical -- largely because it requires no new leverage -- McDonald's once again quickly rejected Ackman's ideas.

"Mr. Ackman is clearly passionate about the company and we respect that. We also appreciate his candor in acknowledging that his previous ideas presented publicly were not workable," Mary Kay Shaw, McDonald's vice president of investor relations, said in a statement. "But the fact is, with his latest presentation, he has not presented anything fundamentally new beyond what we've discussed with him previously and what we have evaluated."

Pershing is not likely to go away quietly. Ackman has admitted in the past that he's stubbornly persistent when he feels he's right. The hedge fund was already influential in getting

Wendy's

(WEN) - Get Report

to agree to spin off its Tim Hortons chain in an initial public offering that is set to hit the market this year.

The Wendy's case holds an interesting comparison to McDonald's. In both situations, Ackman felt lucrative "brand-heavy" businesses were being buried in the lager corporate parents. With Wendy's, it was the Tim Hortons doughnut chain, which is very popular in Canada. With McDonald's, Ackman feels that the franchise-fee business is being buried.

McDonald's current business is split into two main parts: company-operated restaurants and its franchise business. Pershing feels the franchise division is more lucrative because it skims off the top of franchisees' business by collecting 13% of such restaurants' revenues. (This comes in the form of rent and franchise fees).

On the other end of the spectrum, however, are the company-operated restaurants, known as "McOpCo," which Pershing criticizes as being a financial underachiever.

Pershing's current plan calls for McDonald's to issue more transparent financial reporting that shows just how much the company's free cash flow is helped by the lucrative franchise fees it collects, rather than its low-margin burger-making business.

The goal is to show that McDonald's is more like a sexy brand-heavy business like

Coca-Cola

(KO) - Get Report

, rather than just a boring restaurant chain. The theory is that if McDonald's could communicate this brand equity to Wall Street, then investors would reward the stock with a higher valuation.

Commenting on McDonald's "brand business," Ackman on Wednesday told investors, "It's one of the great businesses of the world. If you could own 13 cents of every dollar spent at McDonald's anywhere in the world, you own this currency-hedged, inflation-protected growing stream of cash. It's really the ideal (Warren) Buffet-type business model. ... At the end of the day, in our view, it's really a payment for a brand."

Investors are sure to hone in this point. "He's fundamentally right that they're a brand company and it's masked by the fact that they have this huge operating company that one, isn't very efficient, and secondly, allows them to run a very bloated overhead at the corporation," one smaller institutional investor in McDonald's, who asked not to be named, told

TheStreet.com

.

By spinning off 20% of McOpCo into a new public company with an independent board and more equity-based incentives for managers, Pershing believes McOpCo would be a better performer. The plan calls for the McOpCo restaurants to start paying market rents and franchise fees, just as the franchise restaurants do -- thus ending corporate subsidies and increasing efficiency. Pershing feels investors would reward this lean business model, along with McOpCo's new focus on boosting its presence in China and other emerging markets.

After the IPO spinoff, McDonald's could spend 90% of its after-tax free cash flow on an increased dividend, Pershing says. The hedge fund says the company's annual dividend could jump to $1.93 per share from the current 67 cents. That amounts to a 5.7% yield based on the stock's current price.

But for now, McDonald's isn't budging.

"We continue to believe that an IPO of McOpCo will not deliver the value already being created by our current strategy," said McDonald's Shaw. "We also believe there are better and simpler ways to accomplish the McOpCo goals articulated."

The next step for Pershing is get some backing from influential institutional investors. First up might be Leon Cooperman, who heads the Omega Advisors hedge fund, which owns more than $125 million of McDonald's stock. Even though Omega owns less than 1% of McDonald's, Cooperman is a respected investor, having spent much of his career in top buy-side positions at

Goldman Sachs

(GS) - Get Report

.

Cooperman told

TheStreet.com

he continues to be very interested in Pershing's plan, though he still hasn't come out with full-fledge support.

Ackman has a "view that the market is misvaluing the company and I'm inclined to agree with him," Cooperman said in an interview. "The guy has got very good arguments, and I think the company owes its shareholders a reasoned response." Cooperman says it is "inappropriate" for McDonald's to so quickly dismiss Pershing's proposal.

But ultimately, if Pershing is right, then institutional investors could be swayed by the argument.

"It's really going to depend on how the large shareholders look at this and what they communicate back to the company," says the smaller institutional investor.

After hearing that McDonald's had swiftly rejected his plan, Ackman said the company's earnings call next week should be very interesting.

"Shareholders are not going to be satisfied with the company's statement (today), nor are franchisees," Ackman says.

McDonald's shares closed up 47 cents, or 1.4%, to $35.06.