Pershing Turns Up McDonald's Heat

The battle for the future of McDonald's ( MCD) heated up Tuesday morning, when a major hedge fund investor said he believes the burger giant's stock could trade anywhere from $10 to $15 higher if the company were to spin off its company-operated restaurants and focus instead on its lucrative franchise and real estate business.

Bill Ackman, managing director of Pershing Square Capital, which has amassed a 4.9% stake in McDonald's, brought his proposal public Tuesday morning at the Value Investing Congress conference in New York City.

Ackman said he first urged McDonald's management in September to spin off its company-operated restaurants (which he criticized as a costly and low-margin business) into a separate IPO and keep the remaining franchise business. Under the proposal, McDonald's would keep a 35% interest in the new IPO, but would generate its remaining income from rental leases and fees from franchisees.

The leftover McDonald's would become a real estate-heavy, brand-selling operation, somewhere between a retail real estate company and a brand-heavy firm like Coke ( KO)or PepsiCo ( PEP), Ackman said. The ideal outcome would be that Wall Street then valued the company higher.

Currently, about 73% of the McDonald's global restaurants are franchises; in the U.S., it's 85%, according to McDonald's. Although fees can vary, franchises pay the company, on average, a service fee of 4% of sales in the U.S., and average rent of 9% to 10% of sales. This roughly 13% of franchisee sales is what Ackman wants McDonald's to keep.

For its part, McDonald's rejected Ackman's proposal in late October. Ackman said he is now planning to revise the proposal and bring it to management's attention once again.

But once again, McDonald's isn't budging.

"In our view, the concept outlined at today's Value Investing Congress would not create significant value for McDonald's shareholders," McDonald's Chief Financial Officer Matthew Paull said in a statement. "McDonald's and two separate outside advisors have carefully evaluated the ideas presented and concluded that they would pose serious strategic and financial risks to McDonald's and our overall system.

"The proposal is an exercise in financial engineering and does not take into account McDonald's unique business model. While we remain open to ideas, we simply will not jeopardize the long-term health of our company, nor our relationships with customers, franchisees and suppliers for such a financial engineering exercise," Paull added.

The key disparity between Pershing's and McDonald's views, Ackman explained, regards the valuation of McDonald's after the spinoff of the operating company.

By shedding off its low-margin company-operated restaurants, Ackman believes the new McDonald's would trade at a multiple of 19.9 times to 22.2 times his 2006 EPS estimate of $2.27, meaning shares would hit between $45 and $50, with dividend yields between 5.1% and 4.6% respectively. Currently, McDonald's shares are trading near $34. "That would be one of the largest value creations in corporate America," Ackman said of the possible conversion.

"We also think this will attract a whole slew of new investors to the company," Ackman said. A brand business is more exciting than a restaurant business, he said. "Bottom line, it's not a restaurant company."

One of the biggest roadblocks to Ackman's plan seems to be the advice of the investment bankers that McDonald's hired to advise it on the proposal. In his presentation, Ackman said McDonald's told him that its investment bankers thought a post-spinoff McDonald's would still trade as a restaurant stock, with lower multiples. Ackman said the idea is "absurd" since he calculates the company is sitting on $46 billion of real estate. McDonald's current market cap is about $42.5 billion.

One institutional investor in McDonald's who was present at the conference Tuesday and who requested anonymity, told TheStreet.com that the multiple assumptions for a post-spinoff McDonald's is the key issue and suggested that using current real estate multiples could be misleading, given how real estate investment trust prices have run up in price over the past couple of years.

Currently, retail REITs' median multiples range between 12.3 to 12.7 times 2006 fund from operations, a key REIT profit metric, according to SNL Financial. Simon Property Group ( SPG), the largest mall owner in America, is currently trading at 14 times its 2006 estimated FFO. The median multiple for REITs with net-leases (like McDonald's has) is 12.5 times 2006 earnings.

Ackman's proposal is sure to heat up discussion about valuation among intelligent investors.

Leon Cooperman, senior partner with Omega Advisors, which owns $100 million of direct stock in McDonald's, told TheStreet.com after Ackman's presentation that he'd review Ackman's proposal and "if I agree with his conclusions, I will support him."

"I think really it's up to McDonald's now to come forth and tell us why they disagree with his proposal," Cooperman said. "I suspect that many large mutual funds have an obligation to basically represent their investors in the most intelligent way possible. We're in a different world now. We're in a world of intelligent activists, not unintelligent. This man (Ackman) has done serious work and he is to be respected."

Ackman says he won't back down. "I'm the most persistent person you'll ever meet," he said, especially when he feels he's right. He doesn't think the matter has to go to the extreme of a proxy battle -- but he didn't exactly rule out a proxy battle in the event that management stonewalls him. He added that his McDonald's stake, which is mostly controlled through options, is the largest investment in a company that he's ever made.

He also said he looked at a proposal to convert McDonald's into a real estate investment trust, or REIT, but doesn't favor that strategy since it brings significant costs and complications, especially regarding McDonald's international real estate. Ackman said he hasn't been working with Vornado Realty Trust ( VNO), a major REIT that disclosed a 1% stake in McDonald's earlier this month. Vornado appears to favor some sort of REIT conversion for McDonald's.

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