Lost McDonald's Profit Has Ackman Flipping Whoppers

NEW YORK ( TheStreet) -- "Is McDonald's an enormously bloated company?"

Activist investor William Ackman of Pershing Square Capital Management said "yes" to the above rhetorical question after announcing what amounts to a 10% stake in Burger King. In the deal that has primed the "king of burgers" for a stock market return by mid-summer, Ackman may be betting that the Golden Arches are vulnerable.

The hedge fund manager left a lot out of his McDonald's analysis, though.
With Super Size off the menu, is McDonalds still bloated?

Beneath the Burger King headline is a hedge fund manager who knows the McDonald's business well. In fact, Ackman may be looking to redeem value meal-related investment gains that he left on the table when he failed to fully capitalize on a doubling of profits at the world's leading restaurant. Ackman sold most of a near $1 billion McDonalds investment in 2007 after the company's stock nearly doubled over a two-year span on dividend increases and the acceleration of company-owned store sales.

Ackman, who invests in a style that is a hybrid of Warren Buffett's focus on value and Carl Icahn's corporate activism, first tangled with McDonalds by taking a large stake and calling for management to spin off its company-owned stores in 2005.

As Ackman and other Burger King investors, including majority stake owner 3G Capital look to flip the Whopper-creator for a fast food profit with their share stakes in the company's imminent IPO, McDonalds shareholders aren't likely to look on with much envy. Ackman, on the other hand, may try to instill some of McDonald's recent successful ways at Burger King.

For all of Ackman's negativity on McDonald's bloated size in a conference call announcing the Burger King investment -- he did praise McDonalds as "one of the greatest stories of all time."

Meanwhile, Burger King has failed to realize many of the menu diversification opportunities and international growth prospects that McDonalds has capitalized on in recent years.

McDonalds rebuffed Ackman's notion of spinning stores into a publicly traded real estate investment trust and a prospective $300 million buyback in 2005. However, the company has dramatically outperformed the S&P 500 by heeding some of Ackman's advice and capitalizing on other smart moves. Recently retired CEO Jim Skinner followed Ackman's call to monetize real estate assets. The company now franchises roughly 80% of its stores, as it focuses on keeping menu items relevant at its 33,000 restaurants that serve 68 million visitors a day, according to McDonalds' Web site.

Yes, McDonald's is enormously large with nearly 2 million employees, but that hasn't stopped it from meeting competitive threats to its core business and acting as an insurgent in other markets.

In the last five years, McDonalds shares are up over 100%, to near record highs hovering around $100. In Thursday trading, McDonalds' shares were up over 1% to $98.62, just off record highs of $102.22 reached earlier in 2012.

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Even downgrades have become tolerable for McDonalds, as some question whether the Oakbrook, Ill-based company's momentum can continue. On Tuesday, Goldman Sachs removed McDonalds from its "America's Conviction Buy List," on better opportunities in other food stocks like Starbucks ( SBUX) and Chipotle Mexican Grill ( CMG).

Still the downgrade could hardly come with kinder words. "We see McDonalds as best-in-class within the Restaurant subsector and maintain our Buy rating... The company is nowfirmly entrenched in a positive feedback loop whereby strong same store sales drive higher ad budgets and franchisee investments, which in turn drive further gains in SSS, starting the cycle over again," wrote Goldman.

Overall analysts polled by Bloomberg give McDonalds shares a $108.26 price target on 21 "buy" ratings and 10 "holds." The company is expected to see profits grow to $5.8 billion on $28.4 billion in 2012 revenue, according to consensus analyst estimates.

Ackman exited his McDonald's investment to focus on turnarounds at retailers J.C. Penney ( JCP), Target ( TGT) and Sears Holdings ( SHLD). All are yet to yield big profits. Now, Ackman is poised to focus on Burger King, but he may have been better served sticking with McDonalds, where he once flipped burgers for a day.

The doubling of McDonalds profits since 2005 to $5.5 billion on a near 100% jump in the company's emerging market sales and strong growth in its European operations certainly proves that McDonalds is large. Bloated, on the other hand, is arguable.

In exiting his investment, Ackman may have underestimated McDonalds ability to push into Asian markets, where Kentucky Fried Chicken-owner Yum! Brands ( YUM) has a leading presence, and its appeal to European tastes, where the company generates the largest portion of its sales. Meanwhile, McDonald's McCafé offerings of coffee and smoothie drinks are a big competitive threat to Starbucks ( SBUX) and Dunkin' Brands ( DNKN).

In fact, McDonalds has outperformed a resurgence of Starbucks over the last 5 years, even after CEO Howard Schultz returned to the company. McDonald's has even captured opportunities missed by a much smaller Burger King.

Ackman said on the investor call that he and Burger King's majority owner would franchise the majority of its restaurants. Meanwhile, Burger King recently launched an overhaul to its burger-dominated menu, adding items like mango-flavored real fruit smoothies and honey-mustard crispy chicken snack wraps. Those moves may help Burger King win back its waning market share, while adding to an impressive turnaround of its finances.

Burger King has been a laggard in the fast food lane. In March, Wendy's surpassed Burger King as the second largest burger chain in the U.S., according to Technomic. Overall, McDonalds sales are up 26% in the past five years at McDonald's, up 9% at Wendy's and flat at Burger King, according to the data.

In a Tuesday press release, Ackman highlighted the improving earnings of Burger King, citing metrics that have been a key to many of his previous value investing coups. "Since 3G's acquisition of Burger King in October 2010, EBITDA minus CapEx has increased from $320 million in 2010, to $503 million in 2011, with 2012 EBITDA minus CapEx expected to be nearly double that of 2010's results," said Ackman.

Burger King, Ackman said, can be a "fast-moving, aggressive competitor" to McDonald's in a turnaround effort that he likely hopes could help recover some missed opportunities on previous investments.

"Burger King's going to do the same thing, more quickly," noted Ackman of McDonalds turnaround on Wednesday's investor call.

Either way, the King's attempt to retake the fast food crown by showing McDonald's to be little more than a jolly clown will be a highlight of the coming American summer, as investors await what could be a large share offering.

With Burger King, Ackman is back in McDonald's backyard via a new route, and this time, Pershing Square investors should hope he stays around long enough to reap all the rewards from his fast food menu suggestions.

For more on McDonalds corporate strategy and food investments, see why Chipotle is set to be the next McDonalds and the 5 short sighted stock spinoffs.

See 5 deal ready stocks loved by hedge funds for more on deal trends and five stocks that could be trampled by a share overhang, for more on private equity backed IPO's.

-- Written by Antoine Gara in New York

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