Free Cash Flow to Equity (FCFE) Valuation Model

Sr. Analyst: Leo Cardoso

Name: McDonald’s Corp. (NYSE: MCD) 07/02/10

Country: USA Current $: 66.14
Sector Classification: Consumer Discretionary 1-yr Trg $: 71.38
Industry Classification: Hotels, Restaurants & Leisure Expected % Chg: 7.93%
Sub-Industry Classification: Restaurants Dividend Yield: 3.3%
Our Action: MAINTAIN
Risk Level: MEDIUM

FUNDAMENTALS DASHBOARD

McDonalds Stock Information $30,000 $8,000

Provided by Yahoo.com $25,000

$7,000

Day's Range: 65.96 - 67.00 $6,000

$20,000
$5,000
52wk Range: 53.88 - 71.84
$15,000 $4,000
Volume: 5,280,990
$3,000
$10,000
Avg Vol (3m): 7,522,610 $2,000
Market Cap: 71.15B $5,000
$1,000
P/E (ttm): 15.59 $0 $0
2005 2006 2007 2008 2009 2010 2011 2012
EPS (ttm): 4.24
Revenues Operating income Net income
Div & Yield: 2.20 (3.30%)
90% 70% $12,000 15
80% Gross
60% $10,000
Margin
70%
50% $8,000 10
60%
40%
Operating $6,000
50% Margin
40%
$4,000 5
30%
30% Profit
$2,000
20%
20% Margin $0 0
10% 10% 2005 2006 2007 2008 2009 2010 2011 2012
Total op.
0% 0%
expense Total debt Interest Coverage ratio (Op. income basis)
2005 2006 2007 2008 2009 2010 2011 2012

INDUSTRY COMPETITIVE FORCES

$5.0 $5,000

$4.0 $4,000 Porter 5 forces (1 = low; 5 = high)

$3.0 $3,000
Threat o f New Entrants
$2.0 $2,000 5
4
$1.0 $1,000
3
$0.0 $0 Intra-industry Rivalry 2 Threat o f Substitutes
2005 2006 2007 2008 2009 2010 2011 2012 1
Earnings per share - basic Net income 0

B arganing P o wer o f
B arganing P o wer o f B uyer
Supplier

Defiance Capital Management – Economic and Investment Research & Analysis. All rights reserved. Copyright 2009-2010.
1 – Introduction

1.1. Company description

McDonald’s Corporation, together with its subsidiaries, operates as a worldwide foodservice retailer. It franchises
and operates McDonald’s restaurants that offer various food items, soft drinks, coffee, and other beverages.
Independently owned and operated distribution centers, approved by the Company, distribute products and
supplies to most McDonald's restaurants. In addition, restaurant personnel are trained in the storage, handling and
preparation of products and in the delivery of customer service. In February 2009, the Company sold its interest in
Redbox Automated Retail, LLC. As of December 31, 2009, the company operated 32,478 restaurants in 117
countries, of which 26,216 were operated by franchisees; and 6,262 were operated by the company. It primarily
operates in Europe, Asia Pacific, and northern America. McDonald’s was founded in 1948, employs 385,000 and its
headquarter is in Oak Brook, Illinois.

1.2. Industry description

1.2.A. Restaurant (quick service/take-out; aka fast-food) industry:

In this report, global activity of the restaurant industry is related to the quick service/take-out segment where
customers usually pay before eating; purchases are then consumed immediately on-site, taken out or ordered over
the phone or internet for home-delivered. Most of these establishments sell beverages (i.e. water, juice or soft
drinks), but not usually alcohol. Convenience Store Chains are considered a similar industry since they also provide
a limited range of take-out snacks.

The industry is supplied by the global agricultural, hunting, forestry and fishing industries and global consumers
demand its products. In 2010, the fast-food restaurants segment will account for ~10.7% of the much larger global
food service industry expected revenue of US$3.0 trillion. After a 2.5% decline in global revenues to $307.0 billion
in 2009, the fast-food industry expects a gain in revenues during 2010 of 4.5% to $321.0 billion due to an expected
cyclical economic upturn, particularly an increase in disposable income and a decline in unemployment rate.

In many developed nations, the industry has now reached a market saturation level that has resulted in sluggish
revenue and demand growth, increased competition and further industry consolidation. Heighted concerns among
the global population about health and obesity issues together within increasing concern about litter generated by
take-out customers and waste recycling issues are also taking its toll on the industry revenues. Finally, the global
recession of 2008/2009, particularly the rapid increase in unemployment and consequent decrease in disposable
income has contributed to sluggish demand conditions. Major operators have responded to those concerns by
redesigning their stores, menus and products, introducing discounted and low priced-meals, implementing cost
reduction measures and looking to jump start growth by focusing on developing nations.

2 – Macroeconomic Review

For further analysis on the macroeconomic conditions (Health of the Consumers, Employment Situation, national
Output and Inventories Conditions, Housing and Construction Conditions; Prices, Productivity and Wages
Indicators) of the major countries in which this company operates please refer to our global macroeconomic
analysis at www.defiancecap.com

Defiance Capital Management – Economic and Investment Research & Analysis. All rights reserved. Copyright 2009-2010.
3 – Understanding the Business and Industry (company and industry analysis)

3.1. Industry and competitive analysis

3.1.A. Industry classification

1
A.1. Life cycle position

Particularly in the US and somewhat among other developed nations, market saturation reached its limit
and the industry is in the mature stage of its life cycle. As mentioned, heightened concerns within
developed societies about health and obesity issues, for adults and children alike, its also hurting growth.
Nevertheless, among developing nations the fast food industry is in the growth stage. There, large
populations with a high growth, younger group ages, raising middle-income households, and increase
taste for Western foods are driving demand for fast food establishments. Despite the opportunities to
jump start sluggish growth by establishing presence in those markets, the global trend on healthy eating
habits is also becoming a concern among developing nations as well. This problem will continue to linger
around major operators who provide high fat, salt and sugar products.

A.2. Business cycle

The industry follows the business cycle. As the business cycle progress, unemployment decreases and
discretionary income increases, a great number of households tend to change habits from in-home eating
to out-of-home eating due to convenience and limited time, work and family commitments.

A.3. Sensitivities

o Economic indicators: Consumer Sentiment Index, Unemployment rate and Per-Capita disposable
income (which relates to taxes, interest rates and gas prices).
o Attitude changes: Health consciousness.

3.1.B. External factors: The Big Picture

B.1. Technology

Technological advances do not threaten this industry survival and the use of technology is focused on
enhancing profitability and customer experiences. According to the 2005 Restaurant Technology Study
undertaken jointly by Hospitality Technology and Deloitte & Touche LLP, the current use of technology by
operators in this industry aims to reduce labor costs, reduce food cost/waste and increase sales. The
major operating system is franchising and the technology employed focus on increase quality of service
and decrease customers waiting time. Think in terms of efficient kitchen layouts, front counter and drive-
trough to kitchen ordering systems, point-of-sale systems, supplies ordering and management systems,
among others.

B.2. Government

The general food services segment is relative highly regulated and the trend in regulation is steady. Major
operators are exposed to legislative and political will, as franchise promotions, minimum wage regulation,

1
For detailed description of industry life cycle, see table 1 on appendix 1.

Defiance Capital Management – Economic and Investment Research & Analysis. All rights reserved. Copyright 2009-2010.
 employee benefits and conditions, and food safety and handling are some but not all the areas where
regulatory issues can arise. Examples are, “FDA model food code”; “FDA nutritional value & claims”; ban
of trans-fats in foods in Denmark, Austria, New York and California; and among others, ban of TV
commercial at certain peak children viewing times in Britain, Norway and Sweden. Currently in the US,
Michelle Obama is ahead of a public awareness campaign title, “Let’s Move”, to fight children obesity,
raise public awareness of health and nutrition issues. Furthermore, the idea of governments to levy
specific taxes on fast food sales aiming at offsetting the rising public healthcare costs associated with
overweight or obesity is starting to emerge, albeit stills at its infancy.

B.3. Social

More worrisome than forced taxes is the emerging trend among populations related to healthy lifestyles
and nutrition. Major operators have responded by introducing healthier products and choices.
Nevertheless, some fast-food restaurants have spent million of dollars in campaigns advertising their
“juicy” burgers, combo meals and crispy fries. It remains to be seen if customers will easily change their
perception about some of these places.

B.4. Segmentation and Demographics

When talking about fast-food restaurants one might immediately associate the industry with well-known
global franchises; but in reality, shops operated by one owner serving local cuisine dominate the industry.
Those represent ~ 70.6% of the global market, while fast-food (chicken and hamburgers sandwich shops,
together with pizza style meals) represents the remainder 29.4%. To be fair however, the major operators
capture a much larger share of available revenues in the industry.

North America is the dominate region of the world and is responsible for ~62.8% of the total revenues
share of the fast food industry and the US alone represents 57.3%. The European region comes in second
with ~10.0%, North Asia and South Asia in third and fourth with ~9.2% and ~9.0% respectively. South
America comes in fifth with only 3.8%, and the rest of the world (Oceania, India, Central Asia, Africa and
Middle East) together account for 5.1%.

It is estimated that 55% of total industry revenue is derived from middle and upper middle-income
individuals, with about 30% from upper ranges of the lower income households and the remainder from
high-income households. High-income household have more of a tendency to consume more meals at
full-service, sit down restaurants and they also are relatively better educated at the dangers of over-
eating foods with high fat, salt and sugar content.

B.5. Foreign

As it will be discussed below, the industry is focusing on international expansion as a lifeline for growth
outside their mature markets.

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3.1.C. Porter 5 Forces

Michael Porter has defined five dimensions as Porter 5 forces (1 = low; 5 = high)
a framework to understand significant
Threat o f New Entrants
influences in the industries or companies 5
under scrutiny. On the right is our assessment 4
about these five forces and the degree of 3
Intra-industry Rivalry 2 Threat o f Substitutes
influence that we believe they have in the 1
restaurant industry. 0

B arganing P o wer o f
B arganing P o wer o f B uyer
Supplier

3.1.D. Demand analysis

D.1. End users

The industry is very sensitive to household disposable income, the portion of customer’s budget that
finances such expenditures. In turn, the labor market conditions, as well as taxes, interest rates levels and
gas prices affect household disposable income. Furthermore, consumer sentiment, population size and
growth, as well as consumer attitude also play important roles in the potential market size and growth
opportunities.

D.2. Trends and cyclical variation around trends

Strong trend towards healthy lifestyles will undermine growth opportunities.

3.1.E. Supply analysis

E.1. Degree of concentration

Industry concentration is low. The top four global players – McDonald’s, Yum Brands, Wendy’s/Arby’s and
Burger King, all US based – account for ~ 12.5% of the available market share. Nevertheless, market
saturation in their primary markets (developed nations) is very high. By 2015, it is expected that these
global players will only marginally increase their market shares as single-owner establishments offering
local, traditional and in-demand food styles will absorb more of the demand from the increase in
population and income levels. As a result, further consolidation is expected among the major franchised
and chain operators, as they continue to battle with a low revenue and profit growth environment

E.2. Ease of entry (barriers to entry; threat of new entrants; Porter 5 forces)

The barriers to entry outline the factors that prevent/limit a new operator from entering this industry.
Currently, barriers to entry in the restaurant industry are low as evidenced by the fragmentation of the
industry. Any prospective operator can lease a location and equipment, lowering the initial fixed capital
outlay and borrowings. Entry can also occur through a franchise agreement.

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3.1.F Industry Profitability

F.1. Cost factors

The industry revolves around high turnaround and low margins. As a result, any decline in demand, such
as the one occurred during the 2008/2009 global recession, directly influences the bottom line. Besides,
rent or mortgages, labor, inventory (food + beverages) and food waste are the most important cost
components of an operation. Since the turn of the century, higher food and commodity costs, as well as
labor costs (wages, benefits, insurance and worker’s comp) are squeezing margins and hurting industry
profitability as not all of the cost increase could be passed on to customers as higher prices.

F.2. Pricing

As disposable income shrinks due to the current recessionary environment, and customers continue to
look for value propositions, major operators will continued to have difficulties on passing on increases in
input costs.

F.3. Int’l competition and markets

In recent years, foreign revenue has been increasingly accounting for a higher portion of total revenues
for major operators. The trend toward global competition is intensifying as developed markets reached,
or are close to reach full saturation points. Many of the major operators located in the US already have a
high level of globalization and the battle for int’l growth will be intense.

McDonald’s PROFITABILTY CHART

35% $30,000

30% $25,000
25%
$20,000
20%
$15,000
15%
$10,000
10%

5% $5,000

0% $0
2005 2006 2007 2008 2009 2010 2011 2012

Opera ting ma rgin Profit ma rgin Revenues

3.1.G. Major Competitors

G.1. Burger King Holdings, Inc. (NYSE: BKC)

G.2. Yum! Brands Inc. (NYSE: YUM)
G.3. Wendys Arby’s Group (NYSE: WEN)

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4 – Historical Financial Data and Key Financials Input Forecasts

4.1. Financial Statements

Key financial data
§ in MM's of USD, exc/sh. amt.
Table 1: Key financials§ Actual Forecast
2005 2006 2007 2008 2009 2010 2011 2012

Revenues $19,833 $20,895 $22,787 $23,522 $22,745 $23,427.0 $24,129.9 $24,853.7

Growth 5.4% 9.1% 3.2% -3.3% 3.0% 3.0% 3.0%
Gross margin 74.8% 75.5% 75.9% 76.3% 77.2% 77.0% 77.0% 77.0%
Operating expenses $10,888 $11,427 $13,536 $11,604 $10,894 $11,818.5 $12,173.0 $12,538.2
Growth 5.0% 18.5% -14.3% -6.1% 8.5% 3.0% 3.0%
% of sales 54.9% 54.7% 59.4% 49.3% 47.9% 50.4% 50.4% 50.4%
Operating income (loss) $3,940 $4,356 $3,763 $6,332 $6,673 $6,220.4 $6,407.0 $6,599.2
Growth 10.6% -13.6% 68.3% 5.4% -6.8% 3.0% 3.0%
Operating margin 19.9% 20.8% 16.5% 26.9% 29.3% 26.6% 26.6% 26.6%
EBITDA margin 26.2% 26.8% 21.8% 32.1% 34.7% 32.0% 32.0% 32.0%
Income (loss) before taxes $3,674 $4,154 $3,572 $6,158 $6,487 $6,023.3 $6,204.0 $6,390.1
Growth 13.1% -14.0% 72.4% 5.3% -7.1% 3.0% 3.0%
Pretax margin 18.5% 19.9% 15.7% 26.2% 28.5% 25.7% 25.7%
Net income (loss) $2,602 $3,544 $2,395 $4,313 $4,551 $3,915.2 $4,032.6 $4,153.6
Growth 36.2% -32.4% 80.1% 5.5% -14.0% 3.0% 3.0%
Profit margin 13.1% 17.0% 10.5% 18.3% 20.0% 16.7% 16.7% 16.7%
Current assets $6,219 $5,192 $3,582 $3,518 $3,416 $4,126.1 $4,249.9 $4,377.3
Growth -16.5% -31.0% -1.8% -2.9% 20.8% 3.0% 3.0%
% of total assets 20.7% 17.9% 12.2% 12.4% 11.3% 13.4% 13.4% 13.4%
Fixed assets, net $19,573 $19,438 $20,985 $20,255 $21,532 $21,554.4 $22,201.1 $22,867.1
Growth -0.7% 8.0% -3.5% 6.3% 0.1% 3.0% 3.0%
% of total assets 65.3% 67.1% 71.4% 71.2% 71.2% 70.2% 70.2% 70.2%
Total assets $29,989 $28,975 $29,392 $28,462 $30,225 $30,694.9 $31,615.8 $32,564.3
Growth -3.4% 1.4% -3.2% 6.2% 1.6% 3.0% 3.0%
% of total assets 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0% 100.0%
Current liabilities $4,108 $2,952 $4,499 $2,538 $2,989 $3,399.3 $3,501.2 $3,606.3
Growth -28.1% 52.4% -43.6% 17.8% 13.7% 3.0% 3.0%
% of total assets 13.7% 10.2% 15.3% 8.9% 9.9% 11.1% 11.1% 11.1%
Total debt $9,593 $8,408 $8,175 $10,218 $10,578 $9,801.6 $10,095.6 $10,398.5
Growth -12.4% -2.8% 25.0% 3.5% -7.3% 3.0% 3.0%
% of total assets 32.0% 29.0% 27.8% 35.9% 35.0% 31.9% 31.9% 31.9%
Total liabilities $14,843 $13,516 $14,112 $15,079 $16,191 $15,440.3 $15,903.6 $16,380.7
Growth -8.9% 4.4% 6.9% 7.4% -4.6% 3.0% 3.0%
% of total assets 49.5% 46.6% 48.0% 53.0% 53.6% 50.3% 50.3% 50.3%
Total equity $15,146 $15,458 $15,280 $13,383 $14,034 $15,254.6 $15,712.2 $16,183.6
Growth 2.1% -1.2% -12.4% 4.9% 8.7% 3.0% 3.0%
% of total assets 50.5% 53.4% 52.0% 47.0% 46.4% 49.7% 49.7% 49.7%
(Increase) decrease in NWC na ($163) ($36) $246 $171 ($245.5) $33.9 $34.9
Growth -77.8% -779.0% 30.4% 243.6% -113.8% -3.0%
% of revenues -0.8% -0.2% 1.0% 0.8% -1.0% 0.1% 0.1%
Cash flow from operation na $4,342 $4,876 $5,917 $5,751 $4,648.4 $5,074.6 $5,226.9
Growth 12.3% 21.3% -2.8% -19.2% 9.2% 3.0%
% of revenues 20.8% 21.4% 25.2% 25.3% 19.8% 21.0% 21.0%
Cash flow from investing na ($1,274) ($1,150) ($1,625) ($1,655) ($1,141.8) ($1,176.0) ($1,211.3)
Growth -9.7% 41.3% 1.9% -31.0% 3.0% 3.0%
% of revenues 6.1% 5.0% 6.9% 7.3% 4.9% 4.9% 4.9%
Dividends and other distribution na ($1,217) ($1,766) ($1,823) ($2,236) ($1,952.1) ($2,010.6) ($2,070.9)
Growth 45.1% 3.3% 22.6% -12.7% 3.0% 3.0%
Payout ratio 34.3% 73.7% 42.3% 49.1% 49.9% 49.9% 49.9%
Cash flow from financing na ($5,460) ($3,996) ($4,115) ($4,421) ($4,149.3) ($4,273.7) ($4,401.9)
Growth -26.8% 3.0% 7.4% -6.1% 3.0% 3.0%
% of revenues 26.1% 17.5% 17.5% 19.4% 17.7% 17.7% 17.7%
Soucre: Thompson Research

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4.2. Financial Ratios
Ratio analysis Actual Forecast
2006 2007 2008 2009 2010 2011 2012
Table 4: Key financial ratios
Liquidity Analysis
Internal liquidity
Current ratio 1.76 0.80 1.39 1.14 1.21 1.21 1.21
Cash flow from opeation ratio 1.47 1.08 2.33 1.92 1.37 1.45 1.45
Cash conversion cycle 25 20 17 20 20 21 21
Long-term solvency
Total debt/Total Equity 54.4% 53.5% 76.4% 75.4% 64.3% 64.3% 64.3%
Total debt/Total Asset 29.0% 27.8% 35.9% 35.0% 31.9% 31.9% 31.9%
Interest coverage ratio (Op. income basis) 10.84 9.18 12.12 14.04 13.22 13.22 13.22
Cash to debt ratio 30.6% 35.3% 40.5% 36.8% 29.4% 32.4% 32.4%
Activity Analysis
Short-term operating activity
Inventory turnover 39.83 46.17 47.18 47.57 47.75 45.75 45.75
Receivables turnover 26.11 24.49 23.19 22.35 22.51 23.29 23.29
Payables turnover 7.59 8.49 8.98 8.24 8.26 8.18 8.18
Long-term operating & investment activity
Net fixed asset turnover 1.07 1.13 1.14 1.09 1.09 1.10 1.10
Total asset turnover 0.71 0.78 0.81 0.78 0.77 0.77 0.77
Total equity turnover 1.37 1.48 1.64 1.66 1.60 1.56 1.56
Profitability Analysis
Gross margin 75.5% 75.9% 76.3% 77.2% 77.0% 77.0% 77.0%
Operating margin 20.8% 16.5% 26.9% 29.3% 26.6% 26.6% 26.6%
Profit margin 17.0% 10.5% 18.3% 20.0% 16.7% 16.7% 16.7%
Management Effectiveness
ROA 12.0% 8.2% 14.9% 15.5% 12.9% 12.9% 12.9%
ROE 23.2% 15.6% 30.1% 33.2% 26.7% 26.0% 26.0%

5 – Valuation Methodologies

5.1. Absolute valuation models

Absolute valuation models specify an asset’s intrinsic value. This type of model produces an estimate of value that
can be compared with the asset’s market price. The most important type of absolute equity valuation models are
Discounted Cash Flow models, which can be in accordance with the type of cash flow used as an input.

Since we are valuing cash flows at the company level, we will use the Free Cash Flow to Equity Model. In essence,
we define free cash flows as those remaining after all liabilities claims have been satisfied, including debt related
repayments and reinvestment in operational capability in order to keep the business operating as a going concern.
While free cash flows to the firm (FCFF) are those available to all provides of capital (bondholders and equity
holders alike), free cash flow to equity (FCFE) are those only available to equity holders after obligations to
bondholders have already been satisfied.

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5.1.A. Free Cash Flow to Equity Model (FCFE)

Our model estimates an intrinsic value of $71.38, which is equivalent to a 7.93% appreciation from the current
prices of $66.14 without accounting for the 3.3% dividend yield. All together, we expect a total return of 11.23%
within a 1-yr period. Risks to our valuation are related to the economic environment, consumer attitudes towards
healthy eating and cost of inputs to the company’s products.

Defiance Capital Management – Economic and Investment Research & Analysis. All rights reserved. Copyright 2009-2010.
5.2. Relative valuation models

See related reports at www.defiancecap.com

We use relative valuation models to estimate an asset’s value relative to that of another asset/company or
benchmark. The idea behind these models is that in theory, similar assets should sell at similar prices, typically a
multiple of the price. At Defiance Capital we focus on fundamental measures of prices such as earnings (P/E
valuation), Book Value (P/B valuation), Earnings Growth (PEG valuation), Operating Income (P/Op. Income
valuation) , Free Cash Flows (P/FCF valuation), and Company Total Value (EV/EBITDA valuation).

6 – Recommendation

6.1. Valuation conclusion

Our valuation models focus on a passive investment in the company. A passive investor does not control any
decisions related to dividend policy, capital expenditure and strategic planning, among others. In case of an active
position, we would have to account for a control premium and a lack of marketability/illiquidity discount.

We currently do not have a position in the company, but if we had, we would maintain it. We are buyers of MCD
below $60.0 with a stop price at $55.0 (8.3% risk), seller above $75.0, and short seller above $80.0 with a stop
price at $85.0 (6.25% risk). The risk category is medium due to uncertainties around consumer attitude.

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Appendix

Table 1: Industry Classification – The industrial life cycle

Life cycle phase Description
Pioneer Product acceptance is questionable and implementation of business strategy is unclear.
There is high risk and many failures.
Growth Product acceptance is established. Rollout begins and growth accelerates in sales and
earnings. Proper execution of strategy remains an issue.
Mature Industry trend line corresponds to the general economy. Participants compete for share in a
stable industry
Decline Shifting tastes or technologies have overtaken the industry, and demand for its products
steadily decreases.

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