Are the Golden Arches That Tarnished?

"New Salads Are Here," a sign at my local McDonald's (MCD ) proclaimed the other day. The world's biggest restaurateur on Mar. 24 brought out its latest hope, $3.99 entrée salads with warm chicken breast and dressings from Newman's Own, actor Paul Newman's charitable venture. If this excited anyone inside, it didn't show. From noon to 1 p.m., the only order for a $3.99 salad that I witnessed was mine.

Advertising for the new salads has yet to begin in earnest. Yet few on Wall Street have faith that fresh menu items or even a new chief executive will reverse McDonald's long slide. As the Street awaited an Apr. 7 conference with analysts, at which new CEO Jim Cantalupo is scheduled to detail his strategy, the stock was stuck near 14, after scraping a 10-year low in March. "Does management need a major wake-up call?" asks Brian Rogers, portfolio manager of the T. Rowe Price Equity Income Fund. "I don't want to restate the obvious."

Just the same, Rogers and managers of such other notably picky -- and successful -- mutual funds as Dodge & Cox Stock, Clipper, and Oakmark have built stakes in McDonald's. Even as the stock sank from the mid-20s last summer into the low teens, they kept buying. McDonald's itself spent $687 million last year to buy back shares at an average cost of $26.84 each. You have to wonder: Is this some kind of madness?

To hazard an answer, I set out to examine what another notably picky investor, Warren Buffett, paid for another fast-food chain, International Dairy Queen. Buffett's Berkshire Hathaway (BRKA ) in 1998 bought IDQ for $590 million in cash and stock. IDQ was a much smaller deal than McDonald's, which has a market value of $18 billion. When Berkshire bought it, IDQ had 6,300 outlets; McDonald's today boasts 31,000.

Beyond their differences, both companies share solid assets and persistent cash flow. In the four quarters before Berkshire agreed to buy IDQ, its operations generated cash of $43 million on sales of $421 million. That works out to a cash margin of 10% and a cash return on assets of 16%. At McDonald's, little has gone right, with kitchen blunders, imaginative rivals, a strong dollar, and even mad cow disease stifling growth and crimping margins. Still, in 2002, McDonald's posted $2.9 billion in operating cash flow on revenues of $15.4 billion. That works out to a cash-flow margin of nearly 19% and a cash return on assets of 12%.

So how much did Berkshire pay for IDQ -- and how does McDonald's compare? The ratios in the table below mostly make McDonald's look cheap. But these common measures may overstate the case. That's because they don't consider differences on the balance sheets. IDQ five years back had more than enough cash to pay its debts, while McDonald's nearly $10 billion in debt is 49% of its total capital. Add the debt to McDonald's stock market value, and a buyer of the company at 14 a share would pay 1.8 times sales, 31 times earnings, 9.5 times cash flow, and 2.7 times book value -- a closer call.

Just the same, two other considerations suggest to me that all the gloom around McDonald's has pushed the stock too low. First, since Berkshire agreed to buy IDQ, interest rates have plunged. Back then, five-year Treasury notes yielded just under 6%. Today, they yield 2.7%. Lower rates make higher multiples on stocks easier to justify. Second, McDonald's already is slowing capital expenditures. If CEO Cantalupo on Apr. 7 signals a sharper slowdown, free cash flow will be set to surge. The excess might be used to buy back more shares or be paid out as dividends. Were I a restaurant reviewer, I'd tell you McDonald's new salads struck me as ho-hum. But fresh lettuce of the cash variety, now that would be something under the golden arches to get excited about.

By Robert Barker

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