Sunday, November 14, 2010

McDonalds super bonds vs Pizza Pizza

This summer McDonalds issued bonds at record low yields which as far as I know continue to trade below US debt of the same maturities.  The reason some investors would buy at such low yields is that McDonalds is a very healthy company with worldwide diversified revenue sources.  While bond rates are based on a company's stability, it also has solid international growth prospects.  One can easily imagine that McDonalds will continue to be a stable dominant fast food provider for the next 30 years in North America because it is a cost and value leader in a market segment unlikely to dissapear.  If we were to guess at the future prospects 30 years from now between McDonalds and the US Government, its easy to pick McDonalds as being more likely to have a sustainable outlook.

The reason that investing in any bonds (continuing focus on MCD) below 5% yield is a poor investment, in my opinion, is twofold.  First, there is operational risk.  Competitors could bribe politicians or the judiciary to declare McDonald's value menu "dumping" or other anti-competitive argument preventing growth for those other than McDonalds, and thereby destroy some of its capital value.  Operational risk 30-50 years out, can also be fantasized as technological advance that enables a desktop device to synthesize french fries with little effort, and less expensively than MCD can provide for customers.

Second, and most important, is the risk of further dilution of debt.  McDonalds already has $15B in debt, and only $13B in equity.  The latest debt issue is already portrayed as borrowing because it can, rather than because it needs the money.  If it can borrow cheaper than governments, why not issue more debt next year, say another $5B, and invest the proceeds in higher yielding government debt?  The answer is that it will as long as investor sentiment favours it over the U.S Government.  Greek 10yr bond yields were below 3% in october 2009 (have hit 12% since).  There is no impossibility of the same happening to US Bonds, and if they do, then McDonald's appetite for more debt will rise significantly.  Investors of McDonalds existing 3.5% debt will see their worth plumet alongside MCD's new issues to match US debt yields, if so.  Therefore, there is no real actual relative safety to US treasuries, because whatever temporary safety exists will be cannibalized away by MCD itself through further bond dilutions.

In 2-10 years, its same store sales should level off in Europe and Asia.  Lets say they add $25B in equity organically over 5 years, but then earnings level off at $6B per year after that.If that were the case, they would remain at almost the same market value if their earnings multiple was 14 times, which I would consider too expensive, but  many other investors would happily bid for one of the DOW stocks most likely to survive 50 years.

I present this scenario to portray a mature company with great cashflow ($6B), and very cheap debt.  It becomes a ripe target for a leveraged buyout, which totally destroys the value of holding debt, as there is extreme dilution of debt holders from such action.  The largest (attempted) LBO takeover in history was for BCE and expected to close in the middle of winter 2008 financial crisis.  It was averted only due to general solvency climate concerns of the financial crisis itself, and would have closed disastrously for bondholders days before Lehman Brothers collapsed.

The more attractive a corporate bond is, the more likely it is to result in future dilution.  A primary rationale for natural finance instruments is the impossibility of dilution, and MCD would be able to finance significantly cheaper than their already great rates, while investors would genuinely get the security they may imagine they have through natural finance queued soft loans.  AAA rated bonds cannot exist if sovereign debt is not AAA, and no financial entity can insure others debts and maintain investment grade rating.

A credible alternative for ultra safe seeking MCD debt investors may be equity in a small canadian company currently yielding over 12%, and trading at under 80% of book value. Pizza Pizza
is also is in the fast food business (delivery too), and a well respected brand in Ontario with sustainable future.  It controls nearly 600 restaurants.  The specific attractiveness of this equity is that it has no debt, and $10/share in long term interest bearing investments, and a P/E of 8.  Potential reasons that it has underperformed are that it is in the fast food business and is not McDonalds, and has not had much sales growth since the recession, that it expanded in 2009 by issuing an offendable number of shares (financial crisis influenced), but most likely the strongest reason for its underperformance is that investors misunderstand its performance as a fast food chain with muddling sales growth, instead of a bondholding trust with stable restaurant sales royalty streams and few material expenses.  Its payout rate will drop slightly when it converts to a corporation in early 2011.  A partial cause for its underperformance may be institutional restrictions on owning its current income trust form.

Pizza Pizza management certainly has the power to destroy shareholder value like any other public corporation.  Current management at least has the good graces to do nothing.  The main risk is that its long term investments are in a related private company that symbiotically owns a significant amount of the trust, and the relationship lacks crystal clarity (It is audited however). The business success of the private company appears to be on a roughly identical restaurant success basis, though both are insulated from day to day franchise operations.  The risk is that incestuous corruption between the two entities could be masked by euphemistic reporting language. Both McDonalds and Pizza Pizza have sustainable long term operations, IMO.  PZA's 8 year projected payback with above natural returns is more certain and more attractive than MCD's 30 year payback at below natural returns.  Even if both have equivalent sustainability expectations after payback period.

Pizza Pizza could also significantly benefit from natural finance soft loans instead of its share structure.  The risk profile for loans backed by the next 8-12 years of operational surpluses are comparable to government bonds.  Significantly better than the current market demanded rates for its units could be achieved.

I have no negative-benefitting holdings in MCD, and do have a long position in PZA.UN.

2 comments:

  1. Assume a differentiated-goods duopoly model, with inverse demand curves:

    p1 = 10 – 5q1 – 2q2
    p2 = 10 – 5q2 – 2q1

    and per unit costs for each firm equal to 1.

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