McDonald’s (MCD) CEO Don Thompson’s admission that 2014 was a challenging year is an understatement. The restaurant has been mired in food scandals throughout much of the year, and consumer confidence in the fast food giant has been shaken to the core. McDonald’s sourcing relationship with Shanghai Husi Food, the firm responsible for the mishandling of meat in its China operations, coupled with recent reports of vinyl being found in Chicken McNuggets sold in Japan has given the Dow component a black eye. I talked about McDonald’s on CNBC following its third-quarter report last October, and frankly, the outlook is not much different after its fourth-quarter release.
The time to own McDonald’s has passed.
It is easy to characterize the food scandals as temporary and peripheral, but we think it speaks of a more serious issue: management has dropped the ball. Though the planned efforts to revitalize the brand in 2015 are notable, we don’t think the consumer environment is as forgiving as we originally thought, and we think competition will only intensify. McDonald’s challenge, in our view, has to do with its ongoing inability to connect with the millennials demographic, or those born from the early 1980s to the early 2000s. Unlike the generation before it, Generation X (early 1960s to the early 1980s), millennials do not have as positive of a perception of the Golden Arches. Many millennials, for example, are opting for healthier alternatives such as Panera (PNRA) and Chipotle (CMG), or even more trendy establishments such as Noodles (NDLS). They are just not interested in the 510-calorie, 27g-fat, 36-carb triple cheeseburger. It won’t matter how much they discount it. The millenials aren’t buying, and parents certainly aren’t taking their kids to load up on the 1150mg of sodium that the triple cheeseburger packs.
The McCafe was McDonald’s last hoorah, and it was a huge shot in the arm for the restaurant. However, competition from Starbucks (SBUX) in premium coffee is not letting up, and McDonald’s continues to have a difficult time with its menu, especially in appealing to value customers, its bread-and-butter market. Yum! Brands’ (YUM) Taco Bell has more bang for the buck, and its foray into breakfast is having an impact, albeit gradually. Burger King (QSR) is not backing down either, and the promotional environment has never been this intense. Burger King is selling 10 chicken nuggets for just $1.49. There’s very little margin, and it’s a race to the bottom with price in this category. McDonald’s will have to do something other than compete on price, but its best days of innovation are behind it. There are only so many variants of fast food the consumer can handle.
McDonald’s fourth-quarter global comparable sales fell 0.9% as guest traffic slowed, while consolidated revenue fell 7%, a rather large number due in part to currency headwinds. Fourth-quarter comparable sales fell 1.7% in the US, 1.1% in Europe, and 4.8% in Asia. Consolidated operating income dropped a painful 20% (15% in constant currencies), and for us to even write such a staggering percentage, it’s a shocker. Diluted earnings per share fell 19%, to $1.13. The company remains as shareholder friendly as companies come, returning cash in the form of dividends and buybacks, but operationally, McDonald’s is in a whole host of trouble.
The restaurant is on the defensive as well. 2015 will mark its lowest capital budget in 5 years, as it slows openings in its most challenged markets. Instead of aggressively pursuing improvements, McDonald’s is giving up ground that we think it will not be able to regain. Fast-casual operators have changed the game, and McDonald’s will be playing catch up for the foreseeable future. Management emphasized that January comparable sales are expected to be negative and that results will remain pressured for the first half of the year. Though its dividend is healthy, growth in it will be subdued, and we can think of a great many firms that have better investment prospects. We won’t be adding McDonald’s to either newsletter portfolio anytime soon.