Image Source: Mike Mozart
Things haven’t been going well at McDonald’s (MCD), and they might not get better anytime soon.
McDonald’s initial turnaround plan, released May 4, left a great deal to be desired. Though the major points of the plan seem to be improvements, there was a lack of detail about how to fix the restaurant’s menu issues while improving service speeds, two major areas of concern we have with the fast-food giant. Nevertheless, management is confident that its efforts will return the company to an industry leader, as it works toward its goals as a modern, progressive burger company. We’re not so sure.
Starting on July 1, the firm’s organizational structure will be revamped. It will group the markets it serves into four new segments with similar needs, challenges, and opportunities for growth, instead of by the former geographical divisions. The reorganization is a clear and noble attempt to strip layers of middle-management and bureaucracy at the company and re-focus the business on the customer at the local level. The new divisions are as follows: the US market, which accounts for ~40% of the company’s sales; International Lead Markets, including established markets such as Australia, U.K., and Canada, all of which operate within similar economic and competitive dynamics and collectively represent ~40% of sales; High-Growth Markets, these markets have relatively higher restaurant expansion and franchising potential and include markets such as China, Russia, and Spain, collectively providing ~10% of sales; the final new segment is the Foundational Markets Segment, representing the remaining markets within the McDonald’s system, which feature the potential for operating under a franchised business model. The company’s corporate activities will also be reported in the Foundational Markets Segment.
The organizational structure enhancements will be accompanied by plans to further optimize restaurant ownership mix, deliver G&A savings, and accelerate cash returned to shareholders. Management expects to refranchise 3,500 restaurants by the end of 2018, which is a significant step up from the previous goal of 1,500 by 2016. The firm expects to have 90% of its restaurants franchised by 2018, up from the current level of 81%. A more heavily-franchised business model should provide more stable and predictable revenue and cash flow streams as well as require less support structure spending. Some of the strongest Economic Castles in the restaurant arena are mostly-franchised entities.
McDonald’s also plans to deliver ~$300 million annually in G&A savings, anticipated to be realized by the end of 2017. The firm looks to the consolidation of its organizational structure, refranchising, and more disciplined spending throughout the organization as areas of savings. Though these are positive notions, the lack of a further-detailed plan may raise some concerns for investors. Management did not provide any top or bottom line guidance in its press release, especially troubling when considering year-to-date performance. Comparable sales so far this year, through the end of April, are down 1.9%, and system-wide sales, sales by both company owned and franchised restaurants, have fallen 9.1% on a reported basis.
As far as accelerating cash returned to shareholders, the firm plans to return $8-$9 billion in 2015 and reach the high end of its previous 3-year plan to return $18-$20 billion by the end of 2016. After returning ~$6.4 billion to shareholders in 2014, McDonald’s will have to return somewhere in the range $4.6-$5.6 billion in 2016 to reach the upper bound of its target, depending on actual 2015 results. This goal seems very achievable, assuming the firm hits its 2015 target. Returning cash to shareholders, however, does not imply operating improvement, and it may only mitigate the ensuing pain caused by deteriorating fundamentals.
McDonald’s is working hard to improve its menu, with reports of increased mid-priced items or those in the range of $1.50-$3.00. Increasingly-frustrated franchisees have reportedly been displeased with the lack of mid-priced items and the over-abundance of high and low-end items on the menu. The firm will also test the reduction of the number of items on the drive-thru menu board to only the most popular items, hoping to increase service speeds, which is a focus across all areas of the business.
The trial run of serving breakfast all day at McDonald’s will be expanded, and the firm reportedly will introduce kale into a number of its menu items for testing in southern California. These new items will include a variety of breakfast bowls, but we’re expecting only modest success. Similar products have had huge amounts of success for companies such as Chipotle (CMG), but we note Chipotle has not had much success with its breakfast to date. Should the burrito-giant ever turn its focus to breakfast, McDonald’s would certainly face share losses.
The progressive service ideas may generate excitement about the McDonald’s menu, but they also will complicate the restaurant’s kitchens. Diversifying the menu will require meaningful changes in the business processes of the restaurants, and McDonald’s has not exactly been proficient at handling change in recent years. At best, investors are hoping the new organizational structure and focus on refranchising will provide the progressive changes that will be required to keep McDonald’s relevant. Holding its ground, however, seems like a best-case scenario these days.
According to a survey, after the turnaround plan was released, franchisees remain disgruntled. In fact, the six-month outlook for the company, as provided by the franchisees, (the ones who are in the field executing the actual operations of the company), is the worst it has been in more than a decade. Several operators went so far as to say the summit at which the plan was released was a “waste of time.” Some feel that the plan will fail and eventually force the operators out of business, due in part to the costly equipment upgrades the plan will require. The implementation of new items not typical of McDonald’s is more complicated than simply adding them to the menu, and franchisees have repeatedly expressed their concern with menu complexity.
From our standpoint, it is difficult to get excited about the company’s turnaround plan, especially since the franchisees are so unsatisfied with the plan. If the feelings of those on the “ground floor” are not indicative enough of the ongoing problems, fast-casual dining competition is not going away (in fact, the trend has never been stronger), and McDonald’s may get itself into trouble attempting to become too much like its “trendy” peers. New burger rivals from the likes of Habit (HABT) and Shake Shack (SHAK) also reveal how increasingly crowded the traditional fast food burger restaurant space has become.
Frankly, the lack of excitement stemming from its turnaround plan is telling, and the market success of its new ideas may never again reach the level of McCafe products and those before it. McDonald’s is in the terribly unfortunate position of having to try to reinvent itself at the same time it is attempting to improve company-wide efficiency. Whether or not the new organizational structure will help the management-operator relations remains to be seen, though it seems to make more sense from a corporate organizational structure. Investors are growing impatient.
We’ve recently lowered our fair value estimate on McDonald’s, and while the firm sports a high dividend yield, we think there are much better ideas in the restaurant space. For dividend-growth investors, Cracker Barrel (CBRL) offers a compelling proposition, while for investors seeking wealth creation, Buffalo Wild Wings’ (BWLD) hidden “fast-casual” pizza concept is hard to ignore. Small-cap investors may look at Zoe’s Kitchen (ZOES) as a higher-risk option for long-term capital appreciation.
In any case, the ongoing breakfast war with Yum! Brands (YUM) Taco Bell and Burger King (QSR) and the coffee war with Starbucks (SBUX) and Dunkin’ Donuts (DNKN) have punished recent performance; worse, food scandals overseas have given McDonald’s a black eye. Investors shouldn’t expect a drastic change of fortune at McDonald’s in the second half of 2015, particularly in light of the lack of specifics provided on how it will be able to handle some of its seemingly contradictory plans.
We maintain: The time to own McDonald’s has passed.