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All great truths begin as blasphemies - George Bernard Shaw

This “Black Book” outlines the current state of McDonald’s operations with a particular focus on its U.S. business. The company’s shares have performed tremendously since the implementation of their “Plan to Win” initiative in 2004 and competitors have found it hard to match McDonald’s performance.  Furthermore, the company is healthy and generates impressive levels of cash for shareholders.  All good things come to an end, however, and I see significant hurdles for the U.S. business in 2011 that present an auspicious opportunity to be a seller of this stock. 

When McDonald’s was first embarking on its highly successful “Plan to Win,” the company set out on a comprehensive program designed to “optimize and simplify operations.”  This program included offering fewer sizes of drinks and fries, fewer Extra Value meals, more simplified pricing, and streamlined merchandising supported by intensive hospitality training of employees. 

For most of McDonald’s history, growth was driven by one thing: unit growth.  Until the late 1990s, that strategy worked.  When the company reached a saturation point, sustaining unit growth resulted in cannibalization, which caused same-store sales growth and margins to deteriorate steadily until the “Plan to Win” was announced.  As Jim Skinner once put it, "We had lost our focus. We had taken our eyes off the fries."

Companies churn out new “plans” ad nauseum, but in the case of McDonald’s in 2004, there was a clear need for management action.  In fact, operations had become so complicated that the average crew served one less customer every two hours between 2000 and 2004, which cost the company 135 basis points in company-operated margins.  Over the next six years, the company’s commitment to their “Plan to Win” yielded 600 basis points of restaurant-level margin expansion.  Accordingly, the stock price appreciated by ~160% by the end of 2010, or by 175% at its more recent December 2010 peak, from the implementation of the “Plan to Win” in November of 2004. 

Six years later, however, it appears that the lessons of the late 1990’s and early 2000’s have gradually been forgotten as a focus on driving same-store sales took precedence over all else.  The relentless focus on driving the top line has required the franchise system to invest significant capital in facilities and new equipment.  Further, from an operational standpoint, this approach has resulted in a burgeoning menu as item after item is rolled out, thereby complicating back-of-the-house operations and gradually offsetting much of the progress made in that regard by the “Plan-to-Win”.

As a specific example, McDonald’s rolled out the Southern-style chicken sandwich in 2008 with much fanfare and the goal of taking share from Chic-fil-A.  The rest is history; the product failed to deliver.  This episode smacks of the McDonald’s of old: launch new products, withdraw marketing support when the product doesn’t deliver but keep them on the menu.  The clear result is a complication of the menu and an inefficient back-of-house process. 

The “Plan-to-Win” mantra has always been "better, not just bigger.”  Instead of building more restaurants, McDonald's increased profitability by squeezing more from its existing store base and from its franchisees.  As a side point, the company loves to talk about the increased “cash flow” of its franchise base, but the more salient metric from a franchisee’s perspective is the “net” cash flow after servicing debt incurred to finance remodels and initiatives.

Over the past three years, however, the mantra has seemingly become “beverages, not burgers.”  As the company has shifted its focus away from its core business, that segment of the business has inevitably suffered.  Over time, the company has shifted so much time and effort (including marketing dollars) away from its core menu that it is losing ground to peer QSR burger concepts and also gourmet/niche burger players.  If we assume that the core business of MCD’s U.S. business is declining, then the emergence and growth of new operators in the burger space is likely impacting MCD’s U.S. business.  Bobby Flay, Five Guys, Shake Shack, Burger Bar, the Counter Burger, and others have gained popularity over the last few years. 

I believe McDonald’s needs to get back to what got it to where it is: its core business.  In the Wall Street Journal this week, there was an insightful article on McDonald’s Japan which is focusing on the core business.  Considering the reputation Japan has as a particularly healthy society, I was interested to read the following, ‘Yasutsuru Mori, a svelte 74 year-old patron, wolfed down a Texas 2 Burger this weekend.  "I love hamburgers.  I eat every new hamburger that comes out in Japan, but I especially love McDonald's burgers," he said.  "McDonald's keeps to the fundamental American hamburger profile: ketchup, mustard and beef.’  Clearly, this is just one person, but I believe that McDonald’s needs to refocus on its core business here in the U.S. also.

Notwithstanding my concerns, I would be remiss not to acknowledge the achievements of the company in what was a truly spectacular turnaround from 2004.  By keeping their “eyes on the fries”, MCD’s management team created an example of operational focus and discipline for operators in both the quick service and casual dining categories.  The “Plan-to-Win” forced management to rethink every element of its business, from product development and marketing to restaurant design and technology.  In the process, McDonald's, which had seemed out of touch with consumers just six years prior, had realigned itself with contemporary tastes. 

To see the balance of the McDonald's "Black Book" please reach out via e-mail or phone.  My contact details are below.

MCD - THE BLACK BOOK - mcd black book cover

Howard Penney

Managing Director