MCD: An Espresso-Based Conspiracy Theory

The Street believes that we are close to an inflection point and that McDonald’s sales trends will bounce right back.  If you were reading only the today’s headlines from the McDonald’s 4Q12 earnings release, there are some signs of hope. 


However, with USA same-restaurant sales up 0.3% in 4Q12 and company operating margins down 150bps it would appear that there are other operational issues rooted deeper in the company results.  Global same-restaurant sales trends are expected to be negative in January.  If US trends are also negative, domestic company margins may compress further in 1Q13. 


The real key to driving sustainable top line sales and margin improvement will be running efficient stores.  We continue believe that management needs to address some operational issues that are having a negative impact on store-level margins.  The following note goes through the rationale behind our contention that operational changes need to take place for the US business to get back on track.



Historical Context


McCafé was first launched in Melbourne, Australia in 1993.  It reflected a growing consumer trend toward espresso-based coffees.  In the USA, Starbucks was changing the coffee landscape in the USA, educating the consumer about higher quality coffee and espresso-based drinks.  Bringing McCafé to the USA was the brainchild of Charlie Bell (an Aussie) who was brought in to be CEO following the death of Jim Cantalupo.  Sadly, Mr. Bell died in January 2005 shortly after being appointed as the first non-American to lead the company. 


McDonald’s first started testing McCafé domestically in the Chicago area in May 2001.  The program was designed to take on the growing competitive threat of Starbucks and, later in the decade, the potential incursion of Tim Hortons.  The Starbucks impact went well beyond the coffee and brought to life the theory of the “third place” or “a café” setting.  It was a place to a have a pastry and read the paper or, as it now turns out, connect to the internet. 


In the 2001-2003 timeframe, McDonald’s saw the new Starbucks business model as one factor in its own same-restaurant sales declines.  Complicating matters for McDonald’s was the company trying to open 1,000 units per year in the United States alone.  The focus was on unit growth and not unit productivity.


In 2003, the Plan-to-Win was unveiled but it was not until 2005 that management began upgrading its drip coffee by using higher quality beans, filtered water, and better-tasting cream.  After two years, drip coffee sales were surging, giving management the confidence to upgrade their hot-drinks menu.  Beginning in 2006, management began to put forth the argument that the success of the drip-coffee business gave the company credibility to expand into espresso-based drinks.  McDonald’s shift in focus from being a fast food concept to more of a beverage concept was underway.


The greatest successes in McDonald’s history, like the Egg McMuffin, have stemmed from franchisee initiatives while some of the biggest disappointments, like Arch Deluxe, have been driven by Oakbrook.  In the case of the complete beverage strategy, it was driven by Oakbrook; franchisees had little to do with the shift in focus.


Strategically, I can see the reason for management wanting to drive the sales of higher margin beverages but, absent almost-prohibitive investment, McDonald’s will likely never become a beverage destination over a sustained period of time.  The DNA of the company lends itself to executing on food, as Starbucks’ lends itself to executing on beverages.  Unfortunately for McDonald’s the capital thus far-committed to shifting toward beverages has come at a significant cost. 



Early Test Markets


In 2007-2008, the company expanded the McCafé test in Chicago into Kansas City.  The original strategy called for McDonald’s to spend $100,000 per store, incorporating separate McCafés in each restaurant that could serve a new line of espresso-based products and assorted baked goods.  The strategy also included expanding the drive-thru to ameliorate though-put issues.  In the end, the construction costs exceeded the budgets and, more importantly, the level of consumer acceptance was not meeting expectations. 


So, for the first time in McDonald's history "testing" became irrelevant because the test markets did not go well, the franchisees said "we don't want this, take it out."  Instead, the Oak Brook based initiative went national in 2009 with a roll out strategy that was changed had to be altered from its original form.


Late in 2008, I documented that the company was clearly behind plan in converting restaurants to McCafés in order to nationally promote the product by mid-2009.  In the US, the company was running behind schedule and a lack of enthusiasm among franchisees to absorb rising costs posed a problem for Oakbrook.  In the end, the decision was taken to abandon the plan for a separate “McCafé” within the store, as was the prototype developed in other markets, and move forward with espresso machines being integrated behind the existing front counters. 


Does MCD Know Its Audience?


Selling expensive beverages at McDonald’s in the USA has always been a curious notion, given the brand’s perception among consumers as a value chain. 


Why did McDonald’s take the decision to proceed with the rollout in 2009/2010? Why was there no slowdown?  It seems that the reason behind this decision was the business plan at the time calling for phase II of the “beverage strategy”: cold drinks.  After four years of upgrading the menu and successful new product introductions, management needed to drive traffic and beverage sales were deemed the way forward. 


Back in 2008, a McDonald’s executive was quoted as saying, about the company’s beverage strategy, “That's the great part about McDonald's is that we are actually offering affordable luxuries, so for us we know our customers are looking for those affordable luxuries."  Are “affordable luxuries” going to resonate with the consumer in 2013?  Longer-term acceptance of the McDonald’s as a beverage destination is key to the success of this strategy and a return on the considerable capital investment that has supported it. 


We’re now told that the expensive and complicated espresso machines behind the counter only serve a handful of espresso drinks per day.  The espresso machine is separate from the machine that produces the traditional drip coffee, of which McDonald’s sells a large amount, and is a piece of equipment that requires regular maintenance.  Additionally, the shaved-ice drinks (smoothies and frappes) have no connection with the espresso machine.  Below are some thoughts from the franchisee community on the subject of the expensive drinks machines:

  • History has proven that the more complicated a piece of equipment is the shorter it's [sic] lifetime in a MCD restaurant.
  • The machines were installed in 2008 and early 2009.  What will happen when the machines need replacing? Will franchisees refuse to spend the $15,000 plus to replace them to continue to sell a few drinks a day?
  • The maintenance required for the machine is huge and may end up 'out of control'. We all bought Cadillac’s but at GM, 16 year olds don't do the oil changes.

The most important operational dilemma that senior management faces is the level of media spending that has, and continues to be dedicated to beverages.  We believe investors will increasingly question the allocation of marketing dollars.  Should those media dollars be re-allocated to helping grow other parts of the business? Then what does that say about the potential for beverage trends actions?  Lastly, what are the implications to corporate margins as beverage transactions slow and incremental maintenance expenses?


A core tenet of the Plan to Win, established under Jim Cantalupo, was something called “simplification” which applied to the menu and kitchen operations.  Over time, the tension between the desire to drive traffic and simplification led to an expanding menu including a significant number of beverages varieties.  Franchisees are finding the menu too large and kitchens are far from the streamlined centers of operation that the Plan to Win envisaged.  Service times in the lobby and drive-thrus are likely to suffer if the back of the house has become disorganized due to the expansion of the menu.  Given the ownership that individuals within the McDonald’s organization take of different menu items and/or initiatives, it is unlikely that a menu item cull is forthcoming.   If anything, the complications of the four-wall operation at McDonald’s could be getting worse.



Howard Penney

Managing Director


Rory Green

Senior Analyst




Quick Look at Unilever Results

Unilever (ULVR LN) is up over 3% in European trading this morning, after releasing full-year and Q4 results.  Underlying sales growth (excluding the impact of exchange rates, acquisitions and disposals) was 7.8% with strength in Personal Care (+11.5%, 4.0% price, 7.2% volume) and Home Care (+10.4%, 3.1% price, 7.0% volume).  Foods were a laggard at +1.3% underlying sales growth with price contributing 1.4%.

These results represent a sequential acceleration in underlying sales growth (+6.0% in Q2 and +6.1% in Q3) and represent strength on strength as the comparable result in Q4 2011 was a +6.6%.


We would like to highlight a couple of items from these results.

  1. Unilever is a transformed company, with the transformation beginning with the appointment of Paul Polman as CEO, formerly of Nestle
  2. Unilever is what PG should aspire to be in terms of growth and investment in brands
  3. Personal and Home Care results are favorable on the margin for PG
  4. Food results still struggle to find a balance between price and volume growth

It's been fun to watch the transformation of Unilever over the years from a sluggish, inexpensive staples name to a global growth company.  If anyone suggests that the jockey doesn't matter in a horse race, point them toward Unilever.

Kind regards,




Robert  Campagnino

Managing Director




Growth's Roadblock

Client Talking Points

Tread Lightly

Since 2013 started, stocks have ripped to the upside nearly every day and the S&P 500 is a few handles away from touching 1500, an impressive feat considering that the financial crisis was only five years ago. And while the move in stocks is actually justified this time, we begin to worry about inflation slowing global growth. If commodity prices (oil in particular) keep heading higher, that can stop growth right in its tracks. When consumption slows because of $8 a gallon gas and $5 boxes of Gushers at the supermarket, so does global growth. There is no way that $100/barrel WTI crude is going be OK with the American consumer; Jamie Dimon can kiss his 4% GDP growth rate goodbye if that happens. 

The Big Miss

Apple’s (AAPL) earnings release after the close is the big catalyst for the market. If they miss, people are likely to freak out. People freak out when bad things happen to Apple because it makes up 17% of the tech sector ETF (XLK) and is king of the NASDAQ. “In the meantime, the SP500 is immediate-term TRADE overbought at 1496 inasmuch as the VIX is oversold at 12.19,” says Keith this morning. And if we want to enjoy a market above 1500, we’re probably going to need to see a beat from Apple after the close.

Asset Allocation


Top Long Ideas

Company Ticker Sector Duration

We believe ASCA will receive a higher bid from another gaming competitor. Our valuation puts ASCA’s worth closer to $40.


ADM has significantly lagged the overall market in 2012 over concerns that weakness in the company’s bioproducts (ethanol) and merchandise and handling segment will persist. Ethanol margins suffered from higher corn costs, as well as weak domestic demand and low capacity utilization across the industry. Merchandising and handling results were at the mercy of a smaller U.S. corn harvest. Both segments could be in a position to rebound as we move into 2013 and a new crop goes into the ground. With corn prices remaining at elevated levels, the incentive to plant corn certainly exists, and we expect that we will see corn planted fencepost to fencepost.


HOLX remains one of our favorite longer-term fundamental growth companies given growing penetration of its 3D Tomo platform and high leverage to the 2014 Insurance Expansion from the Affordable Care Act.

Three for the Road


“Economists lowered 2013 economic growth expectations for Asia for the fourth time in a row. However expectations are 2013 will beat 2012.” -@Bain_Energy


“Philosophy is a battle against the bewitchment of our intelligence by means of language.” -Ludwig Wittgenstein



U.S. chains store sales were up 3.2% in January over where they were a year ago.

investing ideas

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It wasn’t as good as the headline $0.04 beat but it was solid and long thesis remains intact.



Following the solid FQ1, our full fiscal 2013 estimate goes from $1.26 to $1.30.  We think IGT’s unchanged fiscal 2013 guidance was conservative – the company has learned.  Our thesis remains intact:  strong EPS growth, stabilized market share, better capital deployment (read:  higher ROI), and a still cheap valuation.  Hard to argue that 65% EPS growth in FQ1, reduced capex (no new acquisitions – Yeah!), and likely stable and possibly higher market share refutes our thesis in any way.  We will be doing some more work on the capex situation in a follow-up note because that seemed to be an interesting development in the quarter.  For now, please enjoy the additional details/thoughts from the quarter.


Product sales

  • North America:
    • Replacements excluding Canada were 3,500 compared to a comparable replacement of 2,800 units in the same period next year
    • Gross margins would have been up an estimated 500bps even without the royalty settlement payment in the quarter.  However, that should be no surprise given the 72% YoY increase in sales.
    • There were 900 units shipped to IL this quarter, 1100 recognized
    • IGT expected to ship about 2k units to Canada this quarter – some of that slipped into next quarter
  • International:
    • 2,500 International shipments in the quarter:
      • Asia:  200 (vs 300 last year)
      • Australia:  1,100 (flat YoY)
      • Europe:  300 (vs 100 last year)
      • S. Africa:  100 (vs 200 last year)
      • Mexico:  700 (vs 200 last year)
      • Latin America:  100 vs (1,100 last year)
    • The thousand deferred units recognized in the quarter were units shipped to Peru and France


  • SG&A was seasonally low and should be higher in the next several quarters.  Moreover, bad debt of $6MM in the quarter actually inflated SG&A.  Management guided to an SG&A number more in line with $110MM/Q.
  • Mgmt was vague on why the bad debt number increased in the quarter – just said that it was several factors and that they increased their reserves related to a few properties
  • Retention and earn out payments should be higher in the next 3 quarters assuming Double Down’s performance remains on the current path
  • Note:  our “normalized EPS” do not exclude the higher amortization related to the acquisition of DD. We never really adjust other company's numbers for higher amortization related to acquisitions so we don’t do it here.  We do exclude the retention and earn out payments.
  • Tax rate was only 33% vs. guidance of 37%
  • Nice decrease in capital expenditures to just $38MM vs $49MM last year.  The majority of the decrease came from a reduction of gaming operations spend.  


The Macau Metro Monitor, January 23, 2013




Visitor arrivals totaled 2,495,851 in December 2012, down by 2.0% YoY.  For the whole year of 2012, visitor arrivals increased slightly by 0.3% YoY to 28,082,292.  In December 2012, the average length of stay of visitors stood at 1.0 day, up by 0.1 day YoY.  Visitors from Mainland China increased slightly by 0.9% YoY to 1,495,316, with those traveling to Macao under the Individual Visit Scheme rising by 5.4% to 603,904.





According to the Oriental Morning Post, the non-performing loan ratio at banks in Wenzhou, the eastern Chinese city hit hardest by the collapse of private lending, dropped for the first time since June 2011.  The ratio fell to 3.43% at the end of November, down 0.01% MoM.  Still, the total amount of soured debt climbed to 24 billion yuan in November, an increase of 87 million yuan from October and up 15.3 billion yuan from the beginning of the year.

In Wenzhou, an export hub where almost 90% of families have taken part in underground lending, more than 100 people fled, committed suicide or declared bankruptcy from August 2011 through last May, and at least 800 lending brokers went bankrupt, Xinhua News Agency reported.


The State Council, China's cabinet, announced a trial plan in March aimed at easing funding for small companies and monitoring underground loans.



The president and COO of Las Vegas Sands Corp, Michael Leven, says Macau’s gaming market could grow to MOP800 billion (US$100 billion) in revenue per year.  In 2012, Macau’s casinos reported gross gaming revenue of MOP304.1 billion.

Leven said, “It will continue to grow, because as income grows in the mainland, it’s going to continue to feed people into Macau. There’s no risk that they won’t have considerable growth.”  He also confirmed of the possible sale of Sands Bethlehem.  “If we get our price, we think it may not fit in the long run for our company. It’s a smaller product. We’ll probably look to sell it. However, somebody’s got to pay the price.  We’re just as happy to keep it,” Leven said.

COH: Coming Clean That Model Is Unsustainable

Takeaway: COH's Sales growth and 30%+ Margin model can no longer coexist. This won’t be the last ‘investment year’, which creates a value trap.

  • Coach is hardly flying in on the wings of glory with its 2Q13 results and a $1.23 print versus consensus of $1.29. No surprises here, as this is in-line with our model, and has been on our short list for a while given our concerns over the levels of spending needed to maintain market share. But the question to ask here is whether this miss is an event to buy into, or one to press. Our sense is that it is the latter.


  • Our rationale is that we’re hearing Coach talk about the promotional cadence and competitive landscape for the first time in – well, ever. Ever is a long time. We get it that China and Men both represent sizable opportunities, but the US Handbag market is one that represents 70% of Coach’s business. If it can’t grow profitably, then nor can Coach.


  • The reality is that when we see a miss like this – for the reasons we’re seeing – it is usually not the last miss. We think that it’s more likely than not that COH is locked in a multi-year period where it grows its top line at the expense of a draw-down in EBIT margin, or it holds margins steady with top line remaining stagnant. We’d bet on the former.


  • Either way, it suggests that FY13 is not the last ‘investment year’ that Coach will see. We think that value investors risk getting stuck in a value trap on this one. This name is cheap, built to stay that way, and lacking earnings growth to move the stock higher.



COH: Coming Clean That Model Is Unsustainable - COH S



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