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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