“Little Mac”? The Case for Shorting McDonald’s
Restaurants sector head Howard Penney adds his Short call on McDonald’s (MCD) to Hedgeye’s Best Ideas with an institutional conference call titled “MCD: Flying Too Close To The Sun.”
With over 34,000 locations worldwide, MCD is the world’s largest restaurants company – both by sales and by market capitalization. Some 80% of MCD outlets are franchised – mostly in the US – and Penney argues that this has had a negative impact on planning. While MCD has made a very visible push in recent years to expand in Asia, the Pacific region, the Middle East and Africa (“APMEA”) – with special focus on China – the US remains its biggest market and, says Penney, it’s Achilles’ Heel (Icarus, Deadalus, Achilles… it may be appropriate that a presentation that questions a major company’s fundamental growth story is full of references to mythology!)
Where Do They Make Their Money?
MCD’s most significant source of revenues is in Europe. Over 39% of the company’s revenues come from Europe, versus 32% from the US – and 23% from APMEA (including China). Penney points out that the majority of European stores are company owned. Even though the ongoing Euro-Zone crisis is taking its toll, Europe, with a high percentage of company-owned stores, remains more profitable than the US, with its high percentage of franchised locations. Management is focusing its growth plans on the APMEA markets, but Penney points out that the combination of weak economic conditions in the Euro-Zone, and low profit margins in the US – which together combine for 80% of MCD’s earnings power – will drive disappointing differences between analyst projections of earnings per share and actual reported earnings over the next few years.
What Do The Numbers Look Like?
Analyst expectations have already been trimmed, with consensus for 2013 EPS at around $5.80. But Penney sees global same-store sales growth declining – he thinks growth rates worldwide could end the year nearly flat, which should drag earnings estimates significantly lower. Nobody likes a downside surprise.
Except, that is, a short seller.
With 41% of stores, and just over 40% of sales revenues, the US represents by far the largest sales and unit base for the company. But put those figures alongside the earnings numbers we quote above and you see that the US provides over 40% of global sales, but only 32% of earnings. Europe, by contrast, represents 39% of earnings, on only 28% of sales. And Europe is weakening.
Penney says MCD’s management has gotten itself into an unrealistic position, looking to be both the low-priced and the premium-profit leader. The company has positioned itself in the US as a super-discounter over the last decade. But “Dollar Meals” don’t return big profits – ask any frustrated franchisee. In their latest earnings call, the CFO acknowledged MCD “expects margins to be pressured throughout 2013.” Translation: Heads up: we’re heading down!
Here are another couple of key takeaways from the CFO’s presentation:
“Our business model is built around growing comparable sales to a level where we can realize margin leverage.”
Translation: if we can sell a whole lot more stuff at really low prices, sooner or later we’ll realize economies of scale and our profit margins will go up a little.
“In this environment, where you continue to have the cost pressures, so commodities will be up, labor rates are going up, et cetera, and yet you have soft economics, declining to flat eating out markets, that battle for market share becomes so critical to the long-term health of the business, that we’re willing to sacrifice a little bit of margin to maintain that traffic and grow the market share.”
Translation: but right now, we have to take our already-tiny profit margins down even further in order to gain market share. That “little bit of margin” we are willing to sacrifice – but hey, we only have a little bit in the first place – oops… there goes the profit margin.
You Don’t Get A Break Today
Penney points to a number of factors underpinning his bearish case.
At the macro level, US consumers are feeling better and spending more, and are less dependent on cheap prices. Europe, meanwhile, just keeps getting worse.
At the company level, MCD same store sales are deteriorating globally, while the company suffers from “self-inflicted wounds.” Two key examples are an unacceptable level of operating complexity, and an inability to field new ideas.
With only tiny profit margins on the majority of their menu, speed and efficiency at mealtimes become critical. Every store has to run at top efficiency to speed diners through between the critical 11:30AM-1:00PM lunch hour. As one example of poor planning, Penney points to the freestanding beverage stations, which customers enjoy, but which make the back-of-house operation much more complex, because staff must repeatedly stop serving customers to go out and service the machines. When a discounter, which is already operating at near-maximum capacity, has to slow down its throughput to tend to an unnecessary machine… well, you get the picture.
And Penney says senior management seems surprisingly uninterested in very specific issues raised by franchisees. MCD management have their game plan which they expect all locations to implement, while they continue to push for new-store growth outside the US and Europe. This means that, while MCD goes through the expense of expanding in new markets, they are not getting incremental benefit out of their highest-revenue and highest-profit generating regions. Management appears to be building a more profitable company-owned base of overseas stores on the back of – and at the expense of – its US franchisees. This can lead to alienation of MCD’s most important revenue base.
Penney expects MCD to disappoint in Q3, and likely also in Q4 of this year, leading to analysts downgrading the stock and pushing prices lower.
MCD’s ongoing focus on “value” (i.e. cheap prices) continues to destroy profit margins and cash flow – and to frustrate franchisees in its biggest market. Penney says the only way out now is the highly unlikely success of a “magic bullet” – a premium product that everybody loves. But MCD has defined itself as a “value” chain. After so many years at the low end of the price range, they will have a very hard time trying to introduce a premium offering.
Add to that the recent surge in their closest competition. Wendy’s (WEN) is now being run by an outstanding operator / innovator. Taco Bell, says Penney, “is on fire” with popular new product offerings and an on-target marketing campaign. Even Burger King (BKW) – a company Penney went bearish on earlier this year (See BKW report HERE___) has gotten itself organized enough to present a marginal headwind for MCD.
“Don’t get me wrong,” says Penney. “MCD is a great company. It’s a financially strong global company, and they will probably raise the dividend again.” But a range of near- and intermediate-term problems that will lead to earnings disappointments. Penney thinks the market will not be forgiving, at least over the next two quarters.