MCD remains on the Hedgeye Best Ideas list as a SHORT.
In this note, we offer our take on MCD’s current downward trajectory. The company reported disappointing 3Q13 results and management appears disconnected from, or at least unwilling to accept, the reality that structural changes must be made.
Setting the stage:
- MCD has now experienced declining traffic for the better part of the year.
- The company continues to blame the macro environment for declining sales, while insisting that its LTOs are “hitting internal goals.”
- Management says it doesn't having pricing flexibility, yet it has already raised prices +2.6% this year.
- MCD lost the head of its U.S. business, the head of its German business, and its U.S. Chief Marketing Officer.
- Over the last two quarters, the company has slightly lowered its new unit growth rate.
- ROIIC is in decline.
- MCD is aggressively pushing the dollar menu.
In our opinion, this is the second time in the last 10 years that the company must accept the need for structural change to their business model. The company appears to be transitioning from Stage 2 Denial into Stage 1 Panic. The core business continues to deteriorate, members of the operating team are being replaced, and management plans to slightly slow its new unit growth rate. If today’s call was any indication, management remains far away from the Healing Process. To refresh, when a concept gets in trouble, the management team’s decision-making process typically follows a pattern similar to this:
- Overconfidence – The concept loses its value proposition when management raises prices too aggressively or lowers the quality of food.
- Stage 1 Denial – Consumers catch on and begin to frequent the concept less often. Traffic begins to decline and management usually begins to blame the weather or another external event.
- Stage 2 Denial – In an effort to avoid the inevitable and appease the street, management begins to accelerate growth through the form of new unit acceleration or the acquisition of new brands. Normally, the core business continues to deteriorate alongside a decline in ROIIC (return on incremental invested capital).
- Stage 1 Panic – Analysts begin to catch on and management responds by slowing new unit growth, although often not by enough. The core business continues to decline, as senior management begins to replace the operating team. Simultaneously, the search for a new advertising agency begins.
- Stage 2 Panic – Now it really begins to get ugly, as management sacrifices margins to increase customer counts by implementing a deep discounting strategy. It then becomes clear that major changes need to be made across the enterprise.
- The Healing Process – Management decides to stop growth and attack the middle of the P&L.
We won’t bore you with the details of the call or the press release, but, to summarize, MCD’s 3Q13 results, as well as their 4Q13 outlook, were uninspiring and consistent with our bearish thesis.
Rapidly decelerating sales trends continue to suggest that management must respond with a viable plan to improve operational efficiencies and spur long-term, sustainable sales growth. Until this happens, MCD is likely to remain a short.