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A 2014 Coffee War Is Brewing!

Our 2013 bearish thesis on MCD revolves around our “espresso-based conspiracy theory.”  In our opinion, MCD will never be what Starbucks is: a leading destination for espresso-based beverages.  Since the first Starbucks opened in 1971, the chain reinvented the QSR space by selling premium beverages in a “café” setting.  McDonald’s decision to roll out the McCafé concept nationally in 2009 was the first direct attack on the Starbucks business model. 

As an example, in 2009, McDonald’s used the tag line “four bucks is dumb," in what was a clear attempt to spite Starbucks.  Around the same time, McDonald’s remodel program began to emulate Starbucks to a degree, in order to foster a “café” or “third place” environment.

MCD: MCDONALD'S OBSESSION WITH STARBUCKS - 4 bucks is dumb

 

MCD: MCDONALD'S OBSESSION WITH STARBUCKS - REMODELS

We contend that since 2009, McDonald’s commitment to premium espresso beverages has failed to generate acceptable returns and, more importantly, has complicated store operations.

Relentless Pursuit

Nearly five years later, Starbuck’s stock is up eight-fold, while McDonald’s is still trying to figure out how to successfully sell espresso beverages in its stores.  We have come to the conclusion that this move did not work out too well for McDonald’s and contributes to some of the issues the company faces today; but, apparently management disagrees.  It looks like McDonald’s obsession with Starbucks (and now Dunkin’ Donuts) will be taken to a whole new level in 2014.

McDonald’s CEO, Don Thompson, hinted at such on the 3Q13 earnings call when he said: “We had just begun really focusing on the coffee opportunity.  I think you’ll hear more about the coffee opportunity, as it still does exist, and you’ll hear more about that at the analyst meeting.”

Mr. Thompson’s comments, in addition to other conversations we have had since the earnings call, lead us to believe that McDonald’s plans to “go after the coffee consumer” in 2014.  It appears that McDonald’s senior management in Oak Brook believe they can duplicate the recent success their stores have had selling coffee in Canada.

In our opinion, McDonald’s potential coffee promotion in 2014 is largely motivated by the recent success of Starbucks and Dunkin’ Donuts.  Looking at 2012-2013 same-store sales results, SBUX and DNKN have handily outperformed MCD.  We believe McDonald’s will be seeking to take market share back from these two brands.  Therefore, it would not surprise us to see McDonald’s utilize heavy discounting in the premium coffee category, in a direct attempt to disrupt the current success of both the other brands.

MCD: MCDONALD'S OBSESSION WITH STARBUCKS - mcd sales

In the U.S., our research indicates that the average McDonald’s store sells hundreds of cups of drip coffee and only 30 or so espresso drinks a day.  This pace of sales suggests that the average McDonald’s consumer has little interest in premium coffee.  It goes without saying, but it seems counterintuitive to put significant resources into a category that consumers don’t care about, especially when the core business is deteriorating.  Management’s decision making process remains flawed, which is one reason we are skeptical the company can gain sales traction in 2014.

We believe MCD’s senior management is not only obsessed with SBUX, but also terrified of DNKN – particularly given the lower price points they sell coffee for.  The charts below exhibit the same-store sales trends of these three companies since 2011 on a quarterly and two-year trend basis.  SBUX and DNKN continue to separate themselves from MCD.

MCD: MCDONALD'S OBSESSION WITH STARBUCKS - all 3 sss

 

MCD: MCDONALD'S OBSESSION WITH STARBUCKS - all 3 2 yr

Despite MCD’s failure to penetrate the premium beverage market, frappes and smoothies have worked well for the company, to the extent that they were able to mask a decline in MCD's core lunch business.  To be clear, these products are an entirely different platform than espresso drinks.  In other words, MCD could have rolled out the cold drinks and enjoyed the same level of success without ever putting in espresso machines.

MCD: MCDONALD'S OBSESSION WITH STARBUCKS - last chart

 

Where Did McDonald’s Go Wrong?

Since opening the first store in 1954, McDonald’s growth had always been driven by one thing: unit growth.  This strategy was successful until the late 1990s, when the company reached a saturation point.  An attempt to sustain unit growth resulted in cannibalization, which caused a steady decline and deterioration of same-store sales and margins, respectively.  Thus, the “Plan to Win” was born.

When McDonald’s first embarked on its highly successful “Plan to Win” in 2003, the company developed a comprehensive program designed to “optimize and simplify operations.”  This led to several major operational and structural changes, including:

  • Fewer sizes of drinks and fries
  • Fewer extra value meals
  • Simplified pricing
  • Streamlined merchandising
  • Intensive hospitality training of employees

Unfortunately, McDonald’s has deviated from this plan and finds itself in a precarious situation once again.  Management wants investors to believe that the macro environment is causing the recent troubles.  However, management has been using the macro environment as a scape goat for poor sales for the past five quarters and continues to deny the notion that the company has operational issues.  We’ve been fairly vocal in sharing our opinion for a while now and our view has not changed – MCD has material internal issues.

Management’s relentless focus on driving the top line has required the franchise system to invest significant capital in facilities and new equipment.  Even worse, from an operating standpoint, this approach has resulted in a burgeoning menu, featuring a seemingly limitless pipeline of new products.  This has complicated back-of-the-house operations and is gradually offsetting much of the progress made during the implementation of the initial “Plan to Win.”  Once again, much like the 2000-2003 period, LTOs are not working as evidenced by a number of recent, unimpressive initiatives, including the national rollout of Mighty Wings.

As we have seen in the past, a disgruntled franchise base is emerging, as operators are finding that the menu is too large and operational issues within the kitchen persist.  We believe the dysfunctional rollout of McCafé is a significant contributor to McDonald’s current operational dilemma. 

McCafé = McMajor Problems

By way of background, McCafé was first launched in Melbourne, Australia in 1993.  McDonald’s first started testing McCafé domestically in the Chicago area in May 2001.  At the time, McDonald’s focus on coffee was designed to take on the growing competitive threat of Starbucks.  In hindsight, the Starbucks impact went well beyond just coffee and brought to life the theory of the “third place” or the “café” setting. 

In the 2001-2003 timeframe, McDonald’s saw the new Starbucks business model as one factor in its own same-restaurant sales declines.  In our opinion, McDonald’s has been obsessing over the success of Starbucks since that time, and has been putting capital to work in order to compete directly against SBUX.  This is precisely what caused MCD to lose its focus in the first place.  The company deviated from its core and stopped executing on what made it so successful – selling burgers, fries, and soda.

Ironically, history appears to be repeating itself, as we believe McDonald’s is once again obsessed with the success of Starbucks.  This continues to cloud management's judgement and will likely lead to poor resource allocation decisions in 2014. Sadly, management continues to stray from its core business model and now finds itself in the position where it is in desperate need of a “Plan to Win 2.0”.

Pulling Back the Curtain on the Starbucks Obsession

Early Stages of the RecoveryBetween 2003 and 2005, MCD realized a significant margin benefit from the “Plan to Win.”  A core tenet of this plan was simplification, which applied mostly to the menu and kitchen operations.  The company’s restaurant level performance benefited greatly from the enhanced emphasis on operational improvement among its existing asset base.

Upgrading Drip Coffee – It was not until 2005 that management began upgrading its drip coffee by using higher quality beans, filtered water, and better tasting cream.  Over the next two years, drip coffee sales surged, giving management the confidence to upgrade the hot drinks menu.

A Beverage Destination – Beginning in 2006, management began to articulate that the success of the drip coffee business gave them the credibility to successfully expand into espresso-based drinks.  Thus, McDonald’s attempted transition from a fast food concept to a beverage concept was underway.

Early McCafé Test Failed – 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.  It also involved incorporating separate McCafés in each restaurant, in order to serve a new line of espresso-based products and assorted baked goods.  In the end, the KC test market didn’t work, the construction costs exceeded the budgets and, more importantly, consumer demand was not meeting expectations.

Oak Brook Ruled McCafé Will Be National – Late in 2008, we documented that the company was clearly behind plan in converting restaurants to McCafés.  Management wanted to promote the product by mid-2009.  Despite the challenges in test markets, the Oak Brook-based initiative managed to go national in 2009.  But, this came with one caveat: the rollout strategy had been altered from its original form.  Instead of developing a separate “McCafé” within the store, which was the prototype developed in other markets, management decided to integrate the espresso machines within the kitchens of the other markets.

McCafé Was a Must – MCD "needed" the McCafé platform to implement Phase II: cold beverages.  After four years of successful new product introductions, management found themselves at a crossroads.  They needed to drive traffic, and they determined beverage sales was the way to go.

The Great Recession  In 2009, breakfast sales took a turn for the worse, as higher unemployment rates resulted in less commuting traffic.  As a result, McDonald’s introduced breakfast items to the Dollar Menu at the beginning of 2010.  Prior to frappes and smoothies, the last product the company introduced that had a material impact on sales was the McGriddle sandwich in 2003.

Cold Beverage Success – In early 2010, McDonald’s implemented the cold phase of its beverage program: frappes and smoothies.  Highlighted earlier in the note, these new cold beverages accounted for more than 100% of the company’s same-store sales growth from 2Q10 to 3Q10.  In 2011, MCD continued to benefit from incremental beverage purchases, as the company spent a very high proportion of marketing dollars on promoting the beverage platform.

Masking a Decline in the Core Business – McDonald’s was so successful in driving breakfast and afternoon traffic with the $1 menu and cold beverages, respectively, that they were able to effectively mask the deterioration of their core business.  

Today – McDonald’s management insists on blaming the macro environment for their issues.  McDonald’s CEO, Don Thompson, was President of the U.S. division back in 2009, when the company decided to roll out McCafé nationally.  Therefore, it is highly unlikely that he will acknowledge the company has significant operational issues and the need to embark on a path of real change.  It is much easier to look for blame elsewhere.

Howard Penney

Managing Director