Editor's note: This research note by Hedgeye Managing Director and veteran Restaurants analyst Howard Penney was originally published January 30, 2014 at 10:42 in Restaurants. For more information on our subscriber services click here.
For the past year, we have been harping on our “Espresso-Based Conspiracy Theory” as one of the reasons why McDonald’s is struggling to grow its top line. The evidence supporting this assertion continues to pile up.
In short, we believe the McCafe strategy creates additional complexity in the back of the house and diverts resources away from the core food business. We’ve always viewed McDonald’s as a food first destination and whenever management shifts their focus away from food and to beverages, the core business suffers. To that extent, we contend that the early success of the beverage strategy (cold beverages) masked a decline in the core business (selling burgers and fries).
At the most recent analyst meeting and earnings call, management finally began to “come clean” with some of the issues that are impacting sales trends. None of the issues the company addressed, however, included McCafe. In fact, part of their 2014 strategy includes increased marketing resources to “go after the coffee consumer in 2014.”
On the 4Q13 earnings call, Chief Operating Officer Tim Fenton admitted that the never-ending LTOs and menu changes in 2013 overcomplicated operations. The menu changes in 2013 included:
- Mighty Wings
- Premium McWraps
- Steak & Egg Burrito
- Fish McBites
- Steak Breakfast Sandwiches
- New Quarter Pounders
- Grilled Onion Cheddar Burger
- Hot’n Spicy McChicken
- The Dollar Menu & More (with five new burgers)
During the analyst meeting a couple of months ago, Don Thompson said: “We stumbled a bit last year with too many new products, too fast and we created a lot of complexity.” This may be true, but we contend that the issues McDonald’s faces did not start in 2013. These issues really date back to 2009/2010, when we saw the national launch of McCafe and an accelerating number of menu introductions.
Later in the note, we use a chart from Burger Business, along with management’s comments from the 4Q13 earnings call, to put our thesis in perspective.
By way of background, part of the 2003/2004 “Plan to Win” strategy included a Time & Motion analysis of the restaurants’ back of house operations. With this study, management had determined that employees’ movement in the kitchen had become inefficient. Management’s desire to fix this was a key driver in simplifying the menu and streamlining operations.
In 2014, management is now once again talking about the Time & Motion of employees in the back of the house. However, this time management does not appear to be a taking a holistic approach to fixing these issues. Rather, these moves strike us as more geared to specific menu items. To illustrate our point, we have reproduced a chart from Burger Business looking at the evolution (bloating) of the McDonald’s menu since 2004.
As you can see in the chart below, the total number of items on McDonald’s menu increased by 75% from 2004 to 2014. This means an incremental 51 items have been added to the menu over that period, making the current day menu very difficult for crews to execute.
More importantly, there are two sections that account for the bulk of the menu proliferation. Not only are the number of Burgers, Sandwiches, Wraps up by 60%, but McDonald’s also created a whole new beverage category called McCafe (espresso drinks added in 2009; smoothies and frappes added in 2010).
Knowing how important Time & Motion is to the performance of McDonald’s restaurants, we continue to believe that McCafe has played a critical role in the slowing sales trends at their restaurants. This is an issue that management continues to ignore and could very well exacerbate!
To their credit, management has addressed part of the menu proliferation with the roll out of its high density kitchen tables. As management said on the 4Q13 earnings call, “These new high density kitchen prep tables are designed to deliver enhance service capabilities and menu choice to our customers.” We believe these high density tables should address Time & Motion issues associated with burgers, sandwiches, and wraps – to an extent. Management also supported this thought: “On the capacity, any time during our peak hours, if I can keep place in place and not have their feet moving to restock or to get something else or have crossover,” they, theoretically, will be able to improve the performance of their stores.
While this may be a step in the right direction in an attempt to better execute the current menu, this will also allow for additional customization. While they may need this additional customization to remain competitive in the market place, it could mitigate some of the benefits of the high density tables.
In addition, management has failed to address the proliferation of beverages and the impact of the McCafe strategy. Is it possible to add two new pieces of equipment (needed to make McCafe beverages) and not create additional Time & Motion inefficiencies? We don’t think so, but management appears unwilling—at least at this point—to acknowledge this.
So how does this end?
The high density kitchens will be rolled out to the entire system by the end of 2Q14. Therefore, McDonald’s should begin to see better sales trends by July 2014. If, however, this doesn’t happen and weakness persists into 2H14 (meaning high density kitchen tables are not the panacea for sluggish sales trends), the focus of analysts and investors will shift to other issues the company could be facing. If and when this time comes, we’d expect management to be more upfront about the issues surrounding the McCafe strategy.
Only time will tell.
If management’s denials persist, we believe the stock will continue to underperform and may prompt Bill Ackman to dust off the old McDonald’s slide deck and step in to push for more changes at the company.