We continue to be bearish on MCD, but we are removing it from the Hedgeye Best Ideas list as a SHORT.
Our bearish thesis is centered on structural (internal and external) issues within the McDonald’s U.S. business. While the company addressed some of its issues with the rollout of high density tables, we believe McCafe’s status as a “sacred cow” will continue to cause throughput issues.
On the positive side, however, it appears Europe has stabilized despite persistent softness in the region’s most important market – Germany. Asia also looks to be stabilizing despite Japan finding itself in the same boat as Germany.
McDonald’s business model is resilient and the stock has benefitted from a healthy 3.4% dividend yield, which we expect to increase in 2014. What concerns us the most in being short the name is the potential for an activist to step in or the potential for a “financial engineering” event.
Whether it is the real estate or the potential for incremental leverage, there is inherent value in McDonald’s balance sheet. We believe someone, at some point, will come along and take advantage of this. If Carl Icahn can push APPL to buy back more stock, we surmise he’d be able to do so for MCD as well.
For the time being, McDonald’s is treading water. The business plan the company presented to the investment community at last November’s analyst meeting is, in our view, unlikely to deliver the intended results. We believe the required changes this company needs will happen soon – and they are significant.
Below we highlight a few changes that we believe need to be made at MCD:
- Higher Food Costs – CMG has permanently changed the way consumers view fast food and MCD knows it. In January, MCD announced its commitment to begin purchasing “verified sustainable beef” by 2016. MCD currently sells over one billion pounds of beef and it will take a couple of years for them to “listen, learn, and collaborate with stakeholders from the farm to the front counter to develop sustainable beef solutions.” These trends suggest higher food costs for MCD as they begin to compete in the new era of sustainability.
- Cutting Capital Spending – At the 2013 analyst meeting, MCD revealed their shift in strategy from “better not bigger” to “bigger and better.” It is unlikely this strategy will improve returns. McDonald’s capital spending has increased 100% since 2006. The only way to fix the inherent issues within the company today is by cutting capital spending.
- Rethink the McCafe strategy – For Don Thompson, McCafe is a “sacred cow.” We continue to believe McCafe is the largest culprit for declining traffic trends at lunch. Since he pushed the strategy aggressively while running the U.S. business, it will be difficult for him to admit defeat.
Given the changing consumer needs, wants, and desires, the MCD business model is in need of a major overhaul. Thanks to CMG and these developing consumer trends, MCD is being forced to look into selling sustainable beef. This is only the tip of the iceberg for McDonald’s. Its entire menu, packaging and carbon footprint will eventually need to be reengineered. The question is: at what additional cost?