The Only Way McDonald’s New CEO Can Turn Things Around

Keith Fitz-Gerald Feb 04, 2015
15 

Just over two months ago I unceremoniously kicked McDonald’s Corp. (NYSE:MCD) off my “buy” list noting that for the first time in more than 10 years that the company was no longer tapped into any of our globally “unstoppable trends.” Now, with the stock down another 7% since then, the Board has just kicked CEO Don Thompson off the menu, too.

Is this move enough to put Mickey D’s back on my list?

That’s a great question. It’s not for nothing that the stock is practically investment royalty. It’s established, it’s widely held, and it returned $6.4 billion to shareholders last year.

It’s also a logical question because a change in senior management can be a powerful catalyst for higher returns. ABB, for example, took off on a 1.359% run in the five years after Jurgen Dormann took over for former CEO Joergen Centerman. Similarly, Yahoo! Inc. has returned more than 190% since former Google exec Marissa Mayer took the reins and launched a series of bold acquisitions in the summer of 2012.

McDonald’s stock jumped 5% the day Thompson hit the pavement after a 25-year career and less than two years as CEO, so investors are naturally giving the stock a second look. They’re all wondering – “Is this the day McDonald’s turns things around?”

My answer may surprise you.

While many investors like to think CEOs have long tenure, in fact they come and go on a regular basis. In 2014 alone, 1,341 CEOs left their companies, a figure up 7% from 2013’s total according to a report by The Street.

That’s because not everything a CEO does is good. Many times new CEOs can destroy a company literally and figuratively.

RadioShack, for example, has fallen more than 91% since it named Joseph Magnacca to the corner office. CEO Ron Johnson was fired from JC Penney after just 17 months on the job following a disastrous reinvention of the company’s brand. The stock was down by 25% in Johnson’s first year at the helm.

McDonald’s risks the same fate.

The numbers – never mind the personalities involved here – are terrible.

McDonald’s last earnings report, released not even two weeks ago, is confirmation that 2014 was one of the company’s worst years ever. Consolidated operating income decreased by 9% for the year, due mostly to supply issues in the Asia/Pacific and Middle Eastern regions.

Diluted earnings per share were down by 13%. Global comparable sales decreased by 1% for the year. This 1% decrease is even more grim when you consider what drove it – a negative trend in guest traffic across every one of the chain’s major segments.

It doesn’t surprise me that a humbled Don Thompson acknowledged “meaningful headwinds” during the earnings conference call. Nor did the assurances that he was acting “with a sense of urgency” to turn the situation around.

The call was like buzzword bingo and I’ve seen this playbook before. You have, too.

Not even the $6.4 billion McDonald’s returned to shareholders in dividends and share repurchases was enough to assuage the board’s concern with McDonald’s direction and Thompson’s future. So out the door he went.

Enter incoming CEO Steve Easterbrook who takes the reins March 1.

He’s got some serious chops. From 2011-2013, Easterbrook directed PizzaExpress, a British fast-food chain that successfully built a brand around the high quality and freshness of its food – an aura that McDonald’s would do very well to restore. I’ve eaten there lots and loved it.

He then became CEO of Wagamama, a Japanese noodle chain also based in London that tastes great and serves up super quality food at a reasonable price. That’s always important in hyper expensive London.

It’s not like he’s an unknown. In fact, the opposite is true. Before being tapped for CEO, McDonald’s snagged him to oversee its menus, marketing campaigns, and technology.

When I’m evaluating a company, this is exactly the kind of CEO I want to see. He’s got global expertise and a proven track record. There’s no doubt in my mind that Easterbrook can repair McDonald’s brand.

Still, it’s NOT enough for me to re-recommend the company. Not now.

For that, I’d have to see Easterbrook tap into at least one unstoppable trend but preferably two.

Opening No. 1: Demographics

For years I recommended McDonald’s as a stock to buy despite naysayers who were turned off by the gradual declines in same-store sales. Critics pointed to MCD’s declining market share among fast-food consumers in the U.S. to justify their downgrading of the stock.

They all had a point, at least in the short term. McDonald’s sagging sales were troubling, but even last summer I still recommended the stock. I was heartened by one development I saw in Asia that outweighed every temporary setback. It was confirmation to me that MCD was making moves that could assure its success for years to come.

I focused on the fact that McDonald’s had opened 225 stores in China in 2013, and was on track to open an additional 300 in 2014. Those openings increased MCD’s presence in China by 15%.

The effort in China made perfect sense to me because of the incredible promise that China’s exploding middle class represents to the company. A 2012 McKinsey & Co. report found that China’s middle class is expected to grow by 800% from 2010-2020, eventually numbering 50% of China’s 1.3 billion populace.

With growth like this, revenue from China could eventually dwarf revenue from the U.S., which, being home to 40% of McDonald’s stores is currently the bedrock of McDonald’s sales. This development – the harnessing of China’s amazing Demographics trend, would be an earthquake for McDonald’s and completely turn around the recent history of declining global sales. Such is the power of an “Unstoppable Trend.”

However, the company got sloppy and was unfortunately took its eye off suppliers that are critical to its success – in this case, a Shanghai meatpacking operation. The tainted meat scandal in 2014 resulted in scandalous headlines for McDonald’s, as well as sanctions and a huge loss of customer goodwill. That’s a much bigger deal in reputation conscious China than it is here. Anyway, long story short, the fallout allowed smaller, nimble companies to gobble up market share – pun absolutely intended.

Hopefully, Mr. Easterbrook will signal early on that he understands this, and continue McDonald’s aggressive eastward expansion by rebuilding trust. The momentum would go a long way towards making McDonald’s a stock to buy once more.

Opening No. 2: Scarcity/Allocation

We’ve talked a good deal about the concept of Scarcity & Allocation with regard to the importance of focusing on “must haves” versus “nice to haves.” It’s a distinction 99% of all investors miss and, sadly, doom themselves to unnecessary risk as a result.

McDonald’s fit the bill nicely selling a narrowly defined menu of carefully selected goods selected as much for their taste as their appeal to hard working folks around the world.

Then, inexplicably, it went upscale and, in the process, became a nice to have company.

That’s why I was so puzzled and disappointed by MCD management’s decisions incrementally increase the prices on its menus, without upgrading quality or service in any significant way.

This move may seem inconsequential, but I believe it opens McDonald’s up to a potential death spiral as its increasingly cash-tight customers “allocate” their hard earned money to competitors. This will result in yet a deeper revenue crunch, still more price increases to make up margin, and yet more customer alienation.

If McDonald’s wants to hitch itself to the Scarcity/Allocation trend, the solution lies with its menu. Instead of trying to make its menu deluxe or boutique, it’s got to get back to the “value meal” that caused people in their millions to flock to McDonald’s in the first place.

When that happens, it will look a lot more like the “must-have” company we used to know and, by implication, be capable of bucking the “headwinds” Thompson described on his way out.

And, once again, it’ll be time to order up shares.

Until next time,

Keith Fitz-Gerald

15 Responses to The Only Way McDonald’s New CEO Can Turn Things Around

  1. Tom Santopietro says:

    Very well written and intuitive article. You make some very valid points and have helped me make a decision to wait a while longer before I buy . Thank you.

    • Ron says:

      In TN level of training of employees is not Adequate. Quality level of meat Is down and prices up. Store management is not qualified or trained to manage the operation in many cases. This pertains to about 50% of the locations I’ve been in during the last 12 months. You soon learn to pick and choose but that’s hurting overall performance.

  2. bob the belgian says:

    Hello Keith,
    Navios is still a favourite of yours. Isn´t there a chance that the new radical-left Greek government will tackle shipowners and the like, as they pay no or very few taxes for the time being?
    Bob

  3. Kathy johnson says:

    Keith,
    Interesting that you say McDonalds increased prices. I ran into that last month. I ordered a salad from the dollar menu. It was charged out as $1.69. I told them, that I wanted the salad from the dollar menu. The answer was, “it is from the dollar menu, the prices have gone up.” I bought that one, but felt a little like bait and switch was used on me. Will be the last one I purchase.

  4. Bill says:

    I had my mother add McDonald’s to her portfolio several years ago. I am thinking of having her sell the stock. What I see happening in the marketplace is people want a better quality product. If McDonalds doesn’t get serious about increasing the quality of their food, they will find themselves falling behind Chipolte’s, Moe’s, Shake Shack, etc. These firms are offering grass fed beef, not pink slime. I am 59 years old and I view the meat McDonald sells as what went for dog food when I was young.

    Their French fries contain 19 ingredients, one of which is a petroleum based product. What is wrong with potatoes cooked in oil. Their oil is the worst kind. All tainted with GMO’s. Peanut oil would be far better than canola, corn, or safflower oil.

    McDonalds should convince Coke to provide them with products that contain real sugar instead of HFCS.

    All I have seen out of McDonalds is gimmicks, such as lets redecorate our stores, or play with the prices on our menu, or add or subtract some menu items. I don’t think it has dawned on them, that more and more people want to eat healthy.

    I would like to see them change but I’m not optimistic. By the time they realize they need to change they will be facing heavy competition with good reputations for serving quality food.

    People are wakeing up to the fact they are being fed a non-healthy product my many companies.

    • guest says:

      The pink slime accusation has been debunked.

      The “19 ingredients” has been debunked.

      GMO risk has been mostly debunked.

      McDonalds quality matches up well with the vast majority of their fast-food competitors.

  5. Cary says:

    so should we sell the stock we bought at $100 per share or hold on to it hoping for a come back? It would be good to know because I did buy on your advice… Even I didn’t expect to lose money on MCD ever. Thought maybe it wouldn’t grow but fall – that was unexpected.

  6. Ernie says:

    I would think one of the items that brings down their profits is filling out the customer survey that you get every time you buy something from McDonalds. They give you a free Quarter Pounder if you fill out the survey. They have been doing this for about a year. This could be biting into some of their profits..

  7. Howard Chura says:

    I’ve been following McDonald’s for a while now, with an eye toward investing in its stock. So, I greatly appreciate
    your viewpoint regarding alignment with demographics and scarcity/allocation. Interestingly, I recently read an article by Dan Farris wherein he suggested that the company take a look at it’s high number of company owned stores(6000 plus) vs 34,000 owned by franchisees. His thought was that several hundred company stores scattered around the world would take care of corporate _____(forgot the term) and the rest should be converted to franchises.
    His reasoning is that the franchises are much more profitable and have been the source of some of the most successful menu ideas. Anyway, what I might do is satisfy my “itchy finger” for this world dominater by buying a small 1st tranche and then waiting to see what happens. Thanks again.

  8. William Heard says:

    What about rumors that unsavory contaminants (woodchips,etc.) and other non food “fillers” are in Mcd”s-and other f. foods cos.-food? This presumably to cut costs. Also, how would one research this to find whether it has any truth to it? Thanks-Mr. Fitz-Gerald–I like your work v. much.

  9. Rich Vernadeau says:

    The secret is for McDonald’s to return to its roots. I have noticed a TV commercial focusing up close on the Big Mac- a smart move, as the Big Mac is its signature sandwich virtually synonymous with McD’s. Time to play the nostalgia card- bring back Ronald McDonald, recycle old commercial them songs like the one Barry Manilow wrote and made famous “You deserve a break today, so get up and get away…to McDonald’s”. You know, some of this is not really rocket science…

  10. Chris Hugar says:

    Terrific explanation of a complicated situation. I have always suspected that the most vocal critics of McDonalds were not customers. Why change the menu to tofu burgers and veggie fries when your loyal core loves the Big Mac and Quarterpounder. I will continue to enjoy the food, especially breakfast offerings but not invest for now. Will be watching though. It’s an unmatched brand. Thanks for your fine analysis.

  11. Austin says:

    Sold Mickey D’s awhile ago and will not be adding back to my portfolio until I see demonstrated long term changes…. MCD is all about marketing and not about offering a quality product. At the end of the day that spells failure with a capital F. They can build all the facilities they want in China and in the beginning the Chinese will come… because of the hype and marketing…. But the Chinese are not stupid and I don’t think they will fall into the carb-sucking rut that represents the majority of MCD’s American customers. I would rather skip a meal than eat a dollar anything at MCD’s, including the salad (take a close look at the ingredients in their dressings). The new CEO has a heck of a challenge ahead of him. I hope he succeeds. If he can make meaningful changes I will take a second look. Right now there are lots of better investment choices out there.

  12. Dan says:

    McDonald’s also needs to streamline their menu. With some 100 items today they have way too many to to be called “fast food” nor can they keep the quality up and the waste down with so many items. To ensure Ray Kroc’s
    QVSC mantra…… Quality, Value, Service and Cleanliness, some of the points mentioned by the article coupled with taking the 15 least profitable items off of the menu would go a long way.

    Another observation is: I seldom see any manager out in the lobby observing how his or her team is doing? You see more from the lobby than you do from behind the counter. Nor do I see many field reps checking on the stores today as they did in the 70’s, 80’s, and 90’s .? have they become too big to inspect ?

    If Ray Kroc or Fred Smith were still around these problems would not be permitted.

    • Keith says:

      Hello everybody!

      First, thank you for the kind words. You made my day!

      Second, what a fabulous group of points you’ve raised. Everything from the concept of lower cost goods impacting margins to the management in the lobby is exceptionally prescient thinking. Not to mention logical, too. I’ll be following up on all of this as I continue to watch MCD’s.

      And, third, clearly many of you share the same affinity for Uncle Ronald I do. In some cases, that’s related to the brand and in others probably the food. Personally, I love tucking into a Big Mac and fries every now and then much to my wife’s chagrin. I think what happens next will be studied carefully for years to come in management programs around the world.

      All the best regards and thanks for being part of the Total Wealth Family, Keith 🙂

      PS: I almost forgot. Stops are stops. The only question is timing. Even the best professionals sometimes take 3 to 4 swings at a stock they want to own before “hitting” the ball. So don’t lose faith or worry that you’ve been bounced out. The markets will always be there. So will MCD. When the time is right, we’ll be back.

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