Monday, September 17, 2012

McDonalds Equity Research

Donald Rumsfeld once memorably outlined his treatise on metaphysics in his known/unknown speech. Alas Wittgenstein was not around to appreciate it, but allow me to plagiarize and describe the recent same store sales numbers from McDonald’s Corp (NYSE: MCD) as being an unkown unknown. All three major regions comparable store sales were down. In the US they were down .1%, Europe declined .6% and the unusually named APMEA (Asia Pacific Middle East) also declined a worrying 1.5%. Analysts were surprised, as were investors, and you can add a third group to the bemused party: McDonald’s management, because on July 23rd they were telling the investment community that July same store sales would be positive but less than the second quarter. I’m going to try out Rumsfeld’s metaphysical epistemology and see where it takes me. No one else seems to know what is going on here.

Known Knowns & Known Unknowns

Presumably McDonald’s has pretty decent sales monitoring technology in place so we can take it that the prediction of positive comps on the 23rd of July is accurate. If so, it suggests that there was a significant drop off in the second half of July. I think this is an important point because it suggests linearity. In other words, a trend is continuing its decline.

Management were keen to blame the macro economy and a worsening consumer environment. I’m sure there is truth in this. I research a lot of company statements, and it is clear that, for example, Spain has had a sharp drop off in the last few months, and I’m told Italy is following it. This is understandable but it neither explains the declines across all the regions nor the linearity within them. Moreover, McDonald’s is supposed to be the great defensive stock. A winner in the new age of austerity and trading down.

To graphically illustrate these points, here is a chart of comparable sales for McDonald’s.

Note how well McDonald’s did in the great recession of 2008-09. Sure growth slowed, but it didn’t go negative, and McDonald’s was a stock market darling in the period. It is therefore very difficult to pin the blame solely on macroeconomic conditions.

The last of our known knowns is revealed by looking at what its competitors are saying. In its last results, released on July 19th, Yum! Brands (NYSE: YUM) reported same store sales growth of 10% in China, 1% in the US and 7% in YRI (Yum Restaurants International) amidst reconfirming full year guidance. This is nothing unusual for Yum because its focus is on aggressive growth in China. A fact which many believe has caused them to drop the ball in the US. So overall it is not painting the kind of macro picture that McDonald’s is.

Nor is its rival that recently returned to the public markets, Burger King (NYSE: BKW), which reported same store sales up 4.4%. With regards to Burger King, I confess I am a bit skeptical in general about businesses sold off by private investment companies (even if they do retain a large share) that rely on franchising to drive growth.

Wendy’s Company (NASDAQ: WEN) reported a more modest system wide same store sales increase of .7% in Q1 for North America and recently reported a 3.2% increase for Q2. Chipotle’s (NYSE: CMG) recent revenue numbers missed estimates amidst talk of slowing traffic in North America. Unsurprisingly, the stock took a significant hit. Chipotle has its own company-specific niche to play in, but the numbers from Wendy’s, Burger King and Yum for North America were are all pretty similar. All of which make McDonald’s numbers so surprising.

So to recap, what are our known knowns?

McDonald’s comparable sales growth figures are trending down in a linear fashion. The economy is a factor but not as much as the company makes out. Competitors are executing better and are not talking so negatively about the macro-environment

As for the known unknowns, they are comprised of questions like: "To what extent the slowing trend is due to operational issues at McDonald’s?" "Did it expand too much too soon, and is now suffering the consequences of trying to wring revenue and earnings growth out of increasingly unproductive stores?"  "Moreover is this a company specific issue which suggests that its product lineup is stale and in need of a revamping?" "Did (now departed) Jim Skinner’s influence and drive start to wane as he prepared to hand over the reins?"

Where’s the Beef?

I think a clear picture is going to take time to come into focus. The evidence of 2008-09 demonstrates that it can generate growth even in a difficult economic environment. However, investors will need to watch the future commentary very closely in order to learn more of the root causes of this sudden decline.  If it is a question of too much expansion too soon then store roll outs might be scaled back. If it is product offering then more revamping is in order.

I can’t speak with the certainty of a Rumsfeld (few can) but I do think the evidence is pointing to a combination of weak end markets and a competition that just got better. My suspicion is that the competition has stepped up and is grabbing market share via promotions, sales and a more focused value offering. If so then, on balance, I think that McDonald’s can recover from here because these issues are largely matters of execution, but it may take at least a quarter or two to turn around.