McDonald's Turnaround Presentation Makes It Clear How Big a Job That Will Be

05/07/2015 10:11 am EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

This once fast food king’s turnaround presentation was disappointing for anyone who wanted to hear a concrete plan for revising sales, but MoneyShow’s Jim Jubak points out that it was also extremely useful because it delineated how hard this turnaround will be to accomplish.

McDonald’s (MCD) big turnaround presentation Monday morning by new CEO Steve Easterbrook was disappointing for anyone who wanted to hear a concrete plan for revising sales at the company.

But it was extremely useful because it delineated how hard this turnaround will be to accomplish.

Listening to Easterbrook, it was pretty clear to me that McDonald’s doesn’t have a way forward unless it’s willing to destroy a good bit of its past.

Most companies spit the bit when confronted by that kind of challenge. It’s hard to give up a hunk of present revenue or a piece of current market share for a chance at future growth. But I think that’s exactly the choice that confronts McDonald’s now.

Here’s what Easterbrook presented Monday morning:

  • More cost savings; $300 million annually by 2017.
  • A restructuring into four segments that groups markets by characteristics. For example, the high-growth markets of Italy, China, and Russia will all go into one group. In theory, this will let the company concentrate its efforts in its most promising markets.
  • The sale of 3,500 company-owned stores to franchisees. That will take the percentage of stores owned by franchisees to 90% from 81%. (This move accounts for part of the $300 million in annual cost savings.)
  • The company intends to return $8 billion to $9 billion to shareholders this year in the form of dividends and buybacks.
  • And, oh yes, McDonald’s will continue experiments that allow customers to personalize their burgers and other sandwiches.

It’s this last item that captures McDonald’s problem in any turnaround. Customers are demanding fresher and better quality ingredients and the ability to personalize their meals. (At least that’s how McDonald’s and Wall Street read the Chipotle Mexican Grill (CMG) success story.) To capture the new customers that McDonald’s needs to restore growth, the company needs to tap into that trend. (Of course, McDonald’s could find its own new trend, but that’s a whole lot harder than shooting to duplicate an existing successful trend.)

But it also wants to keep its existing customers who are looking for quick fast food, ordering at drive-through windows, and low prices. How do you deliver those qualities demanded by existing customers and add those qualities demanded by new customers? There’s a lot of evidence that part of McDonald’s problem is that it is failing both markets. Wait times at drive-in windows and at counters have climbed to a level where some drivers, seeing the line at the drive in window, simply go elsewhere. The bloated McDonald’s menu, designed to appeal to everyone, slowed service (and imposed new, resented costs on franchisees). Nobody knows how to deliver a personalized burger without slowing the drive-in window even further.

And when it comes attracting those new customers, it’s revealing that one of the toughest questions asked to Easterbrook, was when McDonald’s might start offering organic lettuce on its sandwiches. Easterbrook didn’t really have an answer to that, instead he went on about McDonald’s efforts to reduce salt, fat, and sugar in its food. That was the last revolution in healthy eating, remember?

In retrospect, McDonald’s decision to sell its 87% stake in Chipotle back in 2006 was a crucial turning point for McDonald’s. McDonald’s sold, the company said, in order to concentrate on its McDonald’s brand. Which left it without a separate vehicle for addressing a shift in the market.

McDonald’s problem isn’t that burgers have lost their market. The success of Five Guys, Sonic (SONC), In-N-Out Burger, and Shake Shack (SHAK) indicate that. But those companies address very different pieces of the burger market. They don’t try to be everything for everybody. I don’t think the In-N-Out Burger customer is the Shake Shack customer. And they don’t try to sell something for everybody. I don’t walk into a Shake Shack expecting to be able to order a chicken and ranch wrap and I know that if I want a salad I don’t walk into a Five Guys.

So, what does McDonald’s do now?

I think it has two choices.

First, it can follow its recent path—which Easterbrook seems inclined to follow—and try to capture more market share by pleasing everyone. I think this leads the company to please no one, ultimately. They will continue to be the fast-food carcass that nimbler competitors carve into new businesses.

Or they can decide to break up the business into units that do fewer things but do them really well. There is no reason that McDonald’s couldn’t successfully compete with Chipotle, or Five Guys, or Panera, but I don’t think it can successfully compete with them all from under one roof. I think that McDonald’s strategy in Australia, which is serving as a test bed for some of its new ideas, suggests what a move in this direction might look like. Some of the new stores don’t look anything like a traditional McDonald’s.

Face it, the company’s great strength isn’t in its food. It’s in its logistics and purchasing systems and its real estate services. When Chipotle split-off from McDonald’s, Chipotle went through a challenging transition as it learned how to do all those tasks for itself. I suspect that there’s nobody in the industry better at these parts of the fast food business. What McDonald’s needs is to find a way to leverage those strengths without getting caught up in tinkering with its menu. That isn’t going to fix the problem.

McDonald’s wouldn’t be blazing new territory in this approach. The strategy of leveraging manufacturing—which is what these functions at McDonald’s amount to—prowess is exactly what Intel (INTC) is built upon. Yes, individual products rise and fall, are successes or failures. And, of course, that matters. But the long-term, success of the company is built on its factories and on its ability to stay at the cutting edge of chip size, speed, and energy consumption.

McDonald’s has a lot of time to discover its way, but not an infinite amount of time and I worry—so far just a little—about the company’s decision to increase leverage so it can increase returns to shareholders. I understand the impulse—if you’re not going to deliver growth, you’d better deliver dividends and buybacks—but paying for dividends and buybacks by increasing leverage still leaves me uneasy. Standard & Poor’s downgraded McDonald’s credit rating to A- from A after hearing of the company’s plan to return $8 billion to shareholders. That will increase leverage at the company. (As will the effort to sell company-owned restaurants to franchisees since that results in a de facto shift of the costs of efforts such as the customized burger to franchisees.) Credit Suisse estimates that leverage will increase to 2 times 2015 EBITDA from 1.6 times EBITDA in the fourth quarter of 2014.

That’s not a huge shift, but it does increase the risk in the stock just as the company is searching for solutions.

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