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It's no secret that McDonald's (MCD
) burgers-and-fries formula has disappointed Wall Street in recent years. In fact, investors' hopes for a cohesive plan to revive its fortunes have been mashed, dashed, and fried numerous times. On Sept. 17, for instance, citing costs it expects to incur as it tries to reinvigorate its U.S. business, the world's No. 1 fast-food chain substantially cut its earnings forecast for both the third quarter and full year.
McDonald's shares tumbled 13%, to $18, a level they last touched in 1995, and they've fallen to as low as $16.56 in the weeks since then. The stock closed around $18 on Oct. 14.
The recovery plan put forth by CEO Jack Greenberg calls for spending $300 million to $400 million over 18 months to two years, beginning in 2003, to spruce up selected franchise units. The object is to avoid losing U.S. customers to aggressive burger competitors such as Wendy's (WEN
) or to nonburger chains like Subway.
TEMPTING P-E. McDonald's also has said it will scale back store openings in other countries. And it has lowered its share-repurchase plan for 2003 to about $500 million, vs. $1 billion or so in previous years. At the same time, it says it will do better in training store managers and workers to improve service. Add it all up, and McDonald's is hoping that by incurring a modicum of short-term financial pain, it will reap a long-term reward in the form of increased sales from existing stores.
At just 13 times last year's earnings per share of $1.36, vs. a 20.9 price-to-earnings (p-e) ratio for Standard & Poor's index of the five biggest restaurant chains, McDonald's stock may look tempting. But before you start salivating, it may pay to recall that recent turnaround promises have delivered only indigestion. Highly skeptical analysts who have followed McDonald's for years say the strategy will have to show clear results before the stock bounces back.
J.P. Morgan Chase analyst John Ivankoe notes that since the fourth quarter of 1999, the fast-food king's "business has generally been below expectations and strategies enacted have failed to drive results." He calls McDonald's a "prove it" stock.
TOUGH TURNAROUND. Credit-rating outfit Moody's echoes that sentiment. While it ranks McDonald's debt Aa3, thanks to strong liquidity and cash flow, Moody's cut its outlook to negative on Sept. 30, saying "risk continues to increase due to intense competition. Challenged U.S. operations have led to margin erosion in recent years." McDonald's global restaurant operating margins have fallen from 16.9% in 2000 to a projected 14% for 2002, according to Ivankoe's analysis. (J.P. Morgan says it has received compensation for investment banking services from McDonald's in the past 12 months.)
To a large extent, McDonald's is facing the same challenge as mature giants in other industries: Once your business is ubiquitous, where do you go for growth? For McDonald's, with $14.9 billion in annual revenues and a 43% U.S. market share, that's a tough problem, especially since momentum is heading the wrong way.
"It's a very large ship to turn around," says S&P equity analyst Dennis Milton. And not only is McDonald's a mature company, with 30,000 stores worldwide, but its primary business is saturated: The market share that burger chains hold among all quick-service restaurants has fallen from 37.1% in 1997 to 35.3% in 2002, according to Chicago-based market researcher Technomic.
FLAT HEALTH PUSH. Britain's mad-cow disease scare could account for part of that slide, but other more worrisome factors are involved. The Oak Brook (Ill.) company is starting to cannibalize its own stores now that there are so many of them, say analysts and frustrated franchisees. Sales at stores open for at least 13 months declined in almost all geographic regions during the second quarter. Only McDonald's European operations managed to eke out a 2% rise in same-store revenues. By contrast, rival Wendy's same-store sales rose 5.4% in September.
Even determined efforts to change McDonald's high-fat image haven't helped much. Healthier menu items such as tossed salads enjoyed an encouraging debut in 2000, and a more flexible sandwich assembly line called "Made for You" made it easier to customize orders.
Even so, neither has had a lasting effect on sales. "For a while, McDonald's seemed to be going in the right direction. But in the last year or two, its U.S. business has deteriorated," says David Kolpak, managing director of Victory Capital Management, a subsidiary of Cleveland-based financial holding company KeyCorp.
NONSTOP OPENINGS. That has left new stores as the main lever for boosting revenues. Worldwide, the number of McDonald's outlets has more than doubled since 1994, a period that has seen revenues rise 79%. Now, analysts think the strategy has been overdone -- and that, with cannibalization a concern, the chain should start to concentrate on boosting sales at existing locations.
So far, McDonald's shows little sign of taking that advice. This year, it will open 1,300 to 1,400 new units, a number that J.P. Morgan's Ivankoe argues "should be reduced by at least 1,000 units, to a run rate of perhaps a few hundred in 2003." McDonald's hasn't said how many stores it plans to open next year. Ivankoe also wants to see fewer new stores in emerging markets so that the chain can better focus on the U.S. and Europe, which together provide 90% of its operating profits.
Strengthening the brand should be another priority, experts say. "As a brand, McDonald's has been one of the most incredible success stories in history," notes Simon Williams, president and chief executive of New York-based brand consultant Sterling Group. "But there are so many chinks in the armor now, nothing short of reinventing the brand will save it over the long term."
NO "SILVER BULLET." Williams, who doesn't own McDonald's shares, points to its inability to improve food quality and reduce customer complaints of poor service. At this point, increasing the marketing behind the brand should be the last step in the process, Victory Capital's Kolpak argues. "I don't think some new ad would be a silver bullet," he says. "They want to get stores cleaned up and service improved first."
Given the dynamics of its market, McDonald's also might be wise to start planning a future where burgers are a smaller part of its overall strategy. It has already acquired and invested in lesser-known chains such as Boston Market, Donatos Pizzeria, Aroma Café, Chipotle Mexican Grill, and Pret A Manger.
However, some analysts say those moves might see it stray too far from its home turf. "We feel these [other chains] are distractions to fixing problems in the core hamburger business," Kolpak says. Out of the $3.9 billion in worldwide revenues McDonald's posted in the second quarter, just $263.9 million came from nonburger businesses.
GLOWING SHARE. To its credit, McDonald's has cut food, labor, building, and real estate costs about as low as they can go, notes Alan Szydlowski, equities analyst at U.S. Trust in New York City, who doesn't own shares in the company. "I liken them to the Wal-Mart of fast food," he says. "They have the most pricing power and best efficiencies they can generate." And of course, it has that glowing U.S. burger-chain market share, which McDonald's has held onto for the past five years.
Yet Szydlowski isn't recommending the stock, either, until McDonald's same-store sales improve and it puts the kibosh on expansion. When it comes to this stock, analysts seem to agree that investors may want to look elsewhere for their financial health.
Tsao covers the markets for BusinessWeek Online in New York
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Copyright 2002, Bloomberg L.P.
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