Postcards: The Corporate Drama at McDonald’s (MCD)

The company's pushing a lot of chips across the table on value deals to maintain market share. The question now is whether that strategy will enhance its other goals for 2024 and 2025 ͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­͏   ­ Forwarded this email? [Subscribe here]() for more You are a free subscriber to Postcards from the Florida Republic. To upgrade to paid and receive the daily Republic Risk Letter, [subscribe here](. --------------------------------------------------------------- [Postcards: The Corporate Drama at McDonald’s (MCD)]( The company's pushing a lot of chips across the table on value deals to maintain market share. The question now is whether that strategy will enhance its other goals for 2024 and 2025 [Garrett {NAME}](floridarepublic) Jul 29 floridarepublic   [READ IN APP](   Market Update: As expected, our S&P 500 signal has moved back to neutral (Yellow) due to position adjustments made before the Fed meetings on Tuesday and Wednesday. We are looking for a positive drift ahead of the FOMC conference on Wednesday. From there, pay close attention to the market's direction at 2:35 p.m., and then look for structured selling from CTAs in the final hour of trading after the Powell speech. Volatility was ticking higher today as the market awaits a busy week of earnings reports and an update from the Federal Reserve on rate-cut expectations. Markets don’t expect a July rate cut but are projecting that the central bank could start cuts as soon as September. Recall my historical warning that Fed pivots on interest rates have led to sizable downturns in the market. Here’s a chart from Elliott Wave International explaining this phenomenon. Source: Elliott Wave International --------------------------------------------------------------- Dear Fellow Expat:  McDonald’s kicked off a busy earnings week on Monday.  Its numbers came in much worse than most hoped.  Second-quarter profits, revenue, and same-store sales all dropped amid a customer decline. It saw the first drop in same-store sales since Q4 2020.  Source: Bloomberg, McDonald’s earnings results McDonald’s has faced a pullback in the trend of broader restaurant spending among U.S. consumers. However, challenges are especially acute in fast-food businesses. Rising inflation pushed food menu prices higher.  Even though the “rate of inflation” across the U.S. has steadily declined, the prices of McDonald’s menu items have increased. Today, we’ll examine the company’s recent strategy to combat falling same-store sales and explore how discount pricing strategies like its new $5 Value Meal have produced mixed results.   More importantly, we’ll lay out the factors that make McDonald’s successful and what you can do to take advantage of any short-term share-price weakness due to its recent corporate drama.  [Upgrade to paid]( Pricing Pressure on Low-Income Consumers Today’s earnings report showed various challenges at McDonald’s.  It faces boycotts in the Middle East.  Sales in China remain sluggish… Profits in Europe also remain soft.  But at its core, U.S. sales comprise 40% of its total revenue. Our focus today centers on the major challenge McDonald’s seeks to overcome in the U.S.: The impact of higher prices on its customers. The Big Mac Index gauges the economic climate across different markets.  It uses the price of a Big Mac, consistent in make and quality everywhere, to reflect local costs like ingredients and labor.  The Big Mac has increased from a 1% annual inflation rate in 2021 to more than 8% in 2024. Meanwhile, the June 2024 Consumer Price Index is hovering near 3% annually.  Source: The Economist, St Louis Fed The 0.7% annual drop in same-store sales suggests Americans don’t view fast food as a reliable source of value. Yes, companies like Starbucks (SBUX), Wendy’s (WEN), and Burger King (OTC: RSTRF) have faced similar traffic declines.  But McDonald’s is the American icon.  Its struggles generate significant attention during earnings season. On Monday, CNN ran a somber headline: “[Americans keep turning their backs on McDonald’s.]( Harsh… CNN notes that McDonald’s has embraced Value Meals to combat the decline compared to last year. They aren’t alone. [Writes CNBC]( In the hopes of lifting their results for next quarter, chains such as McDonald’s, Taco Bell, Burger King, and Wendy’s have unveiled or revived meal deals with a $5 price tag. A price war is in full effect across the fast food industry.  It requires some caution. The new McDonald’s $5 value deal is part of a company-wide pricing strategy that has traditionally seen mixed results.  Another Price War on the Horizon? McDonald’s faces increasing external challenges from competitors like Wendy’s and Burger King for a declining customer base (or at least one on the sidelines this year).  The company turned to a $5 Meal Deal in late June, accelerating a price war among the nation’s fast food giants. The company plans to extend this value deal strategy beyond its initial four-week rollout period to attract new and existing customers. Of course, Wall Street knows that fast food giants aren’t the ones paying for this value experiment - especially McDonald’s.  At its core, McDonald’s is a real estate company providing franchisees strategic, financial, and operational guidance.  This $5 Meal Deal is subsidized by McDonald’s franchisees, who must cut their store prices, and by Coca-Cola, which generates an incredible business through the restaurants that sell fountain sodas.  Franchisees are already struggling with higher costs, trouble attracting workers, and new government mandates on wages and other benefits nationwide.  Consider this recent image from a McDonald’s in Timonium, Maryland. At a time when McDonald’s is pushing value, the franchisee is squeezed, pushing back on customers who want a free refill. Franchisees are looking to cut costs and maximize profitability in the face of rising labor and food costs.  Monday’s earnings report showed that customers are pushing against McDonald’s and impacting its profitability. After years of growth, profit margins have returned to pre-COVID levels, while revenue figures declined. During today’s earnings conference call, CEO Chris Kempczinski reminded investors about its 2023 warning about price sensitivity among customers. U.S. Labor Department data shows that fast food prices increased by 33% from March 2019 to March 2024, shortly before McDonald’s announced its $5 value initiative. As he noted, lower-income households resisted the price spike, a sign that they no longer saw value in the product. This resistance drove management to launch a new initiative to attract customers to McDonald’s and enhance its core business drivers.  During its March Investor Day, McDonald’s revisited its “Accelerating the Arches” initiative. It centers around value menu programs launched in June 2024 and other plans we’ll discuss.  Kempczinski said Monday that these value menus have “exceeded expectations.” Bloomberg writes that the value offerings pushed customers back into restaurants in May before the promotions began. This has helped the company maintain customer loyalty while preventing defections to other competitors.  From a strategic perspective, McDonald’s has used value menus to achieve three primary goals.  First, price warnings and value menus—like its famous Dollar Menu—have attracted cost-conscious customers, reinvigorated foot traffic, and boosted sales volume.  Second, such aggressive pricing strategies enable McDonald’s to maintain its market share in its industry, especially during economic downturns.  Third, this strategy aims to retain existing customers and attract new ones looking for affordable dining options. But everything comes at a price.  This strategy keeps customer prices low while food and labor costs constantly increase. This can weaken profit margins for the duration of the price war.  Next, these pricing strategies and expanded menus can impact operational efficiency at the national and franchise levels, which may affect the company’s service speed and quality (two hallmarks that have made its brand successful for decades). Finally, competitors always respond with aggressive pricing strategies and marketing, which can lead to an unsustainable promotional battle. In May, Burger King launched its “$5 Your Way Deal” and planned to run it for several months, compared to McDonald’s initial four-week program.  These impacts are why Wall Street remains highly skeptical of price wars, which tend to struggle in the long run. In addition to forcing franchisees and Coca-Cola to subsidize these value deals, McDonald’s has a lukewarm history in price competition. Consider the Examples This isn’t McDonald’s first “Value Rodeo” - in competition against Burger King and other rivals.  McDonald’s 2002 launch of “The Dollar Menu” initially attracted cost-conscious customers and boosted sales volume. It also helped the company maintain market share in the wake of the Dot-Com Financial Crisis and Great Financial Crisis.  However, rising food and labor costs made sustaining the Dollar Menu's profitability difficult. Historically, McDonald’s hasn’t liked raising prices. Decades ago, CEO Ray Kroc, who built the modern-day McDonald’s business model, was reluctant to increase the original hamburger price from 15 cents. After years, many in the company wanted to increase prices to 20 cents per hamburger. However, Kroc was adamant that the first price increase would be no higher than 18 cents. In periods of rising inflation, McDonald's has had to adjust its offerings and prices periodically, sometimes leading to customer dissatisfaction. In addition, as Whitney Tilson recently noted, this Dollar Menu launch in the early 2000s accompanied broader financial challenges at the company, contributing to a 75% decline in MCD stock from its 1999 price peak to a bottom in mid-2003.  In 2015, McDonald's introduced its All-Day breakfast, attracting a broader customer base and increasing sales during non-traditional breakfast hours. Yet competitors quickly responded with their own breakfast promotions, leading to a crowded market. While the company did see its stock improve in the year ahead, one must acknowledge the operational challenges of maintaining quality and speed of service with an expanded menu. In recent years, McDonald's increased its chicken sandwich offerings, boosting customer sentiment in a hyper-competitive, heated market segment. This strategy has driven significant sales growth in the chicken category.  That said, intense competition has forced continuous innovation, and marketing spending can erode profit margins and strain the supply chain during periods of high demand. These pricing strategies require a delicate balance to ensure these promotions accomplish a specific goal.  The goal is to bind the customer to the brand, ensuring repeat business and making the customer believe that the $5 value menu is worth far more money during future visits when prices return to normal. What Makes McDonald’s Work? McDonald’s future success will not be due to price wars with Wendy’s, Burger King, or Jack in the Box. Even Wall Street acknowledges this, noting  McDonald’s success is entirely based on the core values and optimization strategies that have accelerated its growth since the late 1950s.  At its core, McDonald’s thrives because…  - Its globally recognized brand ensures loyalty and trust through consistent quality and experience.  - Its innovative menu introduces new products to meet changing consumer tastes and preferences. (You know they’ll develop new products that customers want to eat.) - Its robust and efficient supply chain guarantees consistent quality and availability of ingredients worldwide. (You know what you’ll get at any franchise on the planet). - It owns strategically located, prime real estate that is accessible and visible, which promotes and maintains foot traffic. - Its franchise system allows for rapid expansion and local market adaptation. - Its marketing campaigns build brand awareness and attract diverse customer segments. - Its streamlined operations and cost management maximize profitability and ensure quick service. - It promotes a consistent and pleasant dining experience across all locations, which enhances customer satisfaction, loyalty, and interaction with the brand. Discounts aim to draw new customers and bind them to the McDonald’s brand.  However, these actions must be sustainable and directly related to the drivers that have made McDonald’s successful. That’s where this Value Meal gamble aims to pay off.  Looking at the Arches McDonald’s hopes that the temporary bump in traffic from the value strategy will bring forward exposure to the three primary initiatives behind the “Accelerating the Arches” strategy.  This program will focus on three main areas: marketing their most popular items, such as Big Macs and McNuggets, introducing new technology to make ordering faster and more convenient, and expanding delivery and drive-thru services to serve customers better.  By improving these areas, McDonald's aims to attract more customers and offer better service. Boosting the brand, committing to successful core products, and technological innovation are at the core of the company’s operations - historically and in the future. The program's goals are straightforward. It aims to boost its value drivers through the framework listed above.  The company aims to expand its restaurant units at a 2.5% pace from the 2% it set in December 2023. This would enhance its strengths in its franchise model and real estate portfolio.  It aims to boost its operating margins into the mid-to-high 40% range, which would result from product innovation, supply chain efficiencies, and other enhancements in the drivers that make it thrive.  The company aims to increase its new restaurant unit growth to 5%, from the 4% figure in December. It targets 50,000 global units by 2027, with a new gross rate of 1,000 new restaurants in the U.S.  It will increase its capital expenditures by about $300 million to $500 million annually through 2027 to achieve this goal.  Based on how these expectations and growth pillars align with the company's history and success drivers, investors should feel confident about this stock's long-term potential. This is one reason the stock shrugged off its bad news from Q2 and jumped 4.2% this afternoon. When to Buy McDonald’s  Today, the CEO said it would reconsider its pricing strategy after Q2 news.  But is that the best strategy to enhance McDonald’s? In an upcoming podcast, Porter Stansberry suggested that McDonald’s should put its vast cash flow to work and purchase a tiny rival that would benefit from the company’s extensive franchisee network.  In addition to radically increasing its potential rent base as it would push for a 1,000% increase in its rivals’ restaurant units globally, such a deal would restore McDonald’s reputation as a “growth engine.”  Such a categorization would signal to the market that MCD is focused on long-term growth instead of just attempting to optimize supply chains and maximize profits in this post-COVID environment.  McDonald’s is a fantastic company. It is a great brand that has found real success by returning to its roots.  It has experienced bumps in the road throughout the decades, only for smart management and innovation to overcome these short-term challenges.  Its ability to realign its operations and strategy to its core will make it a successful long-term investment. Porter Stansberry and Whitney Tilson provided these insights in the inaugural episode of their new podcast.  We are finalizing this edition and will release it on Friday. I remind you that when investing… you’re not buying a ticker… You’re buying a business.  Understanding the core drivers of what makes this a successful investment is critical when putting your money to work.  It doesn’t matter if you eat at McDonald’s or use it a rest stop on long drives. What matters is understanding why customers are returning and what has produced so much cash flow over seven decades.  Moving forward, I’ll continue highlighting these drivers across the many companies we cover at Republic Research.  And I highly recommend Porter and Whitney’s deep dive into McDonald’s, an iconic brand that aims to enhance shareholder value for the decades ahead. Stay tuned… and… Stay positive, Garrett {NAME} Secretary of Podcasts Disclaimer Nothing in this email should be considered personalized financial advice. While we may answer your general customer questions, we are not licensed under securities laws to guide your investment situation. Do not consider any communication between you and Florida Republic employees as financial advice. Under company rules, editors and writers cannot recommend their positions. The communication in this letter is for information and educational purposes unless otherwise strictly worded as a recommendation. 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