Rule Maker Portfolio McDonald's: Hot, Fresh, and Later
Failures Beget Opportunity

The last few years could not have been much worse for McDonald's. All sorts of health problems; the resurgence of anti-commercialism activists with tendencies to celebrate by torching a McD's; and a costly service system that has angered franchisees, waylaid customers, and otherwise failed to produce much in the way of results. But McDonald's is a powerhouse and should be treated as such.

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By Bill Mann (TMF Otter)
May 1, 2002

Last week I detailed an investment theorem on WorldCom (Nasdaq: WCOM), or a non-investment theorem, as it were. Lo and behold, one of the issues that was facing WorldCom has taken care of itself: Yesterday, Bernie Ebbers resigned as chief executive and board chairman for the company, paving the way for new leadership in the person of data communications pioneer John Sidgmore.

Still, the situation facing WorldCom is simply too ugly for us to get too excited by the defenestration of Mr. Ebbers. We want top-shelf companies that are currently out of favor, not ones that are currently on life support. And so we'll take a look at another obvious Rule Maker that has of late been beset by problems and determine if it fits our criteria better.

So let us go to the land of the Hamburglar. The Golden Arches. McDonald's (NYSE: MCD). McDonald's offers everything we would want in a Rule Maker: an unparalleled brand, excellent historical growth, competitive advantages, and a legacy of doing one thing excellently -- delivering meals to customers quickly and inexpensively. This is also a company that has failed to meet its earnings goals for two consecutive years and has a management team that seems to be making it up as it goes along. The stock has responded by dropping more than 45% over the last year.

Perfect.

Yes, I said "perfect." We see people abandoning McDonald's as an investment, disgusted at the company's recent performance. And yet, McDonald's, a top-line company that is presently in disfavor, is exactly the type of opportunity we are looking for as Rule Maker investors.We don't want to invest in a company that is permanently impaired. Thus, the question becomes: Can McDonald's right itself? What are the chances it will?

I'd say those chances are pretty good, eventually. In fact, I'd say that McDonald's intrinsic advantages mean that things cannot get too much worse unless the management shows signs of being not just incompetent, but belligerently so. It has in fact shown some signs of this. What is perfectly clear is that some at McDonald's do not like the lack of prestige they get for, well, being McDonald's. They seem to be trying to make McDonald's everything for everybody, when what people seem to want is for McDonald's to be McDonald's for everybody, and not try to be other things. We take our kids there, and they love it. On long trips, McDonald's becomes the rest stop of default. These are not bad things.

Maybe we should call it "McMurphy's"?
McDonald's has been in the doldrums. Its "Made for You" program of preparing food to order has been an expensive disaster. Its franchise system, which covers 80% of its 13,000 U.S.-based outlets, has never been weaker, and its franchisees have been angered by changes mandated by McDonald's world headquarters. Every time there is some globalist protest, some McDonald's somewhere gets molested. We had Mad Cow disease in Europe, foot-and-mouth in the U.K., foot-in-mouth disease at world headquarters, and a system that tried to change the essence of McDonald's -- all at a huge cost to franchisees, with minimal return on investment.

That's where we are. And yet, in what may be the summer of McDonald's discontent, the company still managed to generate $782 million in free cash flow in 2001, up from $381 million in 2000, but down from $1.14 billion in 1999. For a $36 billion company that is supposed to be collapsing, those are fairly solid numbers. Not great, mind you, but in no way is McDonald's destroying itself.

Its competitive advantage, though strong, is not insurmountable. We need look no further than Howard Johnson's -- not the hotels, the restaurants -- which back in the 1950s seemed to have an insurmountable advantage in the quick-serve restaurant business for travelers. It vaporized by not changing, and more innovative shops like McDonald's came along and destroyed HoJo's, which failed to keep up with the times.

Ronald's nowhere to be found
McDonald's felt it was getting fed this exact same medicine in the 1990s. Surveys rated its food quality consistently low, and it was considered to be a low-brow kids restaurant. American palates have grown more sophisticated -- we've gone from thinking chow mein was pretty freaky to wondering whether the chef has gotten a fresh batch of uni. In such an environment, where consumers can get such offerings for only a few dollars more, Chicken McNuggets simply do not have the same draw. McDonald's tried to keep up with tastes by adding new menu items, including that embarrassment to meat everywhere, the McRib. And finally, CEO Jack Greenberg opted for the "Made for You" preparation system in order to improve food quality, and suddenly wait times have nearly doubled. Most glaringly, the marketing genius that was McDonald's seems to have vanished. All those kids characters -- Ronald, Grimace, Mayor McCheese, and so on -- have been banished, evidently because management felt they cheapened the brand. Even the old catchy jingles are seemingly passe.

Sounds pretty grim, right? That's why people have abandoned this stock. And THAT is exactly why we should look at it closely.

None of the items that I have listed above particularly scares me. Although the "Made for You" program has been a disappointment, I'm glad that McDonald's brass took a chance on it, because it means they understood that they could not assume that things would just stay the same. It has failed, and it has made some franchisees mad. But the company was trying to address what it saw as a weakness: poorly rated food. Turns out, people would rather take things from McDonald's that are hot, fast, and average than hot, better tasting, but slow as molasses. McDonald's has given up its biggest advantage in exchange for some pretty marginal returns. This can be fixed, but it will require that management and franchisees remember the fact that McDonald's was built on unfailingly good service.

In fact, the thing that bothers me more than anything else about McDonald's is its share buyback program. Not that I don't appreciate that they've retired 8% of the share float in the last three years, but, for one thing, their debt has been growing steadily in the meantime. Not good. They've also been getting more giddy with the employee stock options, having handed out 3% of the company's total float last year, up from just 1.9% in 1999. That's not huge potential dilution, but it is nonetheless a pretty heavy hit on the pipe.

But McDonald's is a powerful brand, a restaurant chain with 30,000 outlets in 121 countries. While U.S. growth is about tapped out for McDonald's, the company still has plenty of growth potential overseas. And, domestically, McDonald's is taking a page out of the PepsiCo (NYSE: PEP) playbook by expanding its reach to other concepts, including Chipotle, Boston Market, and Donato's. These chains have a significantly greater potential for growth in the U.S. than does the central McDonald's stores.

And finally, recognize this. The present CEO of McDonald's has been there for little more than four years. Jack Greenberg's reign came at a time in which McDonald's was already under pressure in the U.S. His solution may not have worked, but, at the same time, he tried something entirely new for the company, and there is certainly the possibility that something good will come from it. He's got about another year to set things right, or the problems facing McDonald's will be placed squarely on his shoulders. So, while failure is not something that capitalism rewards very well, it should be noted that McDonald's leadership is still willing to mix things up for the betterment of the company. Greenberg deserves another bite at the apple, and shareholders need to be patient. After all, the market has priced his company as if he has already failed. This is McDonald's, one of the most dazzling growth stories of the 20th century. It may never be a growth stock again, but it's a much better bet that there will never be another McDonald's again.

Our biggest asset is patience. This may be a situation for the Rule Maker to consider further.

One final note: But for a most unfortunate editorial schedule, I might have been able to sell Yahoo! (Nasdaq: YHOO) at $18 -- where it stood prior to its earnings. Instead, my sell announcement and its earnings report came out on the same day, and we ended up selling all 106 shares of Yahoo! on April 17, at $15.81. We now have an additional $1,600 in our cash account.

Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards

Bill Mann's little girl owns about 350 Happy Meals' worth of McDonald's stock. To see Bill's stock holdings, please refer to his profile. The Motley Fool has a yummy disclosure policy.


 

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  Ticker Company Price
 Change
 Daily Price
 % Change
 Price 
  MSFT MICROSOFT CORPORATION 0.49 0.94% 52.75 
  NOK NOKIA 0.09 0.55% 16.35 
  AXP AMERICAN EXPRESS COMPANY 0.73 1.78% 41.74 
  SGP SCHERING-PLOUGH CORPORATION 0.52 1.90% 27.65 
  INTC INTEL CORPORATION 0.02 0.07% 28.63 
  PFE PFIZER INC 1.11 3.05% 37.46 
  CSCO CISCO SYSTEMS, INC. (0.95) (6.48%) 13.70 
  TROW PRICE T ROWE GROUP INC 0.20 0.57% 35.27 
  KO THE COCA-COLA COMPANY 2.11 3.80% 57.62 
  JNJ JOHNSON & JOHNSON 0.09 0.14% 63.95 
      
  Trade Date # Shares Ticker Cost/Share Price  Total % Ret  
 02/03/98 59 MSFT 49.35 52.75  7.77%
 02/15/00 132 NOK 40.21 16.35  -59.34%
 05/26/98 95 AXP 35.38 41.74  18.27%
 08/21/98 44 SGP 47.99 27.65  -42.17%
 02/13/98 147 INTC 27.44 28.63  4.97%
 02/03/98 66 PFE 27.43 37.46  37.15%
 06/23/98 182 CSCO 24.72 13.70  -44.37%
 02/03/98 75 TROW 34.12 35.27  3.69%
 02/27/98 27 KO 69.11 57.62  -16.27%
 04/03/01 10 JNJ 43.65 63.95  46.51%
      
  Trade Date # Shares Ticker Total Cost Current Value  Total Gain  
 02/03/98 59 MSFT 2,911.79 3,112.25  200.46 
 02/15/00 132 NOK 5,307.79 2,158.20  -3,149.59 
 05/26/98 95 AXP 3,360.87 3,965.30  604.43 
 08/21/98 44 SGP 2,111.70 1,216.60  -895.10 
 02/13/98 147 INTC 4,033.23 4,208.61  175.38 
 02/03/98 66 PFE 1,810.57 2,472.36  661.79 
 06/23/98 182 CSCO 4,498.76 2,493.40  -2,005.36 
 02/03/98 75 TROW 2,559.06 2,645.25  86.19 
 02/27/98 27 KO 1,865.89 1,555.74  -310.15 
 04/03/01 10 JNJ 436.50 639.50  203.00 
Cash:3,240.98 
Total:27,708.19 


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Notes
The Rule Maker Portfolio began with $20,000 on February 2, 1998, and it added $2,000 in August 1998 and February 1999. Beginning in July 1999, $500 in cash (which is soon invested in stocks) is added every month.