What McDonald’s, Anheuser-Busch, and PepsiCo Investors Need to Know This Week

We cover all-day breakfast, massive M&A deals, and standout earnings on this episode of Industry Focus.

Vincent Shen
Vincent Shen and Sean O'Reilly
Oct 7, 2015 at 5:49PM
Consumer Goods

McDonald's (NYSE:MCD)launched all-day breakfast at its over 14,000 locations across the U.S. this week as management scrambles to stem quarter after quarter of declining sales. Meanwhile, in the alcohol industry, Anheuser-Busch InBev(NYSE:BUD) hopes to spur growth by creating a world beverage behemoth, but the No. 2 brewer needs more convincing.

And to top things off, Pepsi(NASDAQ:PEP) impressed Wall Street with its latest earnings report, despite major currency headwinds and a $1.4 billion writedown.

A full transcript follows the video.


Sean O'Reilly: We're going to get an Egg McMuffin at 4:00 p.m. on a Tuesday, on this consumer goods edition of Industry Focus.

Greetings, Fools! I am Sean O'Reilly here from Fool headquarters in Alexandria, Virginia. It is Tuesday, Oct. 6, 2015, and with me today is the devilishly handsome Vincent Shen. Vince, have you gotten any pumpkin spice lattes yet this year?

Vincent Shen: No, I have not.

O'Reilly: It's October, man. What are you doing?

Shen: It's not my thing.

O'Reilly: No? All right. I'll get you one later and sell you on it. We've got a lot of ground to cover, including some talks being held between SABMiller (NASDAQOTH:SBMRF) and AB InBev about creating a gargantuan beer company, Pepsi's latest earnings, but first, I wanted to take a look at McDonald's, and why you might not have to run into one at 9:59 a.m. hoping they're still serving breakfast. On a scale of one to 10, how happy are you, Vince?

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Shen: I honestly have never been that big of a fan of McDonald's breakfast. It's not something I seek out regularly, but apparently, according to what management has heard from a lot of its customers, this is a big move for them.

O'Reilly: They're not the first fast food chain to -- breakfast seems to be the moneymaker because, I'm sure you remember, last year, Taco Bell started doing the breakfast push, because they saw all the money McDonald's was making doing it.

Shen: Absolutely. I'll get to that in a bit, but today was the official rollout across the country for U.S. McDonald's locations where you can order some breakfast items during non-breakfast hours.

O'Reilly: Have they got my pancakes?

Shen: I'm actually not sure about the pancakes. Some of their real staples, like the Egg McMuffin, for example, are definitely available.

O'Reilly: Their customers, from what I understand, are rejoicing here. Did they do a bunch of market research? As I understand it, they tested it out in Tennessee. What was the customer reaction?

Shen: As you mentioned, testing began earlier this year, in March or April, in Nashville and markets like San Diego, as well. Obviously, it must have gone pretty well for them. Management had heard that one of the most regular requests that it had seen from customers, and feedback they received, was that they wanted to be able to get breakfast all day.

I think the reason why it's taken them so long -- the company has been around for some time...

O'Reilly: I joked about running in there at 9:59 to see if they're still serving breakfast, but that's been going on as long as I can remember.

Shen: Exactly. I think the reason why it took them so long to roll this out was not just because they were against the idea, but there was a lot of operational and logistical challenges to this.

O'Reilly: That was my next question. I don't want to say it's going to be a hassle, but they have their inventory management down to a science. They need X number of patties per day, they need X number of "other" in the store. This is going to throw a wrench in that. In addition to that, you need to figure how many people are going to buy an Egg McMuffin at 3:00 P.M. on a Tuesday.

Shen: I think what makes it even harder is, previously, a lot of people were talking about why McDonald's has been struggling. Of course, there are the general trends toward healthier foods -- people want higher quality food -- but I think a lot of people -- at least for diners who would go to McDonald's in the first place -- they were complaining about longer wait times, poor service quality, and a lot of that was potentially attributed to an overly complicated menu.

You have a lot of items that you need to be prepared to make, it slows down kitchen staff, it gunks up the whole network.

O'Reilly: That was the first thing that 3G Capital did when they took over -- that was 3G that bought Burger King, right? Private equity guys. The first thing when they went in there, they hired a young guy who was around 32. I have tons of respect for this guy, but his name escapes me. I apologize, gentleman, if you're listening. The CEO that was put in charge to run Burger King after this private equity group bought it, he worked in a restaurant, and cleaned the bathrooms and everything to get a feel for it.

The first thing he did after that was simplify the menu drastically.

Shen: McDonald's is running into the same issue, and now, I think they've made some moves to help simplify the menu; but I think a lot of franchisees were frustrated that they were rolling out the initiative with all-day breakfast, and we're running into that problem again. Employees need to be trained, they need to get all the kitchen equipment ready to throw some burgers and grill sausage patties.

That was one of the hiccups that prevented this from coming out sooner.

O'Reilly: It almost seems like they needed to do this because the reason people go to McDonald's has shifted. Fifty years ago, if you wanted a burger, you'd throw the whole family in the station wagon and go to McDonald's. Now we go to Shake Shack, or Chipotle, or something. McDonald's' breakfast seems to still be hip, and they needed to give people a reason to go.

Shen: Yeah. Obviously, the company has seen revenues slide, especially in the U.S. Their same-store sales have declined for seven straight quarters, it's down 2% in the most recent quarter. Overall, revenue was down 9.5% year-over-year, most recently to about $6.5 billion. They have this rolled out to over 14,000 locations in the U.S.

Keep in mind how large of an operation this was. This was also approved through a vote by a bulk of their franchisees. So it's not like they're just instituting this top down. Overall, in addition to pleasing the people who love McDonald's' breakfast so much, there is a rationale behind this, where NPD Group did some studies showing that the year ended June 2015, for the three major meals, breakfast is seeing by far the most robust growth.

Five percent growth for breakfast versus 1% for lunch, and I think it's flat for dinner.

O'Reilly: People are on the go.

Shen: You mentioned some of the competitors doing this, like Taco Bell, and I think that's a reason why we're seeing breakfast options form a lot of these competitors. Part of that study NPD did, interestingly enough, it's the grab-and-go, quick breakfast sandwiches like that. They're making up the bulk of that growth, so it's very beneficial for these restaurants.

O'Reilly: Before we move on to McDonald's' share prices, what was this about them experimenting with premium burgers?

Shen: Management is aware that they need to do something to improve the situation at the company. They've been testing a ton of different initiatives. I've heard a few things they've experimented with. They did the really fancy restaurant in Japan where it was a very fine dining type of experience. They're launching their premium buttermilk chicken sandwiches; they also had a bunch of bargain meal deals for the summer.

Taste-crafted premium burgers, where you could order at the kiosk and it's supposed to be a little more expensive -- higher quality -- to try and match that better-quality food that people are looking for from some fast casuals, for example. They're not sitting on their hands hoping things will improve; they're testing a lot of new concepts just like they did with all-day breakfast.

O'Reilly: For Foolish investors that are curious, how has McDonald's' share price been doing? Why should I own it? Should I not own it? What do you think?

Shen: This is something I thought was interesting, because considering how many people were ready to write the obituary on McDonald's, saying fast food at its level was not going to be able to compete against the fast casuals that are offering organic, natural foods, the fact of the matter is they have a reputation for being very stable with very solid dividend payments, too.

You've got to keep in mind that the company year-to-date is up 9% versus about a 3% decline for the S&P 500. It's beating the market...

O'Reilly: It is not dying by any stretch.

Shen: Yeah. It's actually pushing up against its 52-week high -- a little over $100.

O'Reilly: It keeps giving $100 a high five, as I recall.

Shen: When you keep that in mind, plus the fact that it's yielding 3.4%, and McDonald's is ultimately a cash cow.

O'Reilly: Which is what a 30-year treasury yields right now.

Shen: It's ultimately a cash cow. They generate billions of dollars every year in free cash flow, they've been using it to invest in these new initiatives to keep their payout going, to keep the business in good shape. I think it's a little too soon. They have a lot of leverw that they can pull to get things going.

O'Reilly: You could do worse.

Shen: Yeah, absolutely.

O'Reilly: Before we move on to discussing the potential merger between SAB Miller and AB InBev, I wanted to point our listeners to a newly redesigned focus.fool.com. There you'll discover a special offer to join The Motley Fool's Stock Advisor newsletter for all Industry Focus listeners. All loyal IF listeners have access to a special discount on Stock Advisor that works out to $129 for a full two-year subscription. Just go to focus.fool.com to take advantage of this offer. Once again, that's focus.fool.com

Moving on, essentially the two largest beer brewers on planet earth were flirting with the idea of merging -- much to the chagrin of antitrust regulators, I assume. They got turned down; but now they're talking again?

Shen: Bloomberg reported recently, the news broke about two weeks ago, where Anheuser-Busch had approached SAB Miller informally. The offer came out around $100 billion.

O'Reilly: Chump change.

Shen: Ultimately, more rumors. Bloomberg reported today that SAB Miller turned down that deal, and I think they're going back to the negotiating table at this point, based on some of their ...

O'Reilly: Do you recall if it was stock for stock? Was there a chunk of cash in there?

Shen: I think that's part of why some investors on the AB InBev side are a bit apprehensive about the deal, because their balance sheet is already stretched quite a bit. I have to imagine it was going to be stock. SAB Miller went back and said the offer was too low, and they weren't happy with it. I think they're pushing for something around 10% to 15% higher.

O'Reilly: I'm trying to recall the portfolios. As I recall, SAB Miller has got a pretty rocking portfolio.

Shen: Yeah, of course. They're huge brands. Since the deal was announced about two weeks ago, those rumors drove the stock price up for SAB Miller about 25%. AB InBev's offer wasn't low. It was a 30% plus premium to the pre-announcement prices, essentially. Interestingly enough, the next steps include going back to the table, and SAB Miller reported ahead of schedule some details from its second quarter results.

They were able to log a currency-adjusted revenue growth of 6%, volume growth of 2%, so they're definitely seeing some pretty strong numbers. You can imagine that was released to influence the negotiations in their favor, at least a little bit. Very importantly, SAB Miller saw strong sales growth in Africa and Latin America, which a lot of analysts believe it's those two markets that are of particular interest to AB InBev.

Again, trying to butter themselves up to look appealing to win that additional premium that they want for their shares. Overall, I think they have until mid-October for AB InBev to make a formal offer, but considering the size of the deal, they might try to push for an extension. How are the brands looking?

O'Reilly: They've got Blue Moon, a bunch of beers I've never seen; they've got beers in Honduras, Atlas beer in South America.

Shen: It's that international portfolio, in particular, that I think is most attractive.

O'Reilly: Newcastle over in the U.K., Coors here, Miller here; they've got 50 to 100 brands. Fosters, of course. Doesn't Dylan love Fosters? What can investors expect? Is this just something that won't happen?

Shen: The stock is down about 3% on the news for SAB Miller, now that they've rejected the offer. It's going to be a roller coaster.

O'Reilly: The advantage of this seems to be the national cost-cutting advantage and cost savings that would occur if you merged these two companies.

Shen: There's been numbers thrown around anywhere from $1 billion to $2 billion, considering the size of these companies and their leading positions. Admittedly, I think anyone who is trying to play this M&A deal really needs to consider the fact that this will have a ton of regulatory scrutiny.

O'Reilly: Yeah. They're No. 1 and No. 2.

Shen: That alone is going to give a lot of people pause, but it's still enough to get SAB Miller stock a 25% bump in the past two weeks.

O'Reilly: Right. Moving on to our last story here, I'm excited to talk about Pepsi. I grew up as a Coke man, but I won't hold that against Pepsi, because they own Frito Lay. Pretty good earnings, although the currency results was the thing that jumped out at me. We'll get to the results in a minute, but adjusted earnings per share beat analyst estimates, but unadjusted took a 15% hit because of the stronger dollar. So currency they earn overseas is worth less. That's one-sixth of your income.

Shen: At least for the one-time charges, they also had that huge hit from the Venezuela operations, as well.

O'Reilly: Yeah. What was the deal there?

Shen: Basically, they had to take a $1.4 billion writedown. It amounted to about a $0.92 per-share hit on their earnings. It basically had to do with some government action in Venezuela, and the company is saying that, going forward, they're not going to be reporting Venezuela operations as part of their main financial results.

O'Reilly: "It's not going well, so we're not going to talk about it."

Shen: Unless it's cash receipts. It has to do with the inflation there, and some of the actions the government is taking to prop up the economic situation. That was a huge, one-time charge for them, but adjusting for that, they saw a lot of positive results, especially from what has generally been their slower growth region, which is their home market in North America.

O'Reilly: As I understand it, drink volume was up 3% in North America, but the real winner here was actually pricing. They just jacked up prices on us.

Shen: I think, overall, they were able to win 6% price increases.

O'Reilly: Across the board, yeah.

Shen: For their North American snack segment, volume was up only half a percent; higher pricing boosted revenue, though, for the actual segment, 2%. You saw something similar with the drink segment in North America. A volume of 3%, but the higher pricing boosted it 5% for revenue. There's also the shift that we're not surprised to see any more in terms of the mix for beverages. Most of that strength came from non-Pepsi, non-carbonated drinks like Gatorade.

O'Reilly: Diet sodas got bombed. That was down about 6%.

Shen: Home market saw a 10% rise in non-carbonated drinks; soda declined 5%. As part of soda, full-calorie options were down 1%, and diet sodas came down at 6.5%. I think management attributed that to concerns over some of the artificial sweeteners they use, like aspartame. I believe they switched their Diet Pepsi over to use sucralose instead.

O'Reilly: That sounds attractive.

Shen: Hoping that an alternative will get people back on that, but the diet soda decline has been something that has been trending for some time now.

O'Reilly: I'm sure you've noticed when you're walking through the grocery store, and both Pepsi and Coke are starting to push the natural sugars, and they'll have Coke Lite, and they have the green bottle, and it's using natural sugar -- and Pepsi did a throwback. They had the original formula with regular sugars, and it looks like the old packaging and their old cans. I wonder what their results would have been had they not been trying to spice things up with real sugar and throwbacks and all that.

Shen: I guess it depends on what your view is of people who care about something like that. Just because you changed over to natural or cane sugar, is that going to be enough to get them to drink soda, anyway?

O'Reilly: I have not said, "Oh, it has real sugar now; I'll drink it."

Shen: I don't know. I prefer those. I have a soda on occasion, and I will look for those versions like the Coca-Cola that uses real sugar.

O'Reilly: The bottles from ...?

Shen: Yeah, the glass bottles especially. I think that shift, overall, is going to hurt them regardless of whether they release some of these limited products or not. There's a reason why they're seeing these trends with their other drinks, like Gatorade, their waters, their teas, that are all doing so much better.

O'Reilly: Right. Before we sign off, what do you think about the reaction to Pepsi's results? The stock is up 1.8% or 1.9% right now.

Shen: I think it was up about 2% before we came down for the show. I think that the strong growth that we're seeing in North America is very beneficial.

O'Reilly: That pricing.

Shen: Also, the fact that they were able to up their earnings guidance for the full-year to 9% growth.

O'Reilly: "And if we aren't on track to hit it, we'll just jack up prices more."

Shen: Considering how important their home market still is, I think that's given them the ability to outweigh some of the really big currency hits that they've experienced.

O'Reilly: One would imagine, over the long-term, that would get smoothed out and the dollar will come back a little bit.

Shen: You're looking at this long-term, and you can appreciate that their core business, their organic revenue, was up 7.4%.

O'Reilly: That's a win.

Shen: That's definitely a win.

O'Reilly: Okay. Thank you for your thoughts, Vince.

Shen: Thanks, Sean.

O'Reilly: Have a good one.

If you are a loyal listener and have questions or comments, we would love to hear from you. Just email us at IndustryFocus@Fool.com. Again, that's IndustryFocus@Fool.com. As always, people on this program may have interests in the stocks that they talk about, and the Motley Fool may have formal recommendations for or against those stocks. So don't buy or sell anything based solely on what you hear on this program. For Vincent Shen, I'm Sean O'Reilly. Thanks for listening, and Fool on!