Judging from the reaction of McDonald's Corporation's (NYSE:MCD) stock to third-quarter 2015 earnings released in late October, investors have already decided that a turnaround of the quick-service giant's fortunes is in motion. While the company posted positive global and U.S. comparable-store sales during Q3 2015, further stock gains may depend on management's successful execution on a number of fronts.
Below, let's drill down on four important quotes from the company's conference call with analysts on October 22nd. These quotes distill management's approach to reinvigorating McDonald's revenue and profits. They're also a pretty decent window into the strategic themes driving the company's shorter-term business tactics.
Increasing complexity in the right places is part of the game
Our goal is net simplification.
-- CEO Steve Easterbrook
Investors have had some difficulty over the past year understanding how seemingly conflicting corporate objectives could be reconciled. For example, shareholders were initially confused by McDonald's trimming of its once-sprawling menu over the past few quarters in the name of reducing complexity. Just as items like the "bacon habanero ranch Quarter Pounder" disappeared, the company tested and subsequently tacked on the operational difficulties of serving breakfast outside of the morning daypart.
Concerns were allayed when McDonald's ended up offering a limited version of its breakfast menu under the banner of all-day breakfast. The now nationwide initiative has increased food preparation difficulty, but to use a term Easterbrook prefers, the result is "net simplicity," as items that management characterizes as "more complex, lower sales" have been pruned in favor of faster-moving, more profitable breakfast items.
During the earnings call, Easterbrook indicated that executives now have a process by which to weigh increases in operational complexity against "the expected impact on the customer and the business." We can read this to mean that McDonald's is aware of the potential to quickly gum up its service times by ill-advised permanent and "limited time" offerings, and will guard against its inherent tendency to bloat its own menu.
We're really focused on one part of our three-legged stool
With more than 80% of our global restaurants franchised, the largest driver of operating income continues to be our franchised margins...
-- CFO Kevin Ozan
McDonald's founder Ray Kroc famously devised the metaphor of a three-legged stool to describe the three stakeholder groups responsible for the burger chain's growth: the company's franchisees, its suppliers, and its employees. Over the years, business conditions have determined which leg management has focused on most closely during any given period.
At the moment, the executive team is honed in on making sure that profits and cash flow from franchisee operations take on an upward trajectory. As CFO Kevin Ozan points out above, the bulk of McDonald's operating income flows from franchised margins.
Just what are franchised margins? These are the royalties and fees McDonald's collects from its franchisees, reduced by the real estate costs the company incurs as a landlord to most of its franchise partners. In Q3 2015, McDonald's achieved a margin of 82.2% for every revenue dollar from franchisees.
In fact, during the third quarter, franchised margins of $1.92 billion contributed 74% of total systemwide margins (i.e., income before general and administrative expenses). Even small improvements in franchisee margins can thus impact McDonald's total cash flow and bottom line. Significantly, it's in everyone's interest for the franchisees to start enjoying consistently rising financial returns again. For McDonald's to continue to grow over the long term, individual operators must have the confidence to keep reinvesting profits in new technology and menu initiatives.
Expect wage expense to continue to climb
The incremental labor costs in the U.S. related primarily to our decision to invest in our people by raising wages and providing paid time off for employees at our company operated restaurants, as well as providing educational assistance to all eligible U.S. restaurant employees effective July 1.
-- CFO Kevin Ozan
Steve Easterbrook hasn't made his admiration for fast-casual chain Chipotle Mexican Grill (NYSE:CMG) much of a secret. While some of McDonald's wage inflation in 2016 will inevitably be driven by minimum-wage initiatives under way in many metropolitan areas, McDonald's C-suite seems to be earnestly copying one of Chipotle's basic business premises. That is, to differentiate your product in the restaurant industry, attracting and retaining superior talent is essential.
This may seem antithetical to McDonald's low-cost, quick-service business model, but providing higher wages and additional benefits may actually improve the company's net income over the long haul -- we'll return to this point in the quote below.
Getting back to operational basics is as important as our brand message
While Easterbrook took over global operations with a reputation as a savvy brand marketer from his time leading McDonald's U.K. business, he's expending much energy on making the average McDonald's restaurant more efficient, not unlike his predecessor, Donald Thompson.
For the last couple of years, it's been hard to escape the conclusion that McDonald's has lost market share to fast-casual restaurants, such as its onetime investee Chipotle. Yet McDonald's executives believe that core customers will be happy to return if the company shows operational improvement on just a few fronts. In other words, the solution to the chain's woes isn't necessarily a more effective marketing message, or a hollow aping of newer chains' menus.
In the box-quote to the left, Easterbrook defines an essential task the company's customer feedback systems have isolated: improve speed, friendliness, and accuracy.
Cleaning up a few basics of McDonald's business such as service times and order accuracy can help boost recurring revenue on a quarterly basis, leading in turn to same-store sales increases. A customer whose expectations are met with regularity is a customer with a low barrier to increasing visits to a restaurant.
But simply communicating as much to the global workforce isn't enough, and that's why McDonald's is departing from former practice to spend additional hard dollars on its people, in the form of rising wages and benefits. We'll likely hear more from management about the relationship between wages, the caliber of employees, and operational gains in the coming quarters. After all, Ray Kroc decreed that employees constitute one of the three legs of McDonald's all-important strategic stool. And Kroc knew a small bit about running a successful global business.
Asit Sharma has no position in any stocks mentioned. The Motley Fool owns shares of and recommends Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.