Perhaps this is emblematic of the problems at McDonald's (NYSE:MCD), perhaps not. I went into the McD's up the street from Fool HQ the other day, thinking I'd try one of their new $3.99 salads, the ones with the Newman's Own dressing.
Ordered one of the three types of salad, the Bacon Ranch one. A few minutes pass, and my order comes up.
"What kind of dressing do you want?"
Not wanting to seem like a smart aleck, but failing miserably, I shot back, "What kind of salad dressing tends to come with a Bacon Ranch salad?"
"Ranch. But we're out of ranch."
"That's going to make it tough for me to enjoy a Bacon Ranch salad, I suppose."
Now restaurants tend to run out of stuff all the time. No problem there. But I would say that the ideal time to let someone know that he is not getting what he has ordered is at the time he actually orders. I got the salad, took it with some other dressing -- Caesar, I think. Really, I just wanted the bacon. But this seemed fitting for a company that has had very little go right lately. Know why their ad campaign is "Smile?" I think it's because smiling people are more capable of pretending they're having a good time.
My colleague Rick Munarriz did a nice job covering the bases of what's happening throughout the fast-food industry in his column on Monday. He was a day early, because McDonald's held a conference that same afternoon to lay out their plans to reverse the company's poor performance over the last few years.
That poor business performance has translated into unhappy times for shareholders. McDonald's stock sat earlier last month at a hair above $12 a share, near 10-year lows, down from a high of $47 in January of 1999, and down by half in the last year alone. McDonald's has already replaced management, closed hundreds of outlets, exited three countries, dealt with mad cow disease, ditto mad Frenchman disease, and faced a near revolt from franchisees in the last year over its profit-draining Dollar Menu. And now the folks at this particular McDonald's can't get my stupid salad order right.
As bad as it was...
But in spite of this, the company still managed to produce more than $2.9 billion in operating cash flow in 2002. It's free cash flow numbers were lower because of an aggressive build out and reinvestment campaign. Well, no more. This week Jim Cantalupo, McDonald's new CEO, recognized what people the world around already know: The growth phase for McDonald's is over -- at least the growth phase as we knew it. At 31,000 outlets worldwide, McDonald's has picked all of the low hanging fruit.
In a transcript released by FDfn, Cantalupo stated that McDonald's present condition is in no small part due to its need to confront its market as it is, not as it was. "It comes down to a willingness to confront harsh realities and then having the focus and discipline to act decisively, again and again."
McDonald's is no longer the default quick-serve restaurant for a large portion of its core markets, and it is seeking to recapture hearts and minds by focusing on what it calls the "five business drivers": people, products, place, price, promotion. Or, to relate back to my most recent experience: I'd like a well-trained person who can sell me a good-tasting, inexpensive salad -- one that, for some reason unbeknownst to me, I have been craving for hours. And if this well-trained person cannot deliver me this good-tasting, inexpensive salad, this well-trained person should know exactly how to handle it. Something other than, "Well, I'm sure he didn't really mean 'ranch.'"
When slower growth is more profitable
McDonald's announced that it was essentially shooting for 3% top-line growth of revenues, with annual operating income growth exceeding 6-7%, and returns on invested capital in the high teens. This basically means that the company is forgoing increased, undisciplined growth, and instead focusing on making each additional dollar of top-line revenues that much more profitable and efficient for the bottom line. Cantalupo called this approach "more disciplined," and I agree. The net openings of McDonald's restaurants in 2003 will number only 360, down almost two-thirds from 2002, and the lowest number in decades.
How does this translate? Recall that the Rule Maker Strategy, which would certainly be relevant for evaluating McDonald's, had a criterion that companies create what we call a Cash King Margin -- total revenues divided by free cash flow -- in excess of 10%. Using this past year's numbers as our signpost, McDonald's produced free cash flows of $890 million on revenues of $15 billion, or 5.9% -- a substantial miss. But if we use McDonald's updated projection for capital expenditure for 2003 and apply it back to the identical 2002 revenues, that $890 million in free cash flow becomes $1.69 billion, for a Cash King Margin of 11.2%.
And that's the end goal for McDonald's. The reality is that its heady growth days are behind it -- it has come up against the law of large numbers and the fact that most of its easy markets have been plucked. This means that so much of the money that would have to go into expansion has declining earnings generating power.
McDonald's has its additional themes in Chipotle, Donatos, and Boston Market, as well as Pret a Manger, all of which can deliver growth that the golden arches cannot. But rather than continuing to fight reality, McDonald's management finally seems to have embraced it. As a result, shareholders can reasonably expect higher returns on invested capital and more return of shareholder funds through increased dividends and share buybacks. Momentum folk may have to look elsewhere, as 3% growth isn't exactly going to light the world on fire, but the end result is that globe-burning is no longer McDonald's forte.
Oh, and they're going to quit monkeying around with the french fry recipe, too.
Fool on!
Bill Mann, TMFOtter on the Fool Discussion Boards
Bill Mann owns shares of McDonald's. He is senior editor of The Motley Fool Select, where you can find his best Foolish stock ideas that you won't find anywhere else. The Fool is investorswriting for investors.
