Keep it (Relatively) Clean
The food business is uniquely challenging. It transcends mere economics: it is a world of rapid technological innovation combined with products brimming with emotion. This emotion is ultimately traceable to the fact that in this business, "consumer" is not a metaphor. People put food in their bodies and in their families every day. Business doesn't get much more personal than that without a PG-13 rating (at least).
Right now, that unique intersection of economics, technology and deep consumer emotion lies at the heart of McDonald's (NYSE:MCD) strategic dilemma. How can MCD do what they historically have done well, and also meet the increasingly contradictory demands of US consumers? Put another way, how healthy and "natural" does the titan of fast food need to become, and how fast do they need to do it?
When MCD headquarters in Oak Brook, Illinois squarely addresses these questions, investors will have their second clue that the worst is over. (The first clue as to when the worst will be over is here). Until then, expect MCD to underperform relative to its past history.
The Great American Public's Paradoxical Demands
Not for the first time, American consumers want it all: they want food with "integrity" - i.e. food that's as natural, healthy and as simple as possible. They also want that same food delivered cheaply, quickly and conveniently. Above all, that food had better be delicious (and none of the above should be understood as permission to mess with any Classics). In short, their food demands are, if not outright contradictory, then often at cross purposes.
Kraft (KRFT) has responded to this trend not only by lowering average sodium levels in many of their products, but also by agreeing in late 2013 to remove artificial dyes from three macaroni and cheese varieties. General Mills (NYSE:GIS) recently reacted to similar public concern about "natural" foods by pledging to remove genetically modified ingredients from original Cheerios. In short, food concerns once confined to California communes are now the conventional wisdom of America's soccer moms, and big food companies are acting.
The "science" behind the KRFT and GIS decisions is debatable (to say the least. I'm not in love with chemistry-set style ingredients list, but there is plenty of room for healthy debate about the science here), but they reflect the rising tide of public expectation about food integrity that MCD is facing. By food integrity, I mean public concerns about how ingredients are grown, processed and delivered.
Unfortunately, no matter what the facts or science, what Exxon (NYSE:XOM) is to "Big Oil", McDonald's is to Fast Food: a magnet for critics. Are Subway's meats higher quality than McDonald's? I'm told by experts that they're not. But that's not what Middle America thinks (especially when hard bodies like The Biggest Loser's Jillian Michaels endorse Subway!). Similarly, a halo of food integrity is an important factor sustaining Chipotle's (NYSE:CMG) eye-popping P/E of 48.
So for investors, the key question is: how out of sync is MCD's basic value proposition with Middle America? How big a food integrity trust gap do they need to bridge, and how will they do it? As a potential investor, that question should give you pause. As a current investor, you must look for how - or even if - MCD is responding.
Distinguish Qualifiers from True Order Winners
What's an investor to do? Well, as a first step you can check the MCD website. There, in the "Values" section, you see that MCD is meeting two of the public's concerns about food integrity head on: the McDonald's site talks directly about "Sustainability" and Animal Welfare.
I hate to break it to the boys and girls in Oak Brook, but those two issues aren't order-winners for American consumers any more, they're simply qualifiers. The American Middle Class drank long and deeply from the well of the Environmental Movement. It expects basic sustainability as a feature of Capitalism 2.0, and it now finds it at businesses it loves like Wal-Mart (NYSE:WMT), and industries it loves to hate, like Big Oil. Similarly, an "Ask me no questions, and I'll tell you no lies" attitude about Animal Welfare prevailed until a few years ago. Not any more: now all it takes is a couple of YouTube videos of suffering animals for a company to attract boycotts. Sustainability and Animal Welfare score MCD no extra points on the food integrity scoreboard. They are necessary but not sufficient qualfiers for MCD to remain around for any length of time.
Meanwhile, companies like Starbucks (NASDAQ:SBUX) are busy raising the bar on sustainability and related "ethical" issues, making them a living part of the brand. Concerned (i.e. guilty) coffee consumers are happy to pay a premium to "do their part" to save the earth. (If one were being cynical, one might say that psychologically this premium is little different from the "indulgences" that medieval Christians could buy to make up for their sins. Meanwhile,the real effect of individual consumer's participation in such programs is approximately the same as that of football fans cheering for their team while watching the game on TV: it makes them feel good, but doesn't really affect the game's outcome.) We don't see McCafes responding in kind to SBUX's initiatives in this realm, do we?
In sum, the tide of basic expectations about food is rising, and it presents a strategic dilemma for those businesses like MCD that rose to greatness under a different set of expectations.
Going to the (rotten) core of the matter?
The last thing that I would allege is that McDonald's is unaware of food integrity trends. Indeed, it is partly this quest for perceived health, nature and simplicity that explains the menu over-expansion that I explored in Part One of this series. It's what put salads on the McDonald's menu as early as 2005, and partly lies behind the explosion of (perceived healthy and more natural) wraps.
But at the same time, MCD still has a problem. There is now a mini-industry of people (bloggers, journalists and food activists) who make it their business to compare and contrast how McDonalds' products age versus products without preservatives. The more popular of this bunch blog under names like "FoodBabe.com" and "The Best of Mother Earth". The not-so-subtle message of the resulting photos and opinions that they post is that food that doesn't rot (which McDonald's products appear not to) can't be good for you in the long run.
Frequently, the charges against MCD and its Fast Food contemporaries amount to little more than restatements of the Naturalist Fallacy (i.e. the simple-minded assertion that a thing is good because it is "natural", or bad because it is "unnatural"). But the damage for Fast Food firms is real. Finally, brands are about trust, and the steady drip, drip, drip of "their food has no integrity" activism is undermining America's trust in MCD's core value proposition.
"Everything needs to change, so everything can stay the same"
Therefore, investors need to look for what I call a "Leopard moment". No, I'm not talking about waiting for MCD to launch Endangered-Species Burgers. I'm referring to the famous Italian novel The Leopard, which chronicles the changes in Sicilian life and society during the 19th century. In the book a prince is compelled to choose between upholding aristocratic values and breaking traditions in order to maintain his family's influence. In the course of this choice, the prince utters the memorably paradoxical statement, "Everything needs to change, so everything can stay the same".
For investors in MCD, the paradox is the same: on the issue of food integrity, everything needs to change, so everything can stay the same, i.e. MCD continues to be a sound investment. They need to get out in front of more than issues of sustainability and animal rights, and squarely address America's demand for delicious Fast Food that's as natural, healthy and as simple as possible. Strategy is choice, and MCD can't duck the issue of food integrity forever.
Will we see the same old Big Macs, or Big Bang changes?
American consumers aren't going to drop traditional Fast Food - including McDonald's current offerings - tomorrow. (They're still smoking in substantial numbers, too, and Altria (NYSE:MO) pays a sweet dividend as a result). But in the long run, investors in McDonald's need to see the firm address the issue of food integrity head on. To counter the drip, drip, drip of consumer charges about food integrity, MCD needs to announce some "big bang" changes to their positions on healthfulness, preservatives, additives, etc. These changes need to address many aspects of how MCD food is grown, processed and delivered. In other words, it isn't about fixing one thing, it is about a myriad of related and linked changes linked to perceptions of food integrity.
If MCD doesn't make some big bang changes to the Big Mac and its brothers to restore a perception of food integrity, its share price will likely continue to languish. Perhaps it will keep paying a good dividend. But with a core value proposition increasingly out of touch with Middle America, its glory days as an investment will be over. Activists will continue to bash MCD's core products, and trust in their brand will die death by a thousand cuts.
I don't underestimate the operational and logistical challenges that food integrity issues pose for MCD, but as an investor, I won't believe the worst is over until I see a decisive response. In other words, we need to see a Leopard moment, when the Oak Brook headquarters says, "Everything needs to change, so everything can stay the same".
In the final part of this series I'll address the third thing MCD investors should watch for to know the worst is over.
Disclosure: I am long MCD, KRFT, MO, XOM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.