McDonald's - Operational Problems Are Building

| About: McDonald's Corporation (MCD)
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Summary

All-Day Breakfast will become All-Day Problems.

Hope you enjoy waiting – speed of service will slow.

Frustrating App.

Refranchising 4,000 Restaurants By 2018.

Investment Risks

All-Day Breakfast will become All-Day Problems

The launch of the All-Day Breakfast Menu in the U.S. has seen a resurgence of customers come back to McDonald's (NYSE:MCD) restaurants. This is clearly shown as Q4 '15 had comparable U.S. sales increase of 5.7% and Q1 '16 had comparable sales increase of 5.4%; see Table 1- Comparable U.S. Sales. The recent top line success that MCD has enjoyed has come at the demise of sales from domestic competitors. Lenny Comma, Chairman and CEO of Jack in Box, highlighted a slowdown in sales for Q1 '16, he specifically pointed to "…a competitor's messaging around its launch of all-day breakfast had some impact on our results, particularly in the 10:30 a.m. to noon period." The competitor Mr. Comma is referring to is McDonald's, which officially started the All Day Breakfast Menu October 2015 (Q4 '15).

Table 1 - Comparable U.S. Sales

Comparable Sales

The early prosperity of the All-Day Breakfast will quickly fade and will create a nightmare of problems for McDonald's Corporate and Franchisee Owners due to the operational difficulties and unsustainable economics of All-Day Breakfast.

By offering customers the All-Day Breakfast Menu the Company has now opened the door for customers to swap higher priced items, lunch/ dinner menu, for lower priced items, breakfast menu. For example, if a customer in Denver, Colorado decided to have an Egg McMuffin Meal ($4.89) for dinner instead of a Big Mac Meal ($7.38), they can save $2.49 before taxes; see Table 2 - Sample Pricing Across the U.S. The same customer in Denver can buy small fries for $1.39 or can buy a hash brown for $1.09, saving them $0.30 before taxes. The cost differential for small fries and hash browns is even greater in Lewiston, Pennsylvania, where a customer can save $0.49 by opting out of small fries ($1.49) for a hash brown ($1). In addition to the cannibalization from the new breakfast menu items, the cost of keeping breakfast food in the hot holding unit also means there is a potential for more waste and higher costs, as more items are needed to be prepared throughout the day. The hot holding unit which previously held a quarter pound beef patty for a Quarter Pounder with Cheese will now also hold a sausage patty for a Sausage McMuffin. Ultimately, the tradeoffs will hurt both sales and profits as customer's trade down for more value and cost savings.

Table 2 - Sample Pricing Across the U.S.Table 2 - Sample Pricing Across the U.S.

Not only does the All-Day Breakfast come with financial troubles as its main course but also comes with a side of operational challenges. Before the introduction of All-Day Breakfast there was a set cutoff time for breakfast, 10:30 a.m. on a national scale, which meant there was a time designated to changeover to lunch. This usually meant cooking, cleaning and preparing for different items on the menu. Without this set transfer over period, the All-Day Breakfast Menu has created chaos as team members scramble to meet lunch orders while simultaneously cooking breakfast menu items. This is very risky as equipment and utensils may be overused for handling different proteins leading to a potential allergy outbreak due to cross contamination. For example, if a customer is allergic to eggs and the same breakfast tongs were used to assemble their order of a Quarter Pounder with Cheese they would get very sick. As we saw with Chipotle Mexican Grill's (NYSE:CMG) latest food-borne illness which started in Q4 '15 led to very disappointing results of Y/Y declines of -7% in Q4 '15 and -23% in Q1 '16. Between October 1, 2015 and July 1, 2016 CMG's stock price was down ~45%.

The All-Day Breakfast sandwiches (Egg McMuffin, Sausage McMuffin with Egg, and Sausage Burritos) reduce menu quality and add complexity to the team members of the restaurants. According to an article from Nation's Restaurant News, authored by Jonathan Maze, McDonald's will be adding the Biscuit and McGriddle sandwiches to the All-Day Breakfast Menu in September. This will further slowdown the speed of service to customers which goes against the areas of focus in the U.S. as stated in the 2015 10-K filing, "While results in the first half of 2015 were weak, the steps taken to enhance menu quality, simplify restaurant operations and offer more convenience to customers led to a meaningful shift in momentum starting in the third quarter."

Hope you enjoy waiting - speed of service will slow

The roll out of Create Your Taste (CYT) and Table Service are destined to increase the wait time for customers as the complexity of custom sandwich builds rise and the reallocation of team members from the kitchen to the front of the restaurant. CYT is the opportunity to choose from 36 gourmet ingredients to build your own customized burger. The new ingredients available include items such as guacamole, grilled pineapple, and sliced beetroot. These new items also mean new additional costs in training and food preparation. The added complexity to the sandwich build will lead to more mistakes, customer complaints, and greater level of waste - higher costs for the franchisees. Based on the 2015 10-K the Company has an estimated 420,000 employees worldwide, which means there is an average of 65 employees per restaurant. By applying Bruce Grindy's, chief economist for the National Restaurant Association, 2015 turnover rate in the hospitality industry of 72.1% that means almost every week a new team member will join a restaurant or ~47 new employees are hired each year at each restaurant. Based on interviews with restaurant managers, the rate of employee turnover spike's near the end of August and early September due to back to school. The addition of the Biscuit and McGriddle sandwiches to the All-Day Breakfast menu expected to be launched in September will only further sacrifice the speed of service. The complex sandwich builds (All-Day Breakfast, CYT, and traditional burgers), burdensome cleaning and preparation, and the inflow of consistently new team members (training and learning on the job) is a recipe to fail the standard 3 minute target required - slower speed of service.

In addition to the added complications of CYT the release of table service will only add to the customers wait time. By having a team member dedicated to the self-order kiosk and another one focused to delivering the food the restaurant is essentially taking away two key members from the kitchen. In order for the restaurants to keep the same speed of service additional staff members in the kitchen would be required, which would mean higher labor costs. Leslie Patton, of Bloomberg, reported that "…about 70 percent of sales are made to people who don't leave their vehicles." By extracting two key members from the back to better serve the customers (30%) in the restaurants this has now compounded the negative impact of CYT to the speed of service for the drive-thru which Ms. Patton points out is about 70% of MCD's business. MCD is known as a restaurant that focuses on speed of service and affordability. By introducing new fancy gourmet burgers that are more costly and slower to build it can potentially alienate their core customers.

Frustrating App

Domino's Pizza (NYSE:DPZ) has found a way to turn the traditional pizza delivery business into a fast growing business with the help of modern technology. From 2008, when DPZ first launched its digital ordering platform in the U.S., to 2015 it saw its total revenues grow at a CAGR of 7.6% compared to MCD's CAGR of 1.3%. The average growth rate for same store sales was 4.6% for DPZ's compared 2.1% for MCD's. According to DPZ's 2015 10-K filing, "...approximately 50% of our U.S. sales came via digital platforms. That metric is higher in some of our international markets. " Ultimately, the adoption of DPZ's digital platform has supported this tremendous growth and exposed MCD's vulnerability.

In Q3 '15 MCD launched its initial mobile app to improve restaurant service and to better understand customer behaviors. Over 7M customers have since downloaded the app, which provides the customer with helpful tools like coupons, nutritional information, and restaurant locator. The app at the moment is largely "offer-based" meaning its intentions are to drive customers to go to MCD's- to use the coupons. App users do not have the ability to make purchases directly on their phone. However, the response from the app has not been overly positive, as one of the respondents said, "Only works half the time." The top ten comments shown reflect how far MCD still has to go with its mobile technology to get to a similar level as Domino's Pizza; see McDonald's App Store Comments. Out of the top ten comments 8/10 respondents gave the app a ranking of either 1 or 2 out of 5. In comparison, 8/10 respondents gave the DPZ app a ranking of 5 out of 5; see Domino's Pizza App Store Comments. One of the respondents even points out that he doesn't like Domino's Pizza but cannot deny the convenience and ease of use in the app, "I don't like Dominoes as a company usually, but I gotta say that their app is on point."

McDonald's App Store Comments

MCD App Comments

Domino's Pizza App Store Comments

DPZ App Comments

Investment Driver

Refranchising 4,000 restaurants by the end of 2018

The Company is in the midst of a four-year program, ending in 2018, to refranchise an estimated 4,000 restaurants. The long-term plan is to become 95% franchised. Based on the most recent Q1 '16 filing the company has franchised 83% of the restaurants.

In 2015, MCD refranchised approximately 470 restaurants, which means it has approximately 3,530 restaurants remaining to refranchise. The primary markets where the refranchising efforts will take place will be in the High Growth and Foundational markets.

The shift towards a more franchised business model will translate into more stable and predictable sales and cash flow, and function with a less capital demanding system. As we know franchised restaurants on average command ~82.3% in margins compared to Company-Owned restaurants which only receive ~17.1% in margins. This is 4.8x higher percentage in margin. Therefore, the transition from the most recent ~17% of Company-Owned restaurants to the long-term target of 5% will mean that total margins will rise, ceteris paribus.

Valuation

As of July 1, 2016 MCD trades at a 23x P/E multiple which is well above its traditional 5 and 10 year P/E average of 19x and 18x respectively. By applying its long term historical P/E average of 18x at a $5.52 estimated 2016 EPS an implied share price of $99 is received.

P/E

Multiples Table

Conclusion

Between Q2 '15 and Q2 '16 MCD's stock price increased ~24% mainly from the excitement of All-Day Breakfast, new leadership (Mr. Easterbrook), and a new value combo platform (McPick 2). As the excitement for these things start to slow down I anticipate the stock will also churn lower as it returns to its long term historical P/E level of 18x. MCD does pay a 3% dividend yield and has a plan to return $14.2Bn back to shareholders in 2016. However, I believe this is not enough and is ultimately management's way of financially engineering a more encouraging stock pitch to investors.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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.