Tuesday, September 22, 2015

McDonald's: the next Tesco?

A few years ago, Tesco was a popular value stock. It was written up four times on Value Investors Club. Warren Buffett was a shareholder. While the company's recent earnings were disappointing, its historical results were fantastic and bulls thought a turnaround was likely.

Today McDonald's is a popular value stock. It was written up twice on VIC earlier this year. A large hedge fund, Glenview Capital, is a shareholder and has touted the stock. While the company's recent earnings are disappointing, its historical results are fantastic and bulls think a turnaround is likely.

With the benefit of hindsight, we know that Tesco was a value trap. I think McDonald's is another value trap. The arguments that investors have made for buying McDonald's are similar to the arguments people made for buying Tesco.


Bad same-store sales are blamed on loss of focus

When they were written up on VIC, Tesco and McDonald's both suffered from deteriorating same-store sales.The VIC authors argued that this was a result of the companies losing focus.

After Tesco became the largest grocer in Britain, it made an ambitious effort to expand internationally. In June 2012, kevin155 wrote, "I believe that since Tesco was so focused on their growth initiatives, some of the best management talent and resources has been foucused outside the UK."

In April 2015, cmg90 wrote, "In 2013-2014, MCD’s SSS turned negative as a result of strategic misdirection, operational inefficiencies, and disenfranchised franchisees." He added, "Menu proliferation (100 items added over last decade) has hurt order speed (doubled order time in many stores) and order accuracy."


A good investment for the next few years

In 2011, cowboy wrote, "We believe an investment in Tesco plc offers an excellent risk/reward for those with a 3-5 year time horizon."

This past April, gordon703 wrote, "I believe MCD represents a compelling risk/reward investment opportunity over the next 3-5 years."


A wonderful company with scale advantages, etc.

Both the Tesco and the McDonald's bulls are backward-looking: they portray TSCO/MCD as a legendary company and its ongoing problems as a temporary deviation from phenomenal long-term results.

According to the VIC authors, "Tesco is one of the world's great retailers" and "a good franchise with a strong long-term history of growth and returns" while "MCD is a very high quality business with a irreplaceable brand" and "market leading position in a growing, defensive category, significant scale advantages and a highly stable business model."

Each company has economies of scale. Tesco "enjoys significantly lower COGS than its competitors, as well as operational economies of scale" while McDonald's has "a margin of safety provided by its significant scale advantages."

Each company owns valuable property. "MCD's sacrosanct real estate could be worth ~$140B alone," while "Tesco owns ~70% of its real estate. Based on management’s estimate of its properties’ worth, the stock currently trades at approximately that value." Another Tesco bull argued that "According to management this property is worth GBP38bn, which is more that the current enterprise value of GBP33bn."

Each company promoted a promising manager from its international business to the top spot. Tesco's former CEO, Phillip Clarke, "did a very good job establishing new foreign markets as well as growing them to their current sizes today." McDonald's "new CEO Steve Easterbrook is credited with successfully turning around the McDonald’s UK business in the mid / late 2000s."


Concluding thoughts

This is a superficial comparison, and Tesco and McDonald have many important differences: they're headquartered in different countries, they operate in different industries, etc. I don't know if McDonald's will implode the way Tesco has, but I think theMcDonald's bulls are making many of the same flawed arguments that the Tesco bulls made.

Another important difference between Tesco and McDonald's is valuation: Tesco traded at 10-13x earnings before its share price collapsed, while McDonald's trades at 21x this year's expected earnings. McDonald's has all the makings of an undervalued turnaround except that it isn't undervalued.

7 comments:

  1. Interesting post. I worked at Rax Restaurants when I was in college. They fell on tough times in later years and I see some of their mindset in McDonald's too.

    Rax (restaurant)

    During this time, Rax began diversifying its core roast beef sales by adding baked potatoes, pizza and a dinner bar with pasta, Chinese-style food, taco bar, an "Endless Salad Bar", and a dessert bar. Rax began to transform its restaurants from basic restaurant architecture into designs containing wood elements and solariums, with the intention of becoming the "champagne of fast food". This transformation drove away its core working class customers, blurred their core business, and caused profits to plunge for Rax as others took advantage of Rax's techniques and improved on them, as Wendy's did.

    If you try to be all things to all people, especially in the "fast" food industry, then you risk someday being nothing to nobody.

    The menu was way too complicated the last time I walked into a McDonald's. I had to wait for it to scroll electonically just to see what was on the value menu. Waiting and fast do not beling together.

    Further, I did not find the complicated nature of the huge menu relaxing or enjoyable. The employees seemed frantic which fed my discomfort. It had the vibe of an emergency room, lol. Sigh.

    And the worst part is, I never order without knowing the price. That means that I would have to repeat the process each time I visit, just to make sure the prices hadn't changed.

    No desire to invest in McDonald's. Many of my favorite restaurants from childhood did not stand the test of time. It's a tough business.

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    1. Mark,

      That's really interesting. I'd never heard of Rax before, but rapid growth seems to be a common stumbling block for restaurants. As you say, it's a tough business.

      In MCD's case, I think they're stuck between a rock and a hard place-- if they simplify the menu and stick to what they've traditionally offered, they'll lose customers who want healthier food; if they expand the menu into "growth" areas, the customer experience will worsen a la what you describe.

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  2. As a side note, I knew Rax was doomed when I worked there.

    I often drank their milkshakes. I loved them. The managers knew this. One day I was given a free milkshake and was asked what I thought of it. I took a few sips and said that something changed. It didn't taste as good. She said that she was hoping I wouldn't notice. The recipe had changed to ice milk. Yeah, I noticed. Big difference between ice cream and ice milk. Yuck.

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  3. Good points James.

    I wonder how much of the perception of MCD, and other struggling stalwarts like KO, is just generational. Maybe it's my age (34) but I don't see why MCD or KO has a larger place in the future than SHLD, JCP or RadioShack.

    Newer fast-casual chains or retailers don't have the established brand / scale of the established players, but it's not clear to me that those things are even advantages. There is no economic benefit or necessity to having a diner-esque menu in 2015 - people are happy to go to Jimmy John's for a sandwich, In-N-Out for a burger, Chick-fil-a for chicken, etc. Fairly or unfairly, newer brands don't bear the "Super Size Me" stigma and can pick locations based on where the more desireable present-day customers live.

    Words like "legendary" or "sacrosanct" strike me as evidence of baby boomer navel-gazing, not undervalued corporations.

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    1. Thanks. I think you're right about scale advantages-- if customers want X, who cares if McDonald's is better at procuring Y? I also suspect that scale advantages are more discrete than the bulls assume-- e.g. Tesco may have more overall buying power than Aldi/Lidl, but Aldi carries far fewer SKUs, so it has more ability to influence costs for the things it actually buys.

      Regarding generational attitudes, my sense is that culture is also becoming more fragmented-- e.g. instead of having four TV channels and everyone watching the same shows, there are hundreds of channels, lots of online media, etc. and new subcultures and submarkets are developing all the time. It wouldn't surprise me if the same thing were happening with food, although that's just a hunch.

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  4. Having a well known brand is great unless that brand becomes synonymous with low quality and unhealthy products. My generation and younger (I'm 28) in general has a very negative outlook towards McDonald's. Even if me and my friends are road tripping and have to eat fast food, no one ever suggests McDonald's. It is quite literally one of the last options.

    I think people sometimes overestimate how important a brand is. Do I care how well known McDonald's is or how long they've been around? No, I want to eat half decent food. If that's one of their smaller competitors that's where I'm going.

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    1. Good points. I also know a lot of people who have given up on MCD or would never think of going there.

      Bruce Greenwald once made an alanlogy where he said (I'm paraphrasing) that brands are like real estate, in the sense they need reinvestment to stay relevant. An 'A' office building that the owner doesn't reinvest in can earn the same level of rent for a while, but eventually the building goes to seed. Seems like the same thing is true of brands: an iconic brand can coast on its reputation for a while, but if it loses the things that made it iconic in the first place, then customers who leave won't come back.

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