Ashley Pittard

Head of Global Equities

Flipping the Burger Model at McDonald’s

We often like to highlight our “common sense business person’s approach” to investing. We are contrarian by nature and focus on the leading businesses in areas that are out of favour, facing change, or are at risk of being depressed in the near term. This approach led us to traverse the US on our most recent investor trip, where we had the opportunity not only to work our way through the menu at various operators in the Quick Service Restaurant (QSR) sector but also meet with McDonald’s management at their headquarters in Chicago.

Two all-beef patties, special sauce, lettuce, cheese, pickles onions on a sesame seed bun…today it is more likely to be a gourmet Angus burger, garden salad and truffle salted fries, ordered and paid for via a touch screen. No Ronald McDonald in sight.

Transformation of the McDonald’s menu to cater for changing consumer tastes and preferences has been a key feature of the company’s strategy in recent years, almost to the point where it is cannibalising its traditional offerings like the Big Mac. “How very un-McDonald’s” was the key slogan in a recent advertising campaign.

Evolution of the McDonald’s business model dates back to 1940 when two brothers, Dick and Mac McDonald, opened the first McDonald’s BBQ Restaurant in California, serving a limited menu of burgers, fries and beverages with a model that focused on quality and quick service. But it wasn’t until 1954 when the incarnation of the McDonald’s that we know today began. Ray Kroc, a business man and supplier to the brothers, was impressed by the effectiveness of the small but successful burger restaurant. Kroc saw an opportunity and a year later he founded McDonald’s System, Inc., a predecessor of McDonald’s Corporation. Kroc spearheaded the franchising model and rapidly expanded the number of stores. By 1958, McDonald’s had sold its 100 millionth hamburger.

Today, there are nearly 37,000 McDonald’s restaurants worldwide. The company’s top five markets are US, Canada, England, Germany and France, although most of the expansion is occurring in its International High Growth segment. The company has nominated eight key growth markets within this group – China, Korea, Russia, Poland, Italy, Spain, the Netherlands and Switzerland – to expand the development potential and further diversify its earnings base from the US.

McDonald’s – total system units and segment operating income 


Source: Company data, 2016

Change at McDonald’s goes well beyond the menu

In 2011, McDonald’s US market share was 16%, today it stands at 13%. Over this time, McDonald’s has likely lost market share to competitors like Burger King and to up-market QSR operators. During this time McDonald’s has struggled to deliver earnings growth (-1%, based on its five-year compound annual growth rate) and its net debt ballooned by 2.5x to US$22b, while the company’s return on invested capital had flat-lined. McDonald’s has found itself lagging the QSR sector which overall, has continued to grow at a compound annual rate of 5% since 1992.  

McDonald’s – US Market Share (1992-2016)

Source: BTIM, using data from company filings and US Census Bureau

It’s no wonder that McDonald’s appointed a new Chief Executive Officer (Steve Easterbrook) in 2015, who was their first British-born CEO. Since taking the helm, Steve has acknowledged the recent poor performance. “The numbers don’t lie,” ……“I will not shy away from the urgent need to reset this business.”…..“Our existing organisation is inefficient and lacks clear accountability”…. “We need to execute fewer things better” and the company needs “stronger financial discipline, faster decision-making and hard-edged accountability”.

We believe that Easterbrook’s acknowledgement of the challenges facing the burger empire, his owner-operator mentality and a clear and transparent articulation of what he wants to achieve is setting the company on a stronger footing. This is exactly what we want from the management of companies we invest in. Easterbrook has been methodical in his approach and acknowledges that a new strategy will take time to execute, especially when it comes to addressing the market share declines, which is his top priority.

Business transformation occurring at multiple levels

Perceptions of poor value have been addressed by a revamped value menu and product delivery model. Healthier options and customisation have been key enhancements to improve the value proposition, while a focus on quality ingredients is helping to convert those with a more discerning palate. Digitisation of the ordering process has also been a critical part of the strategy, from in-store digital kiosks to mobile ordering apps.  Drive-thru (70% of US sales) times are being improved by the introduction of dual lanes and an in-store table service has been introduced. The roll-out of these strategies has been careful, considered, and trialled in select markets. In 2017 we will see the roll-out of many of these strategies to a broader footprint of stores globally.

While the menu may be more calorie-light, the company is also becoming more asset-light, with a target to grow the proportion of franchised restaurants to 95% from 85% in 2016. McDonald’s are also exploring new ways of supporting their franchisees, which could further reduce the capital intensity of the business. Return on invested capital has flat-lined for years and should begin to improve, as will the free cash flow which is all being returned to shareholders.

Investing with diligence and patience

Investors in our fund understand that we focus on leading businesses that have owner-operator management working for our interests, and who pay a healthy dividend as we wait for the business to normalise its operating performance over time. McDonald’s fits that bill. We are favourably disposed to the initiatives currently underway and remain confident that they will deliver value for our investors. In recent years, the company has delivered dividends of around 3% which provides a solid income return while management steer the company towards its full potential.

McDonald’s remains the world’s largest QSR operator and is three and a half times the size of its nearest competitor. The market appears skeptical of management’s ability to grow the business, with consensus factoring low expectations for growth, continued market share loss, and like-for-like sales growth of 1-2% p.a. versus a sector growing at 5%.

McDonald’s is currently on an ambitious drive to improve operating margins towards the mid-forty per cent levels, improve its returns on invested capital and strengthen its capital efficiency by continuing to return capital and to refranchise 4,000 restaurants by the end of this year. With operating margins at 40%, improving returns on invested capital and disciplined cost management, we think the business and management are very compelling, as are the additional margins gained through its improved service and amenity.

The company has come a long way since 1940 and we believe the management team is placing focus on the right areas of quality, convenience and value that will transform the business far beyond a Big Mac and Fries producer.