McDonald's - Crisis and Turnaround of 2002-2003
Ted Weschler’s record while running his fund (Peninsula Capital) for the 11 years from 2000 to 2011 is epic. He generated 26% CAGR, turning a $1M investment into ~$13M in just over a decade.
When he got hired @ BRK, I pretty obsessively went through all of his old 13Fs and tried to reverse engineer his rationales for the investments he made at the time he made them. I read the old 10Ks and news articles of the firms he invested in to try to learn what was going on at the firm at the time and hopefully learn some lessons.
By now, his investments in DaVita, WR Grace and DirecTV have been pretty well studied. A major theme emerges. The basic thing that Weschler did incredibly well over his 11-12 year career at Peninsula was that he found about 4-5 companies whose core businesses were moaty and growing but profits or valuations or both were severely depressed due to problems that were scary, but that could be fixed.
In his 20s, he worked at the old WR Grace conglomerate in a strategy/finance position and got to understand the various businesses they owned, including a dialysis firm and the core chemicals business.
While running Peninsula, he was able to invest in DaVita (dialysis clinics) after its near death experience from bad billing practices that almost bankrupted the company. The core dialysis business was fine and would basically grow for as long as Americans continued to like sugar.
He made the investment in WR Grace a few weeks after it declared bankruptcy due to asbestos litigation.
So two of his 3 best investments were literally from experiences he gained as a 20 something year old working at WR Grace.
The investment in DirecTV (and Echostar-Dish) was partly made when the market was fearful about cable TV stealing satellite’s customers. The market ended up being right that the broadband provided by cable cos did end up killing satellites but in 2003-2004, that was all still a decade plus away. Satellite had a higher quality digital feed vs. analog basic cable, had many more channels, unique sports content and generally was a better TV product. It continued to grow and Weschler made a ton of money by fading the market.
I remembered recently that he had put about 50M of his 350M fund at the time (late 2002, early 2003) into McDonald’s. I’d never looked into it so finally, after about a decade of following Weschler’s moves from back then, I decided to follow up. Just for curiosity’s sake, I wanted to study what was going on at the time and what his potential thinking could’ve been.
Though he did not hold the investment for very long, I was still pretty amazed. From late 2002 / early 2003, depending on when you invested, holding MCD till today would’ve earned about a ~17%-19% compound annual return.
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McDonald’s - the road to the crisis of 2002:
MCD had communicated to investors it’s goal of 10%-15% EPS growth. This was a company that had been growing double digits % for decades.
To start 1995, the company had ~16K restaurants worldwide. By the end of 2000, there were 29K restaurants, a 10% CAGR. However, same stores sales growth had not exceeded 2% in any single year from 1996 to 2000 and averaged about 1%.
Despite an almost doubling of the store base, revenue rose only 50% and pre-tax income went from 2.2B in 1995 to 2.9B in 2000. Cash flow from operations rose less than 20%, from 2.3B to 2.7B.
The company was too hell-bent on opening locations rapidly that operations inside the restaurants were starting to suffer. Managing food quality and service times was becoming unwieldy.
An ill conceived and expensive new cooking system called “Made for You” that cost about 25K-30K per store had led to the doubling of service times to about 3 mins and made the management of “rush hour” traffic difficult. It pissed off franchisees, who were asked to invest 25%-30% of their profits into a system and didn’t see any return.
In fact, rather than slow down and fix the deterioration of the restaurant level economics, the mgmt got swept up in the tech mania and in late 2000/early 2001 conceived of a plan to put $1B into an IT project called Innovate. (net income in 1999 was 2B).
It was basically an IoT project that would put sensors in absolutely every part of the restaurant and allow real time tracking of operations from HQ. They would be able to track the exact temperature of the frying oil or how long the fries were fried, how many seconds between each patty flip etc. There would be sensors and meters in the fridge that would alert HQ if the store was running low on buns or potatoes and deliver more. Then MCD could standardize quality like no one else before and measure performance real time and keep restaurants accountable for lagging.
To me, it seems like the company was a stock being sold to investors rather than a business being run for the long term benefit of customers, employees and shareholders. This has been substantiated by interviews I’ve read from ex employees. The goal was to show high store growth. And perhaps a shiny new IT project to top it off in 2000 would really have gotten investors excited.
By 2001, the model was untenable, net income was starting to decline and same store sales growth had turned negative. Management had lost credibility.
In late 2002, the company brought in a retired VP, Jim Cantalupo to take over the CEO position. This was a controversial decision because he wasn’t really an outsider - he had been the #2 just a few years before and had retired when he was passed over for the CEO job.
The stock had been around $25-$35 in late 2001 - early 2002 (~20x EPS of $1.50) and fell below 20 bucks.
In early 2003, the company, under new mgmt, reported Q4 results, which were horrendous. The new mgmt team was putting the brakes on new openings, closing 700 existing locations and taking an impairment charge on the $200M already spent on the INNOVATE IT project.
Also, the CEO basically came out and said in his 2002 letter that the old goals of 10%-15% EPS growth were not really sustainable and MCD was basically too mature of a company to expect such growth.
That is when the stock hit bottom at around $13 (vs. normalized EPS of ~$1.50)
Late 2002, early 2003, amongst all of this news is when Weschler invested.
Basically, in early 2003, you had:
A statistically cheap stock but where earnings quality had deteriorated (cash flow hadn’t grown at commensurate rates to store growth)
Relationships with franchisees weren’t that great bc the company had focused on growth over operational excellence and franchisee economics
New CEO had retired from MCD as a VP just a few years ago - investors wanted some fresh thinking not the same old same old
Same store sales growth had stagnated for over half a decade and had recently turned negative
New management had overturned the decades long expectation of 10%-15% growth in EPS and was signalling much more modest goals for the future
Despite the low PE ratio of below 10x normalized earnings, there was a lot of negative info out there that would’ve kept investors away.
My one takeaway, with full hindsight 20/20 (obviously I already knew the result - the stock did like 19% a year from the bottom in 2003), was: when most businesses go through a crisis, there is a massive reduction in sales/earnings/cash flows.
The worst it really ever got for McDonald’s was that SSS had averaged ~1% for the last 6-7 years and had dipped in 2002 briefly to -1%. That is not a disaster. It’s interesting to me that the stock was selling at 9x earnings at one point but looking just at the numbers you wouldn’t have seen a business in serious, existential crisis. Earnings quality had deteriorated, but McDonald’s was still a very popular place to eat at.
I think it was a combination of investor shock at what they thought was a 10%-15% grower turning into maybe a 5%-6% grower and the relatively poor performance of the preceding 6-7 years that was the combo that caused investors to flee.
2003 turnaround:
As I mentioned, the restaurant base was growing at 10% per year before Cantalupo took the helm. He put on the brakes: the number of restaurants grew only 3% in 2002 and 0% in 2003.
The new strategy and company reality was communicated to investors in the 2002 AR:
“McDonald’s is in transition from a company that emphasizes “adding restaurants to customers” to one that emphasizes “adding customers to restaurants.” I am confident that the basic McDonald’s concept is strong—that we are doing many things right. However, there’s no denying that we’ve disappointed way too many customers. That has to stop. You see, McDonald’s has a new boss...it’s not me...it’s the customer.”
By 2003, due to more focus back on operations (introduction of salads was a big hit) and a halting of aggressive store openings the company got back to positive SSS.
Cantalupo: “This meant a remarkable cultural change after 48 years—learning to grow by being better, rather than being bigger”
The other takeaway may be that big, ubiquitous fast food brands are “sticky” because of their convenience and low cost, even when they are not super well run.
This was summed up by the former CMO of MCD under Cantalupo during the turnaround (interview is from the fantastic inpractise.com):
Lots of people rely on fast food multiple times a week and often they’re rushing to work or tired after a long day at work so cost and convenience are both very important and lasting advantages. It gives management time to fix the business. You won’t see a sudden 25% decline. It’s not enterprise software but you can still afford to be patient.
The core economics of the franchised model are so good that even at a lower growth rate, returns can be fantastic.
Normalized EPS since 2000 grew at ~9%/yr (6% earnings growth, 3% from buybacks), multiple expansion contributed ~5%/yr and the rest was made up by dividends even though the store base only grew 1.5% / year after Cantalupo’s turnaround.
It’s probably forgotten and understated how well Cantalupo was able to turn around McDonald’s and put it back on the path of strong same store sales increases that lasted decades.