The Inexorable Decline of McDonald's

 | Oct 22, 2013 | 11:00 AM EDT
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There is one thing that you can reliably count on when it comes to human civilization: Absent political upheaval, things get better over time. Technology gets better. People's standard of living gets better. Even food gets better.

McDonald's (MCD) reported Monday, putting in a slight beat on earnings and a slight miss on revenue. With big, widely analyzed companies like McDonald's, it is easy to get lost in the weeds of trying to figure out the contribution of this or that menu item to earnings, or the macroeconomics of the dozens of countries in which McDonald's operates. As is true with most things in the stock market, whether McDonald's succeeds or fails will have little to do with its rip-off Pumpkin Spice Latte, and everything to do with the company's overall strategy to compete in a rapidly changing marketplace -- and this company's strategy is awful. Even if it weren't, this company probably doomed regardless.

If we rewind about 10 to 20 years ago, we find there were two tiers of dining: fast food and everything else. Nowadays, we have something called fast casual in Chipotle (CMG) and Panera Bread (PNRA) and even places like Potbelly (PBPB). Fast casual isn't quite as fast, and isn't quite as cheap, but the quality is a whole lot better. This is indisputable. Fast-casual operators are actually like tech companies -- they are working to make people's lives better. They've made people realize how shoddy fast food is and positioned themselves such that you only go to a place like McDonald's if you're really hard up for cash.

So it shouldn't really be a surprise that McDonald's is getting 10% to 12% of sales from the Dollar Menu. That's bad for business, and everyone knows it, but McDonald's is stuck, because fast food is in a race-to-the-bottom price war. If the company raised prices, it would lose market share. Yet the fast-food companies are impaling each other trying to capture a piece of an increasingly smaller pie, while the whole sector loses share to delicious carnitas burritos with black beans and white rice.

So, as dining investors, we have an interesting choice: We can pay through the nose for growth (Chipotle) or we can go dumpster-diving for value and dividends (McDonald's). Which strategy is working out better? This is part of a larger discussion about growth vs. value, which I'll talk about another time. For the time being, it is sufficient to understand that it can be a struggle to invest in businesses that are in secular decline.

I'm short McDonald's for that reason. Regardless of whether you realize it, McDonald's is a buggy-whip company. It is a relic of the past. It makes bad food, and people don't want bad food anymore. They are trading up. McDonald's will always have customers, but they're not the kind of customers they want. The customers they want will buy their wings and lattes, but the customers they get will continue to order the McDouble off the Dollar Menu.

All of this, of course, leaves out the very obvious fact that McDonald's is under constant threat of regulation; that its menu is bloated and unmanageable; and that social pressure is building for it to pay its employees more, which would squeeze its already negligible profit margins. It's been a while since I've seen a company in such poor competitive position. This is not the kind of short position that will make anyone life-changing amounts of money, but it would be the perfect addition to a finely-tuned long-short portfolio.

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