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Why McDonald's and Coke Might Stop Growing

Written By Briton Ryle

Posted October 22, 2014

The third quarter reporting season seems to be bewildering everyone, with plenty of surprises to be had — some pleasant, others disconcerting.

Three blue chip companies — International Business Machines (NYSE: IBM), Coca-Cola (NYSE: KO), and McDonald’s (NYSE: MCD) which have long served investors well as stable long-term foundation stones in conservative portfolios from IRAs to pension funds — have turned brittle and crumbly on very disappointing Q3 reports yesterday.

All three stocks tumbled from 0.63% to 6.03% yesterday, even as the Dow Jones Industrial Average they all belong to surged upward 215 points for a 1.31% gain. In fact, IBM, Coca-Cola and McDonald’s were the only companies in the Dow index of 30 companies to end the day down, with all other 27 stocks rising.

Their disappointing Q3 results are giving investors a clear indication that times have changed, and the preferences of consumers and businesses have changed with them. Investors who have regularly stocked up on these “buy-them-and-forget-about-them” stocks might have to do something they never thought they would ever need to do… re-evaluate them as components of their portfolios.

Let’s consider Coca-Cola and McDonald’s, since their futures are both being threatened by the same growing trend… healthy eating.

Coca-Cola — Don’t Pour Me Another

Coca-Cola’s Q3 report was not very sweet to investors as its main products are too sweet for consumers. Here are the highlights:

  • Revenue declined to $11.98 billion from $12.03 billion in Q3 of 2013; analysts were expecting $12.14 billion.
  • Net income fell 14% to $2.11 billion from $2.45 billion in Q3 of 2013.
  • Earnings fell to $2.11 billion, or 48 cents a share, down from $2.45 billion, or 54 cents a share in Q3 of 2013.

Much of the declines in income and earnings were due to a more expensive U.S. dollar, which incurs higher conversion costs when exchanging foreign sales income to USD. While the company reported an increase in total worldwide beverage sales volume of 1%, soda volume was flat, the increase coming from the growing demand for non-carbonated drinks.

This is a trend we can expect to accelerate over time, as consumers the world over are becoming much more health-conscious. S&P Capital analyst Joseph Agnese cautioned investors that “sluggish growth is expected to continue.”

The company is attempting to change with the times, rolling out new products sweetened with the healthier “stevia” derived from the foliage of tropical plants, as well as buying a 16.7% stake in energy-drink producer Monster Beverage (NASDAQ: MNST).

However, most of the company’s focus at the present time is on reducing expenses, rather than increasing sales, as CEO Muhtar Kent promised to reduce annual operating expenses by $3 billion by 2019.

“We are taking decisive action to position The Coca-Cola Company to continue delivering long-term value for our shareowners… to make the changes in terms of a leaner, better-operating model,” Kent unveiled yesterday. An important part of that cost-reduction plan is to re-franchise the majority of its North American bottling territories by the end of 2017.

Yet investors need to consider that while cost-cutting will improve net results over the near term, if sales continue to slide then declines in revenue will eventually erase any gains made through cutting costs, and the net result will once again be down year after year. A company can cut costs only so much. Growth — real growth that is long-term and sustainable — can only come from improving top-line revenues.

Investors need to consider what type of consumer Coca-Cola will face when it completes its cost-cutting plan by 2019. Do we somehow expect consumers to suddenly turn back to sugary drinks? Most assuredly the current trend away from sugary beverages will accelerate, not reverse.

As it is currently, Coca-Cola’s growth is mainly outside of North America, where the majority of consumers have yet to turn as health-conscious as Americans have. But as knowledge about obesity and its causes spreads, we can expect the rest of the globe to improve its drinking habits in due time.

That means just one thing for Coca-Cola: unless it makes a wholesale change to its product line toward healthier beverages, its stock will spiral down the drain along with most of its drinks.

McDonald’s — Set In Its Ways?

McDonald’s Q3 report released yesterday shows a company that is well beyond its bloom of youth and well past its growth spurt. Here are the highlights:

  • Global comparable store sales fell 3.3% in Q3, worse than the 2.9% decline expected.
  • U.S. same-store sales fell 4.1% in September alone — the worst monthly decline since early 2003.
  • Revenue fell 5% to $6.99 billion, worse than the $7.18 billion expected.
  • Profit fell 30% to $1.07 billion, or $1.09 a share, from $1.52 billion, or $1.52 a share, in Q3 of 2013 — the worst drop in quarterly profit since 2007.

The company has attempted to attribute slowing sales to economic slowdowns in Europe and Asia, but that doesn’t sit right with many, seeing as it caters to lower incomes over there as it does back home in America.

Instead, McDonald’s seems to be suffering from the same ailment that Coca-Cola is — consumer tastes are changing. Where Coca-Cola is hurting by consumers’ changing drinking habits, McDonald’s is being hurt by consumers’ changing eating habits.

“The U.S. market, which accounts for roughly 40% of [McDonald’s] more than 35,000 global restaurants, is facing a fundamental shift in the way Americans buy food,” reports the Wall Street Journal. “Young consumers, in particular, have been flocking to fast casual restaurants such as Chipotle and Panera Bread Co.”

Of course, the company is aware of consumers’ changing tastes toward healthier foods, and has rolled out a new campaign to improve its food’s image by inviting customers to ask questions about it. Among the first questions the company answered were, “Why doesn’t your food rot?” and “Do you use real chicken in your Chicken McNuggets?”

Another change McDonald’s is experimenting with is giving customers the flexibility to fix their own burgers by installing self-serve prep tables stocked with toppings. It is also testing a “Build-Your-Own-Burger” service where customers can pick the bun, patty, and toppings to be used in their order.

Tony Scherrer of Smead Capital Management likes the company’s approach. “To add some components that would give you a sense of local feel and health and for them to brand it as such would speak to the demographic they’ve missed out on,” he approved, referring to the growing market share being swayed away by Chipotle and others like it.

Yet transforming McDonald’s into another Chipotle is hardly going to mean the company’s salvation. Even Scherrer admitted, “For people to expect McDonald’s to change their lineup in order to become a Chipotle is unreasonable.”

Why? Because that part of the market is rapidly becoming saturated. Even Chipotle itself lowered its own future growth and guidance in its Q3 report this week, reducing its 2015 same store growth to the low-to-mid single digit area. There’s no room in that space for McDonald’s 14,000 U.S. restaurants.

Moreover, it’s the wrong demographic. McDonald’s caters to two main types of customers… those on tight budgets and those who are in a hurry.

Edward Jones analyst Jack Russo explained that “customizing menu items at a chain that derives about 70% of its sales from the drive-through could slow service… Becoming more healthful isn’t a panacea… for a chain that has already tried adding salads, fruit smoothies and oatmeal to its menu with little traction.”

“There’s a huge portion of the population that could care less about health and wellness,” he added. “They need to get lower middle-income consumers back to their stores.”

The sad reality is that McDonald’s is kind of stuck where it is. That’s its market, and it would be futile to try to be all things to everyone. The healthy eating craze will continue to grow, but the market isn’t large enough for a mega chain like McDonald’s to fit into. You pretty much have to leave the space to the smaller boutique chains who cater to a less thrifty and less hurried clientele.

Trying to mix that clientele in with McDonald’s “on-the-go” and “on-a-budget” clientele isn’t going to make either demographic enjoy eating at its restaurants. Investors need to look at McDonald’s as just something that is what it is and will always be so. It’s too big and too specific to change just a little.

However, that does not mean the chain is dying, since there will always be people who are “on-the-go” and “on-a-budget” who will eat there. What it does mean, however, is that investors should not expect very much growth from the company, but for it to simply maintain the presence it has established for itself.

Still Useful for Something

Both Coca-Cola and McDonald’s — though no longer the major growth vehicles they once were — are still valid investments, especially with their meaningful dividends of 3% and 3.74% respectively.

But investors should not kid themselves that the companies will resume growing at their previous paces once the U.S. dollar backs down and the global economy recovers. Why? Because other chains are waiting for the same things, and will be right there wherever Coca-Cola and McDonald’s go.

Cutting their markets down all the more are the improving food and drink preferences in more and more nations. The changing tastes sweeping across America today will be sweeping around the world tomorrow.

Joseph Cafariello