Is McDonald’s a Dying Brand?

History teaches us that even the strongest consumer brands can die off. Just this summer A&P, once America’s largest grocer and most feared retailer, finally reached the end of the road. In recent years, we’ve also seen the demise of RadioShack and the near extinction of Hostess and its legendary baked goods such as Twinkies and Ding Dongs.

This got me wondering about another storied American brand, McDonald’s (NYSE: MCD), which has been having serious troubles lately. The very idea of McDonald’s demise is hard to swallow since the golden arches have been part of the landscape for generations. Yet other chains that were just as ubiquitous have vanished in the past, including Woolworth’s and RadioShack.

There are some symptoms of the death spiral present at McDonald’s even though it is still a very healthy company. The signs of decline at the fast-food goliath include:

• McDonald’s is planning to close more locations than it plans to open in the United States in 2015, the Associated Press reported. The wire service noted that this is the first time since 1970 that McDonald’s footprint in the USA has shrunk. Unfortunately, the exact number of stores McDonald’s plans to shutter in America is unknown.

 

• McDonald’s is planning to close more stores than it plans to open worldwide. In April it announced plans to close 700 underperforming locations worldwide but only add 300. The effect from closings should be minimal because the chain still operates around 36,000 restaurants worldwide with 14,300 restaurants in the U.S. alone.

 

• McDonald’s has stopped reporting monthly sales data, Slate reported.

 

• McDonald’s U.S. sales fell by 2.2% in May, the next to the last last month for which it reported sales data, The Wall Street Journal reported. The drop was steeper than what analysts had expected at 1.7%.

 

• McDonald’s has only reported one month in which same store sales did not fall since 2013.

 

• Same store sales in some areas outside the U.S. were falling faster. Same store sales fell by 3.2% in May in the Middle East, Asia and Africa.

 

• The only area where McDonald’s saw improvements was Europe, where same store sales increased by 2.3% in May.

 

• McDonald’s revenue was falling at a rate of -9.52% on June 30, 2015, according to YCharts.

• McDonald’s revenue seems to have fallen off a cliff. In June 2014 McDonald’s reported a TTM revenue of $28.30 billion; that fell to $26.02 billion in June 2015. According to my calculator, that created a revenue loss of $2.28 billion.

 

McDonalds Is Still Profitable, but for How Long?

Despite that, McDonald’s is still a very profitable company. It reported a net income of $4.18 billion, a profit margin of 18.5% and a free cash flow of $1.098 billion on June 30, 2015. Yet one has to wonder how much longer it can maintain those numbers in the face of such revenue losses.

McDonald’s is still a pretty good deal for investors. It offered a diluted earnings per share of 4.319, a dividend yield of 3.32%, a forward dividend yield of 3.38% and a return on equity of 32.35% on June 30.

A Brand in Trouble

Despite its robust financial health, McDonalds still looks like a brand that is in a lot of trouble. A chain that has an almost legendary reputation for retaining diner loyalty is losing customers at a staggering rate.

Think about it. This way if McDonalds loses 2.2% of its customers a month for 10 months, that would be 22% of its market gone. Those that do not think this is realistic should take a look at the revenue figures: McDonald’s lost almost 10% of its revenue in a year.

So what is going on here? Why is this once mighty brand in so much trouble? A brief look at how brands die can tell us and, more importantly, show us how McDonald’s could be turned around.

How Brands Die

Brands die from many different causes, some of which can be very hard to diagnose.

One common malady that often proves fatal is plain old fashioned mismanagement. This seems to be the case at Sears and Kmart, where our friend Eddie Lampert has succeeded in destroying two great American brands. McDonald’s seems to be very well managed, so this is not the cause of its affliction.

A more likely cause of McDonald’s troubles is a fast-changing business environment that the chain is having a hard time adapting to. The current level of competition McDonald’s faces in the American fast food market is absolutely staggering. In addition to historic rivals like Burger King and Wendy’s (NASDAQ: WEN), it faces the rise of better-burger outlets such as Shake Shack (NYSE: SHAK) and high quality quick service restaurants led by Chipotle Mexican Grill (NYSE: CMG). Another long-time rival, Yum Brands’ (NYSE: YUM) Taco Bell is making a strong push for lower-income diners.

There are more chains competing for the customers’ dollar at a time when the average American has less money in his or her wallet. Real average wages of young college graduates, those most likely to buy fast food, have been falling since 2000, the Economic Policy Institute noted. The Institute also found that wages for lower income people, another key market for McDonald’s, have fallen by 5% in the last 35 years.

McDonald’s seems to be a victim of growing income inequality. The fastest-growing segment of fast food is chains like Shake Shack and Chipotle that cater to more affluent customers. Brands that market to lower income individuals, such as Taco Bell and Popeye’s Louisiana Kitchen (NASDAQ: PLKI), also seem to be holding their own. Popeye’s reported a revenue growth rate of 13.41% on March 31, 2015, yet McDonald’s, which is a solidly middle class brand, is struggling.

Is McDonald’s Business Model Obsolete?

Both customer demands and the basic economics of the market have changed in ways that could make McDonald’s business model obsolete.

McDonald’s business model is built on three assumptions that no longer seem to hold true. Those assumptions are:

1. Its customers will always have a certain level of disposable income available. They will not be rich, but they will always have an extra $5 for a burger. That no longer seems to be true because of income inequality and wage stagnation. Those trends hurt McDonald’s because people with less money to spend are more discriminating; they will think twice before splurging on a quarter pounder.

 

2. Customers will be willing to put up with lower levels of service and quality in exchange for a lower price. Historically, McDonald’s was able to get away with selling fairly low-quality food because it could offer a very low price and fast service. Most customers were willing to put up with this because it fit their lifestyles. This no longer seems to be true, largely because restaurants like Chipotle have raised the bar by selling very high quality food with prices only slightly higher than McDonald’s at a similar level of service.

 

3. Customers will be willing to put up with lower quality and service if we provide certain amenities such as a clean bathroom or a drive through. Like many people, I have dropped into McDonald’s just to use the bathroom. Unfortunately for McDonald’s, there are a lot of other chains with very clean bathrooms and drive through windows out there—some of which serve better food.

As you can see, the challenge facing McDonald’s is a big one. Its business model could be obsolete, and its sales are dropping fast. Not surprisingly, many people will wonder, is McDonald’s still a good investment?

I would not say no. McDonald’s will probably survive; it still has a very strong brand and a lot of cash. Yet it will face a fierce struggle to survive and reinvent itself. That means it is not a good long-term investment, because such reinvention will take a lot of cash.

My opinion is that it will take two or three years or longer to turn McDonald’s around. That means we are likely to see two or three years of declining sales and serious revenue losses before the chain turns around. Investors should stay away because McDonald’s stock price is likely to take a nosedive as management struggles to keep the brand alive.