Market Mad House

In individuals, insanity is rare; but in groups, parties, nations and epochs, it is the rule. Friedrich Nietzsche

The Death Spiral

Is McDonald’s the New Sears?

McDonald’s (NYSE: MCD) and Sears (NASDAQ: SHLD) have far more in common than you might think. Both are great American brands that are suffering from massive revenue losses, bad reputations, lousy management, and collapsing sales.

The difference is that  McDonald’s stock is grossly overpriced; it was trading at $173.39 a share on December 20, 2017. Meanwhile, Sears was fairly honestly priced by the market at $3.87 a share on that day.

Despite the differences in price; Sears and McDonald’s share one attribute steadily and dramatically collapsing revenues. The pattern of revenue collapse at the two companies is eerily similar.

The Revenue Keeps Going Down and Down

McDonald’s reported revenues of $27.96 billion in September 2014. Those revenues fell to $25.64 billion in September 2015; $24.93 billion in September 2016, and $23.51 billion in September 2017. The revenue keeps going down and down despite all of the vaunted turnaround efforts at McDonald’s.

Disturbingly Sears has exhibited a very similar pattern of revenue collapse. Sears reported $33.69 billion in revenues in October 2014; that figure fell to $25.94 billion in October 2015, $23.93 billion in October 2016, and $18.38 billion in October 2017.

The rate of revenue depletion is larger at Sears, but the pattern is the same. It keeps going down and down, no matter what management does. Although there is one key difference at McDonald’s, Mickey D’s still makes money.

Why is McDonald’s still Making Money?

The strange aspect of all this is that McDonald’s is still making a lot of money. McDonald’s reported a net income of $5.687 billion on September 30, 2017, a new high.

Strangely enough, McDonald’s income has recovered in the past year. Mickey D’s reported a net income of $5.057 billion in September 2014; that fell to $4.421 billion in September 2015, rebounded a little to $4.669 billion in September 2016, and jumped to $5.6878 billion in September 2017.

Nor was it just income McDonald’s reported a free cash flow of $1.268 billion on September 30, 2017. The hamburger emporium also reported $2.617 billion in cash and short-term investments and $995.1 million in cash from investments on the same day. That gave it assets of $32.56 billion in assets at the end of third quarter 2017.

My guess is that McDonald’s is still making money because the margins on its products are incredibly low. The company does such a great job of buying materials at a low price, and keeping expenses minimal, that it can squeeze every penny out of every dollar. The danger at McDonald’s is that there are fewer dollars and pennies to squeeze.

McDonald’s is making far Less Money

There is one very frightening figure in McDonald’s earnings report that is reminiscent of Sears: cash from operations. Like Sears, McDonald’s is making far less money from its actual operations.

McDonald’s reported making $7.101 billion in cash from operations in September 2014, that number fell to $6.663 billion in September 2015, fell again to $6.623 billion in September 2016, and plummeted to $5.257 billion in October 2017. If these numbers from ycharts are accurate, McDonald’s is running $1.063 billion worth of cash through its till than it was last year.

The situation is not as a bad as Sears; which has reported negative cash from operations for the past five years. The latest cash from operations figure at Sears was -$1.87 billion, which is horrendous.

The frightening pattern here is shrinking cash from operations. No matter what management does the actual amount of cash coming in shrinks. Sooner or later that will have to affect the income.

Why is McDonald’s Surviving

So what is sustaining McDonald’s, and how is that different from Sears? McDonald’s is surviving because its brand has not been totally destroyed. There are still a lot of people out there who believe in the McDonald’s brand and trust it.

Part of the reason for that is McDonald’s customer satisfaction is easy to maintain all it has to do sell burgers, fries, and soft drinks in a clean restaurant at a low price. The food does not have to be good, or tasty, just cheap. Nor are expenses that high, paying a high-school dropout to mop out the bathroom and flip burgers does not cost that much.

Another reason why McDonald’s is surviving is that it operates a lot of franchises in places where customers’ expectations are very low. That includes market outside North America and parts of the U.S. where people have never tasted a decent hamburger.

This presents a dilemma because all McDonald’s seems to be able to serve is the bottom-level of the market. It retains the cheap customers, those who cannot afford anything other than the dollar menu but loses persons who buy more expensive items.

Is Management Looting McDonald’s?

There is another disturbing similarity between Sears and McDonald’s, management appears to be looting the company. Most of Sears’ problems stem from CEO Eddie Lampert’s attempts to convert the company into fast cash. A similar pattern of events seems to be unfolding at McDonald’s.

A largely unnoticed change under the Golden Arches in the past few years is that management has decided to make 95% of McDonald’s into franchises, Seeking Alpha contributor Keyanoush Razavidinani noted. That move is being taken to generate cash and float and make the franchises more attractive. Management seems to be more interested in selling franchises rather than hamburgers.

The danger from this is that it diminishes corporate control and food quality at a time when diners are demanding higher levels of quality in their meals. A greater threat is that management conducts sales and promotions designed to pump up the brand and sell franchises. Examples of this include “breakfast all day” and “quality burgers.”

This ruins franchisee relations because management effectively pushes the costs of its promotions onto the franchisees. The franchisees get hit with lower sales and higher operating costs while the franchise salespeople at corporate rake in the money.

Another similarity to Sears is a focus on real estate at McDonald’s. Lampert famously spun a large portion of Sears’ properties off into a real estate investment trust (REIT) called Seritage Growth Properties (NYSE: SRG). Lampert did that to make it easier to mortgage those properties.

One way management uses real estate to pillage a company is to borrow against real estate. Management takes the equity of the company’s real estate by mortgaging it.

McDonald’s is building a Mountain of Debt

That seems to be happening, Razavidinani calculated that McDonald’s has tripled its fixed debt in the United States since 2014, and doubled its fixed debts in Europe between 2014 and 2016. Since those debts are mortgages, the similarities with Sears are frightening.

McDonald’s has accumulated a lot of debt, it had $36.04 billion in total liabilities and $28.62 billion in long-term debt on September 30, 2017. Those liabilities have grown dramatically, McDonald’s reported $22.39 billion in liabilities in September 2014, that increased to $24.65 billion in September 2015, $34.11 billion in September 2016, and $36.04 billion in September 2017.

Since revenues are falling, one has to wonder how McDonald’s will pay those debts off. A disturbing conclusion to make here is that much of McDonald’s income is financed with cheap debt, and efforts like breakfast all day, automated kiosks, and quality burgers are being financed with borrowing rather than sales growth.

Obviously, that is not sustainable but it might last a long time at McDonald’s because of the extra cash the company can tap. There is a strong possibility that McDonald’s management will destroy the company’s reputation and brand with lousy customer service much like Lampert did at Sears.

McDonalds and Sears are Horrendous Stocks

There is one final similarity between McDonalds and Sears, both are horrendous stocks.

McDonald’s stockholders were punished with a negative return on equity of -250.8% on 30 September 2017; that means they lost 250.1% of their investment. Sears delivered a return on equity of 31.87% on October 31, 2017, but only because its share price was abysmal $3.83 a share on 16 December 2017.

This makes Sears and McDonald’s the opposite of value investments, because you will lose money with them. Stay away from Sears and McDonalds they are great American brands doomed by greedy and perhaps incompetent management.