McDonald's latest image brings home the bacon

U.S. comparable store sales climbed 8.8 per cent in August, the fifth consecutive monthly increase, giving the company the confidence two weeks ago to announce a 70-per-cent increase in its dividend. The annual payout will rise to 40 cents a share from 23.5 cents, a sum that amounts to $500-million a year.

The Globe and Mail
October 9, 2003

McDonald's latest image brings home the bacon
Change in corporate strategy makes shares more attractive again
Oliver Bertin

By the middle of last year, McDonald's Corp. was in trouble. Consumers were shying away, sales were falling and the company was heading toward the first quarterly loss in its history.

The shine had gone off hamburgers and McDonald's had no suitable replacement. Gourmet coffee chains were drawing away the all-important impulse buyer, while in Canada, Tim Hortons sailed past the hamburger chain when it added soups and sandwiches to its coffee and doughnuts formula.
Investors fled McDonald's and the stock tumbled from $30 (U.S.) to the $12 range on the New York Stock Exchange, one-quarter of its value in late 1999. It was clearly time for drastic medicine.

Jack Greenberg, McDonald's chairman and chief executive officer, left the company. Jim Cantalupo was brought out of retirement to take his place, and he embarked on a thorough overhaul of the restaurant chain, a process he estimated would take 12 to 18 months.

Mr. Cantalupo quickly abandoned deep-discount pricing. He threw out Mr. Greenberg's pet project, customized meals, and he cut McDonald's dependence on low-cost hamburgers — a core product for two generations. Instead, he returned to basics with better-quality food, better service and better value.

"The world has changed. Our customers have changed. We have to change, too," Mr. Cantalupo said at the time.

He strengthened the core youth market with the introduction of improved Happy Meals and hired teenage heartthrob Justin Timberlake to promote them. These products have proved so popular they already account for 18 per cent of sales, according to analyst Larry Miller of Prudential Equity Group Inc.

Mr. Cantalupo attracted a broader clientele with healthier meals, New Orleans-style restaurants and McCafé coffee bars, products that would appeal to adults while heading off the competition from gourmet coffee bars and sandwich shops.

There was another reason to move the customer demographics up the age scale. Mark Wiltamuth of Morgan Stanley & Co. Inc. noted that adults typically spend $8 on a salad meal, twice as much as kids spend on hamburgers.

Mr. Cantalupo replaced a host of executives, closed hundreds of lacklustre restaurants, pulled out of seven countries and restructured operations, invoking a huge writedown. He slashed the company's expansion budget and used the savings to reduce debt by $400-million. He also trimmed the company's profit and sales growth targets to more conservative levels.

"We will grow by becoming better, not just bigger," he said.

To the surprise of many analysts familiar with the company, Mr. Cantalupo's strategy seems to be working.

U.S. comparable store sales — a key industry measure — climbed 8.8 per cent in August, the fifth consecutive monthly increase, giving the company the confidence two weeks ago to announce a 70-per-cent increase in its dividend. The annual payout will rise to 40 cents a share from 23.5 cents, a sum that amounts to $500-million a year.

The new dividend reassured investors that McDonald's was truly on the road to recovery, and helped to shoot the stock that day to a 52-week high of $24.37, twice its level of last spring.

"Given that the company is in the first stages of a turnaround, we did not expect an increase of this magnitude," Janice Meyer of Credit Suisse First Boston LLC said in a research report the day the dividend increase was announced. "The U.S. business has been stronger than projected."

"We continue to like the shares," she said, adding that she rates the stock as "outperform."

"In our view, the U.S. business should continue to be strong, allowing for modest upside still to the shares."

She has a 12-month target price of $25, slightly above yesterday's close of $24.15, down 57 cents. A 52-week high of 24.87 was set Tuesday. She expects profit per share to rise to $1.36 this year and $1.45 in 2004 from $1.32 in 2002 — in line with forecasts from other analysts surveyed by Bloomberg.

Ms. Meyer also pointed to McDonald's favourable price-to-earnings ratio, saying it is expected to fall to 17.6 in 2003 and 16.5 in 2004 from 18.1 in 2002. That would make McDonald's a bargain compared with the industry average of about 20.9.

Prudential's Mr. Miller had breakfast with Mr. Cantalupo after the dividend announcement, and was impressed with his performance.

"We came away from the meeting with greater confidence in this turnaround story, believing management gets it," he said. "In fact, we think the turnaround is progressing much faster than most, including us, expected."

He checked a number of key measures in the restaurant industry, and all were optimistic. Traffic is increasing and consumers are spending more at each visit. More important, sales of traditional core products are rising at comparable restaurants. These are important indicators for analysts, who have worried for years that McDonald's was boosting its sales by continually launching new products and opening new stores.

"We have greater confidence in the company's ability to rebuild margins and unleash its significant [profit-per-share] power," Mr. Miller concluded, rating McDonald's stock as "overweight" with a target price of $34.

Mr. Wiltamuth of Morgan Stanley attended the same breakfast, but was more cautious in his projections. He has a "neutral" recommendation on the stock with a target price of $23. He is leery of the fast-food industry because of the weak U.S. economy, tough competition and low consumer confidence. Mr. Wiltamuth also suspects that shareholders may take their profits before the seasonal decline in sales this winter.

"In our opinion, MCD shares are already pricing in the earnings recovery," he said. "Accordingly, we advise investors to remain disciplined."

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