McDonald’s: Advance Directly to Go

Posted on May 11, 2016 by Travis Lane

Two mornings of every week, I pull into my local McDonald’s and order the same thing: an Egg White Delight McMuffin meal with an iced tea and a Fruit ‘N Yogurt Parfait. Not a bad breakfast healthwise – the whole thing is 550 calories including a hashbrown (the worst offender) – and it clocks in at $5.79 for a tasty, mostly health-conscious breakfast a couple times a week. But for the past few weeks, I’ve been getting a bonus with my meal. Along with my balanced breakfast, I’ve been racking up a lot of – you guessed it – McDonald’s Monopoly pieces.

On the breakfast bags, McDonald’s claims there are “100 million food and cash prizes!” Note that according to what they’ve posted on their rules website including odds of winning, they’ve actually undersold it quite a bit. According to their posted rules, there are actually 131,907,433 winners (132 million vs. 100 million), with a total prize value of a staggering $353,480,757.77. Yes, three-hundred and fifty-three MILLION dollars. See the results spread below:

Aha, now you see why this is relevant to corporate finance. McDonald’s is a big company, but $350M is a significant amount of money for most businesses, even ones of good size. In these lessons, part of my goal is to emphasize that finance and accounting can be both useful for answering questions about what businesses do and interesting in the kinds of things you can uncover with it. Let’s see what else we can learn about McDonald’s longest running and best-known promotion.

Monopoly, like the infamous McRib, seems to be deployed when needed or convenient throughout the year rather than consistently on a set schedule. In 2013, it ran in July, in 2014, October, and in 2016, April. In 2015 Monopoly wasn’t run at all in favor of a November cross-promotion with the NFL called Game Time Gold, which for convenience I assumed utilized a similar payout structure. This makes it a little bit hard to see in the financials exactly how the major promotions affect earnings, but we’ll do our best to try. Side note: if you happen to know where I can find historical Monopoly runtimes, hit me up, I’d like to expand the range of my data and apparently my Google Fu isn’t strong enough.

The chart below shows revenues, operating income, and operating margin for quarters before, after, and including these promotions (yellow). Let’s check out the results and discuss them below.

Alright so, McDonald’s was having a tough time in 2014 and 2015. What we see in 2014 is pretty dire – the trend across these three quarters is almost linearly downward. But how does the Monopoly promotion affect its quarter? Well… it doesn’t look like it does. Yeah, it’s down from the previous quarter, but it’s right between that one and the next one on all three parameters – sales, earnings, and margin. In other words, at worst, it did nothing, but at best, it arrested a trending loss of revenue and earnings that was realized in the following quarter. Big promotions weren’t a major enough factor to overcome other trends, positively or negatively.

2013, however, was an absolutely beautiful comparison. The quarters before and after Monopoly ran were practically identical on all three components. The quarter that Monopoly ran in showed over 3% gains in revenue and a 10% upside in earnings, making for a 2% boon to operating margin.

Now, for any of these quarters, how much impact would $350M of free food have? I took the simple average of these 8 quarters for revenue and operating income, calculated a margin, and then hacked $350M off of operating income to represent giving away that amount of free food with no additional revenue. The results:

If there wasn’t some positive impact to the numbers, the Monopoly prizes would absolutely hammer earnings, with operating margin diving nearly 20%. It’s probably not surprising to anyone, but McDonald’s is not losing money on its promotions. At the very least, it’s not losing as much as it should be without secondary positive effects. You’d also expect them to not run it for 20 years unless there was a benefit. Case in point, how does the company view the game? The 2013-Q3 report mentions Monopoly specifically. Well, for a sentence anyway. All we get from the company in the quarterly report is, “Sales results for the quarter were also positively impacted by the popular Monopoly promotion.” If there wasn’t some level of offset against the free stuff they gave away, you’d expect some statement like, “Operating income is down this quarter as we gave away $350M worth of free food during our Monopoly promotion in order to… I dunno, build brand value or inspire return customers or something.”

So why does a promotion that puts $353M worth of prizes in circulation (99% of it in free food) appear to make the company money, or at least, not lose as much as it should? Several factors may be at play here:

Not all of the winning tickets are actually bought, or looked at, or recognized. Boardwalk is famous, but what are the other rare pieces? Would you know them if you got them? (Helpful hint: it’s the last piece of each set alphabetically, except for Boardwalk)

A small percentage of the food prizes are actually claimed.

The food prizes, even when claimed, are an excuse to spend even more money.

Unclaimed Monopoly winners is a non-factor; the total amount of available cash prizes from collecting pieces is less than $2M, which for McDonald’s really is a drop in the bucket. The last two are probably significant, but I suspect the last one is the real cause of the difference between claimed prize cost and actual financial results. If you win a Quarter Pounder, you’re not going to just go in and get one. You’re going to go in and spend the same amount of money that you usually do, plus a “free” Quarter Pounder. You’re not going to eat that Quarter Pounder without a Coke right? And of course you wouldn’t go to McD’s without getting some hot, salty fries. And since you saved money on the burger, why not top it off with a McFlurry? Most of the loss of the “free” items is probably entirely compensated by additional purchases when people cash in winning food tickets, resulting in straight upside for the company. After all, look how abysmal the odds and total amounts of the cash prizes are, and how prevalent the food prizes are. The tiny chance of winning cold hard cash brings you in the doors, but then if you win food, you’ll come back and buy more. To borrow Monopoly parlance, by giving free food away, McDonald’s rolled doubles and gets to take another turn. This is why in the more ideal 2013 comparison, and in the Q3 results, the benefit of Monopoly is seen: increased revenue, without impacting margins.

Now, make what you will of this. Just because a company is making more money doesn’t mean they’re doing something evil. In the sometimes idealistic world of MBA-land, “marketing” isn’t akin to “manipulation,” it’s responding to markets and giving people what they want, often in what we might call mutually beneficial ways. After all, it’s not like McDonald’s is selling lottery tickets here; you’re not getting vague, conceptual “hope” and nothing else for your money. You still get your food for the same price as before, plus the added fun of peeling off and collecting game pieces. An economic description might say that you give McDonald’s more of your money during promotions like Monopoly because you get added value for the same price, shifting the value proposition in favor of the customer, or generating additional consumer surplus. I could throw more terms at you but you get the picture. Of course this works in McDonald’s favor too, since they enjoy added revenues and profits.

Let’s quickly look at another great example of this mutually beneficial marketing from the fast food realm. First, let’s think about the busy-ness level (volume) of a typical fast food restaurant. Well, there’s probably a breakfast crowd, peaking maybe 7:00-9:00 a.m., a lunch crowd between, say, 11:00 a.m. – 1:00 p.m., and a dinner crowd between 5:00-7:00 p.m. This is rough guesswork, but it’s reasonably accurate for general purposes.

It’s easy to spot the downtimes. Downtimes are problems, especially for a low-margin, high-volume business like fast food. There are lots of financial reasons for this. For one, fixed assets like buildings and utilities are sitting underutilized when they could be making money. Inventory isn’t turning over (insert burger flipping joke) and making money, it’s just sitting. And even though you can maybe staff less during downtimes, if you’re open for business you’ve likely got someone being paid to twiddle their thumbs. All told, it would be better to be able to fill those gaps. But we’re not really going to inspire people to eat a fourth meal… what could we do?

Cue Sonic’s Happy Hour promotion. From 2:00-4:00 p.m.,　 customers get half-price drinks. To sample the efficacy of this idea, drive down the street and look at how busy the fast food places are at 2:00 p.m. Then pull into Sonic. With a little creativity, Sonic has filled a huge gap in their daily productivity. And by doing it with drinks, which are probably 90% profit to begin with, they’re bringing in material additional revenue and earnings, not just utilizing fixed assets to keep them moving. Add in the fact that people coming to Sonic for drinks will be tempted to get a snack, and you’ve effectively created that elusive 4^th meal (sorry, Taco Bell, we didn’t buy your midnight 4^th meal). Sonic made this temptation even more palpable in 2013 when they added $0.99 snacks to Happy Hour. And they didn’t stop there… Sonic has another promotion so customers get half-price shakes after 8:00 p.m. What a coincidence that this time also corresponds with a slowdown between dinner and closing. It usually only runs in the summer too, when more people are likely to be out later due to nice weather, daylight savings time, and school breaks, and are more likely to want a cold milkshake to battle the heat or finish off a summer date night. I’m not getting kickback from Sonic on this, it’s just freaking brilliant how seamlessly they implemented these business catalysts. And they did it in a way that people love!

What’s the takeaway from this? Well shoot, I just wanted to learn how McDonald’s fares on Monopoly. But maybe I can drum up something…

There’s a lot of negativity in the modern zeitgeist regarding corporate profits, sales, marketing, and business in general. Yes, there are sleazy or cheap methods of selling. Overhyping, fearmongering, clickbait headlines, sexual content, proprietary ecosystems (critique of Apple), and fine-print restrictions are all ways for companies to manipulate consumers by legally getting away with outright lying or by artfully deceiving the careless. BUT – there are also perfectly honorable and noble ways of selling that benefit the customer and the company. Innovation, beautiful design (praise of Apple), superior value, superior quality, superior support, cool factor, unique utility, and yes, even fun are ways to increase sales and customer participation while simultaneously increasing customer satisfaction.

So, yeah, be skeptical and look out for sleaze. It does exist. You owe it to yourself to learn the bottom-feeder sales and marketing tactics in order to avoid being taken advantage of. But you also should recognize and reward the good side, and if you’re creating a product yourself, implement some of the positive approaches to marketing in order to ethically increase your value.

Alright that’s all I can shoehorn in. Hopefully this has been an interesting look at a couple of things and has given you some things to think about. In the meantime, I’m off to go cash in a free Quarter Pounder piece… and maybe buy a McFlurry to go with it.

Spirit AeroSystems – Q1 2016

Posted on May 11, 2016 by Travis Lane

Hey folks, Spirit announced 2016 first quarter earnings on April 29^th. I had some family business to attend to and was out immediately after the call and most of the following week, so I’m even tardier than usual. I’m going to be fairly brief on the earnings call portion, but don’t worry, you’re not being shortchanged. It was a pretty run-of-the-mill call, and the biggest takeaway for me was Mr. Lawson flexing a bit of his military knowledge regarding the bomber program and its impact for our future. He offered some pretty good insights into the differences between military and commercial programs from a high-level perspective. The “lesson” this quarter is a bit off the beaten path. I assigned myself a little homework project on something I was curious about and thought it might make for an interesting take on business in general. Hope you enjoy. Let’s jump in!

Financial Summary

The numbers here are pretty cut and dry. Revenues were slightly down, because of some seasonal delivery oddities and rate decreases on stuff like 747, but operating income (money made from selling planes after taking out part and labor costs) was up, which is probably indicative of more programs transitioning into a production mode rather than design. In spite of operating income being up, net income was down, which is probably because we’re keeping money sort of “in circulation” to support rate increases and other buildup projects.

The most obvious difference in the high-level financials was free cash flow. My good friend, Spirit analyst George Shapiro, who I love because he always asks super technical financial questions (he seems like he might’ve been an engineer in another life), painted a little clearer picture: after removing a lot of one-time items that were included in Q1 of 2015, the real difference in trending free cash flow is about a $50M downtick. Mr. Kapoor attributes this to “working capital,” which I’ll explain a bit more in the Q&A portion, but is basically just what I said – keeping money warm on the bench and ready to jump into the action when needed instead of sending it to the showers and calling it “free cash.”

Overall, the numbers show a few things. One is a transition into production mode on several programs. One is an increase in investment in future growth (“working capital,” as mentioned, but also an $11M increase in purchases of property, plant, and equipment vs. Q1 of 2015, as shown). And of course, aside from these things, Spirit’s continued improvement in stable, predictable earnings.

Now let’s quickly hear what our leadership had to say, then we’ll jump to analyst Q&A.

Executive Introductions

Larry mentions the A350 deferred inventory improvement. Last quarter we had brought it down to $1.2M per plane. This quarter, it was $400k per plane. It’s really getting to a good point pretty quickly!
He mentioned that during the quarter we achieved “investment grade” credit ratings. To put it in personal terms, it’s sort of like getting your credit score above 800. It might not really make a huge difference in your everyday life, but it’s a good barometer of your performance, and can have some small practical impacts like lower rates if you need to borrow.
Sanjay noted that revenue was weighed down by fewer 737 and 747 deliveries (one seasonal, the other systematic), but was partially compensated by higher A350 and A320 deliveries. It’s kind of an interesting point, because we’re seeing a little bit of transition happening out of the 747 “jumbo” era and into the era of the new lean programs like A350.
Free cash flow was lower because of seasonality (Q1 is kinda slow) and also because of incentive payouts – all those greedy engineers wanting their bonuses 😉
We had a few small, favorable cumulative catchups on mature fuselage programs.

I’ll talk about this a bit more in my commentary on the Q&A portion, but this quarter we get to learn something about how Wall Street operates. By any measure, it was a fine quarter. We met expectations, we delivered on our guidance, and we didn’t have any surprises except a few small positive ones. You would think that would mean the stock price would go up, or at least stay about the same. We actually took a small hit on the day of earnings. Why? Analysts have a bit of an obsession about companies beating expectations. They like it when companies upwardly revise their guidance a couple of times like they’re doing even better than they expected. This can cause companies to issue overly conservative guidance and then positively revise it to stay in favor.

But really, we (and by “we” I mean on a huge scale – not just “we, Spirit” but American business, corporate employees, investors, banks) put a lot of weight on quarterly reports. Quarterlies are a fine snapshot of the health of a business at the most fundamental financial level. Financial reports are important. But some of the culture around these things can get a little silly, like the beat vs. meet expectations and guidance thing we saw this quarter. Last quarter, Lawson’s jab at the analysts was the “9 P/E” thing, where he basically said we’re underpriced and being undersold. Well, this quarter, my jab is that the whole “beating guidance is the new meeting guidance” culture is counterproductive if our goal is to get accurate representations of a business’ finances each quarter. Side thought, if you get frustrated about your manager “raising the bar” on your performance reviews, well, right or wrong, even your CEO isn’t immune to that treatment.

Anyway, I can’t complain too much since I love writing these reports for you fine people, so I’ll leave that at that and hop off my pedestal. To the Q&A!

Q&A

Question: Guidance question – seems based on Q1 that estimates should be higher. What’s the negative drag?
- Sanjay: Rate ramp-ups can be expensive, so we retained some conservatism since we sometimes have to expedite or do extreme things to meet our commitments. Also share repurchases are not included in guidance (could be a positive factor
- Travis: So here’s what I was just ranting about… and it’s not surprising that it’s the first question. We met our estimates for the quarter, so why isn’t our annual forecast better? Mr. Kapoor says, well, we gave you an accurate forecast and here’s proof that we know what we’re talking about. Then he gave some of the factors that went into this quarter’s numbers and some expectation of significant events later in the year. Ah well. You did what you could do, buddy. Quick reminder: we talked about share repurchases in a recent quarter, but keep in mind that if we buy back shares, it means fewer shares to divide things like profits into, meaning higher earnings per share (EPS), all else constant. So there’s potential that our numbers show improvement as the repurchase program kicks in, and Sanjay briefly reminds us of that here.
Question: A350 cost progression looks good. When is break-even expected? Have Airbus delivery delays affected our work?
- Larry: The front end of the line runs faster than the back end (our production goes faster than Airbus’ final assembly). We haven’t seen any slowdown from plan in regards to demand/delivery from our customer. At this point, we’re still very rate sensitive (he mentioned this last time) because each “step” unit is huge on both revenue and utilization of fixed cost. We do pay a little extra early on for expediting cost to react to unknowns early in production. The proof is in the pudding though – look at our deferred curves over the last year
- Travis: Our analysts keep worrying about Airbus getting behind on their deliveries and more or less gumming up the end of the pipeline. And… so far it continues to not be a problem for our production or a concern for our top brass. Mr. Lawson’s answer touches on several financial concepts we’ve talked about before. Notably, it’s all stuff that they mentioned in their executive introductions this quarter. It’s almost like they were smart enough to anticipate what the questions would be. Hm. Larry basically says, again, we’re keeping some extra money in the game to deal with unexpected stuff that can happen, and we’re early enough in the program that single units still matter. Dividing tool, machine, and plant costs by 3 instead of 2 makes a huge incremental difference; dividing by 20 instead of 19 makes much less.
Question: Address the possibility of taking a “step function” in recovering costs. (he’s asking about how we’ve taken relatively small catchups against the big historical losses we’ve taken on some programs).
- Larry: Don’t expect any large changes, especially losses
- Travis: I feel for Mr. Lawson here. A lot of the work Larry and Co. did early on was a clean-sweep on program estimates and costs. This was a bit of a silly question, since we spent like 8 quarters talking about making sure we had everything estimated and accounted properly. I’m going to sound like a fool if we ever have a huge forward loss, but Lawson spent a great deal of time and effort on arrival to level-set the finances of every program. He put great pains into making sure we were going to have smooth numbers going forward. Not to say that he would be able to fix every deficit we ever had, no one would, simply that we would much more firmly know where we actually stand on an ongoing basis rather than constant, major surprises. It seems like the last few quarters that has really come to fruition in the numbers, and now they’re asking him if we’re going to get any happy surprises on writing off former losses! A year ago you were asking for stability, and now that you’ve got it, you want big surprises!
Question: Cash flow Q1-15 vs. Q1-16 when taking corrections into account looks like about a $50M loss – is that correct? Also, the favorable cumulative catch-ups come from what programs?
- Sanjay: A little inventory build-up on 787 and A350, but it’s representative of rampup. So it’s working capital. Also a big impact from incentive payouts. Not really any particular program on cumulative catches
- Travis: It’s a pretty self-explanatory term, but “working capital” basically means money that’s ready to go if something unexpected happens. The technical definition of working capital is “current assets less current liabilities.” In accounting terms, “current” generally means an asset or liability that can be turned within a year. Inventory is typically a current asset, so Sanjay’s answer that we’ve got more inventory and less cash is another accurate way of saying that the money is at work. To use a personal finance metaphor, I increased my “working capital” last year because I expected my air conditioner to go out. Instead of spending or investing that money, I kept it ready to jump into the game because I had some inclination that I would need that money at the ready to respond to needs in the short term. Spirit’s doing the same thing.
Question: Where do we see Tom’s responsibilities focusing and where does that leave you (Larry) focusing?
- Larry: We’re a manufacturing company. And an engineering company, but manufacturing is the biggest thing financially. That means our ability (and efficiency) in meeting delivery commitments is the most critical piece of our business. Tom is going to be in charge of that. Ideally, my meetings start going down when he gets ramped up
- Travis: This question intrigued me. And with all the rumors about Tom Gentile being brought in to be groomed to be Lawson’s replacement (you guys’ rumor mill is funny), it was an interesting question from an analyst. I won’t speculate about Spirit’s leadership plans; part of an executive’s job is ensuring continuity, and they’re people that are allowed to have their own life plans too. But I will expound on Larry’s answer. Basically, we build stuff. The top job managing how we build stuff was open. That’s a huge gap. We brought in someone who we thought was a great fit to manage how we build stuff, so the guy whose job it is to strategize and plan stuff can do that, instead of always managing how we build stuff. Is Tom a future CEO candidate? Eh, sure. But for today, it really is as simple as we had a huge hole in our executive team, and we finally filled it with someone we hope is going to do a great job.
Question: Larry said would be disappointed if we didn’t win some more defense projects longer term. Do you have a target mix for the company in, say, 5 years?
- Larry: I don’t ever really see defense being more than 20% of the company. Especially unless we expanded the things that we do with rate and design and stuff. For it to become a bigger part, we’d have to do some M&A (buy some defense companies and integrate them into Spirit). Attractive M&A companies are ones that have high rate on long-term programs, but military work is an additional bonus. Discussions on Trainer and Unmanned are always in the air, but for us also M&A
- Travis: Suuuuper interesting answer. Ya’ll remember when Lawson signed on as CEO and it seemed like everyone was talking about the company becoming Lockheed 2.0? In this answer, Lawson concretely says his target mix for military-to-commercial is no more than 20:80. What this tells me is that, yeah, he’s got lots of experience and connections with military stuff, but he’s here to advance Spirit within our core competencies, which is designing high quality aircraft and then building a crapload of them. It’s been several years now he’s been our CEO, and this question says a lot for me. When he came on, people seemed worried about the company becoming “Larry Lawson presents Spirit AeroSystems,” but what we’ve seen is still Spirit AeroSystems, shaped by new leadership, but essentially the same core company.
Question: During the quarter, there was some news on aftermarket arrangements with Boeing. What was the arrangement in the past and what will it be going forward?
- Larry: We don’t describe contract terms, but we sold parts and provided services to the market and to Boeing. Now, we’ll sell all the parts to Boeing. Our business will continue. Boeing thinks it can capture some of a growing market, we think it’s just representative growth for a larger fleet with less retirements. I’ve never said “It’s my objective to grow aftermarket.
- Travis: Mr. Lawson pretty much covered it. Boeing thinks they’re getting some great deal on a big growing market segment. Spirit execs just think aftermarket is growing because the overall market is growing. It’d be like investing in iPhone cases when you could just invest in Apple. The overall market drives auxiliary markets; those auxiliary markets rarely grow on their own. Either way, we’re retaining our business in that space with small changes, and it’s not a huge deal in the scope of our portfolio anyway.
Question: On B-21, can you sell analysts/shareholders on why we should be excited about this? It’s low volume, if it goes like other DoD programs it’ll be overbudget, etc.
- Larry: (lightheartedly) Seems to me the defense guys are doing quite well when you look at their share price. First, it doesn’t expose you to losses, so there’s no real commercial risk. Margins aren’t as attractive as what you end up with on the commercial side, but then there’s huge investments you have to make using your own coin on commercial programs. I’ve seen (and run) a lot of big DoD programs. The service has been incredibly disciplined on this one; never seen this level of discipline on defined requirements. What are the benefits though – as I mentioned, I’d be disappointed if it didn’t lead to more future business. It should show that we’re a capable partner for this type of business moving forward. On its own, it’s fine, not huge. Honestly can’t think of negatives unless someone’s thinking of really small margin dilution
- Travis: We saved the best for last. Since Mr. Lawson’s answer was so good, I’m just not gonna add much. Neat to hear the differences between military and commercial highlighted by someone who really knows both markets. Commercial has more risk and more reward, military less. B-21 is cool, but on its own, it’s just okay. Hopefully it’s a starting point to get Spirit into more new and exciting stuff in the future.

Well, I ended up taking more space than I thought I would, so I’m gonna tie it off there. As reflected in the STIP score, it was a good quarter, and we did our part. The stock market may have disagreed, but hey, forget ‘em. We keep doing our thing, and Spirit’s in a great – and improving – position moving forward.

This quarter’s “lesson” was actually born out of a curiosity, rather than inspired by our financials. I often find myself asking questions that I can’t immediately find an answer to, but then think, “Hm, maybe I have the skills to just answer it myself.” It’s not directly Spirit related, but I think it’s well enough in the corporate finance realm that you’ll find it useful for learning, and hopefully just interesting in general.