Will McDonald’s Buy The Farm Or Bet The Farm?

Summary

McDonald’s Corporation is the consumption veneer of the United States farm and food economy, champion of a populist right to inexpensive food that confuses low prices with food security.

Because of its iconic status, McDonald’s is the canary in the coal mine for the entire United States food industry.

McDonald’s has profited for many decades from government agriculture subsidies, anachronistic water law, and concealed external food production costs.

Environmental stress, water supply trends, and drought threaten the beef and corn belts of the Midwest on which McDonald’s depends.

If McDonald’s does not want to buy the farm, the company must bet the farm on radically new principles and policies involving food technology, resource accountability, and human capital.

McDonald’s Corporation (NYSE:MCD) again reported miserable quarterly financials in October, with revenue and earnings both disappointing. Company management and various pundits, looking for proximate causes amenable to tactical management and sound-bite journalism, have assigned responsibility for the dreadful performance to the China beef scandalmillennial disinterest“fast casual” competition, and the old familiars, menu creep and confused leadership.

Unfortunately, these events and trends are epiphenomenal, emanations of structural and long-term forces that more deeply, persistently, and unavoidably threaten the future of McDonald’s, not simply its revenue or earnings, but its entire business. And not simply its business, but the culture of food consumption created and sustained by McDonald’s in the past half-century.

The Canary in the Coal Mine

Let’s call McDonald’s the canary in the coal mine for the entire United States food industry. And let’s identify what ails this canary by scoping out its flight path, comparing the 10-year performance of McDonald’s stock to the performance of the S&P 500 ETF (NYSEARCA:SPY) and a peer benchmark, the Vanguard Consumer Staples index fund (MUTF:VCSAX).

  • McDonald’s stock dramatically outperformed SPY and VCSAX through most of the past decade (2005-2014), with a total return of 301%, nearly three times the return of the S&P.
  • McDonald’s market performance was especially impressive in the first seven years of this period (2005-2011), when it handled the Great Recession like a speed bump and returned 283%, while SPY returned only 20% and VCSAX yielded just 72%.
  • In the past three years (2012-2014), however, McDonald’s stock has vastly underperformed the S&P, with a return in this period of only 6%, compared to a 69% return for SPY and a 61% return for VCSAX.

MCD Total Return Price ChartMCD Total Return Price Chart

What accounts for this dramatic reversal in the market performance of McDonald’s since the beginning of 2012? And if McDonald’s is a canary in the coal mine, what does its unhealthy performance relative to the S&P 500 in the last three years tell us about longer-term challenges the U.S. food industry may experience going forward?

Peremptory review of basic financial trends indicates that in the first seven years of the past decade, McDonald’s net income generally tracked the upward curve of the company’s market capitalization, while also growing more rapidly than revenue. Producer beef prices helpfully lagged behind net income and revenue through this period. Metrics stacked perfectly, as in a Bacon Double Cheeseburger.

MCD Market Cap Chart

These relationships have reversed since 2012, however, with beef prices unhelpfully escalating far more rapidly than the market cap, net income, and revenue. Net income has turned sharply downward, and presently underperforms revenue growth. The financials are a fast food mess.

MCD Market Cap Chart

As with sound bite explanations, however, numbers may conceal more than they reveal. Indeed, one might surmise that by stripping the sheen from the McDonald’s share price, financial markets themselves are sussing out future expectations that, by definition, are difficult to demonstrate or quantify.

And so while the financials certainly are illustrative and suggestive, and a good starting point for further inquiry, particularly with regard to beef prices and food costs, generally, a deep dive into them may not serve our purposes. We don’t want to thresh the weeds. Understanding the meaning of the McDonald’s market struggles requires us to focus on the global forces bearing down on the company’s business, and to deduce their impact and meaning, not simply for McDonald’s but for the food industry and the food culture in the United States.

Where’s the Beef?

The 12-month calf-to-kill life cycle for beef cattle illustrates the general trends toward both time compression (life-cycle velocity) and industrial and geographic concentration in the beef industry, where beef cattle destined for slaughter move progressively closer to the heartland of the nation, the windy plain stretching from Texas to the Dakotas, within a food processing matrix of successively larger, more industrialized, and more punitive factory environments.

Early in their short lives, most beef cattle forage on private ranches and public lands spanning a good portion of the nation. When cattle hit 500 pounds, they are typically removed from their pasture of origin and transported by truck for “finishing” to grassless feedlots, with the largest of these feedlots, and the highest numbers of them, concentrated in Texas, Kansas, and Nebraska.

In 1969, famed animal science and husbandry professor L.S. Pope had predicted (with apparently papal infallibility) that a geographically confined “beef belt” would in ensuing decades tighten across the southern and central Plains of the United States, converging orthogonally with the nation’s “corn belt”.

And this belt-tightening did occur as Pope foresaw.

In 1974, the dawn of the modern, or industrial, agricultural era, Texas, Kansas, and Nebraska accounted for 38% of feedlot cattle sales nationally. By 2012, these states had truly become the pivot point for the beef economy, staging more than 60% of all cattle delivered to slaughterhouses for dispatch and disassembly.

Over this same period of time, 15 contiguous or nearby states (including Arizona, California, Illinois, Iowa, South Dakota, Michigan, Minnesota, Missouri, Montana, Nevada, New Mexico, North Dakota, Ohio, Utah, and Wyoming) saw their share of feedlot sales plunge from 46% in 1974 to only 22% in 2012.

Corned Beef

As Michael Pollan has emphasized, when we eat beef, we are really eating corn. Vast amounts of corn. Beef cattle destined for slaughter consume as much as 32 pounds of corn-based feed each day (or about 2,000 pounds of feed during their pre-mortem feedlot sojourn).

To meet the demand for animal feed (and the production requirements of ethanol mandates), corn acreage harvested for grain leaped 45% between 1974 and 2012 (from 60 million acres to 87 million acres). States leading the charge included Texas, Kansas, Nebraska, South Dakota, Minnesota, and Wisconsin. So while beef production consolidated in the narrow corridor angling from north Texas through western Kansas and eastern Nebraska, the waist of the corn belt has stretched west into the dry High Plains states, aligned precisely with the High Plains Ogallala Aquifer.


[How to read this map: Data derives from USDA census and survey data for each US county. Yellow columns = corn crop in 1988. Green columns = corn crop in 2013. Red columns = beef cattle in feedlots in 2012. Flat circles and splotches = areas of corn irrigation. Trends = Corn belt expanding, pushing west, south, and north into dryer land that requires groundwater irrigation. Beef cattle feedlots concentrate in the High Plains, with codependent relationship on groundwater irrigation and corn production in this region of the country.]

Production of corn on the scale required to support the markets for both ethanol and feed requires enormous inputs of water (corn is both thirsty and drought-sensitive). Here’s where it gets tough for McDonald’s. Beef is not a growth industry to begin with (nor, for that matter, is ethanol). But the High Plains corned beef nexus highlights the degree to which water shortages will squeeze almost every part of the McDonald’s business model, which is ludicrously dependent on corn-based, heavily processed food products. And this gets to the heart of the matter, because McDonald’s beef dependence is only the most visible dimension of its corn dependence, which is ultimately its water dependence.

The View from the Sky

Iowa and Illinois receive quite a bit of rain, and surface water provides almost all of the moisture needs for corn. Not so on the High Plains, where farmers have increasingly depended on groundwater pumped from the Ogallala Aquiferto nourish, domesticate, and overindulge their corn crop.

The insatiable demand for groundwater has led to the spread of center pivot irrigation systems, a cloned army of engineered water sucking and distribution soldiers tracing eerily beautiful half-mile and one-mile radius crop circles that span the windy plain extending from Texas up to North Dakota.

The Ogallala Aquifer is one of the largest groundwater reservoirs in the world. However, drought – a term that never once appears in McDonald’s SEC filings – now implacably encroaches upon the agricultural belt, alongside water use practices draining so much water from the Ogallala that the aquifer’s future is presently in doubt.

Groundwater Irrigation, Water Rights, and the Obfuscation of Reality

What does drought mean for McDonald’s? Well, that partly depends on whether you think it matters if beef disappears from its restaurant’s menus. It could happen. Because producing beef requires enormously large volumes of water at every stage of the supply chain – from the dependence on vast quantities of corn used to feed cattle (directly and from ethanol byproducts), to water used directly in the feedlots and slaughter houses.

Producing one pound of boneless beef requires about 1,850 gallons of water. In 2013, American meat companies packaged 25.5 billion pounds of beef. At 1,850 gallons per pound, the water volume supporting this production level totals out to more than 47 trillion gallons of water. Given what we know about water usage aggregates in the United States, the actual number may well be smaller, but probably not enormously smaller. In the context of climate change and drought, the water usage exponent is the concern, not the actual number, and so we need to grasp the meaning of animal husbandry water waste conceptually, not mathematically.

How much water is 47 trillion gallons? Well, it represents one-third of all water used annually for any purpose in the United States (as of 2005), and is roughly equivalent to the total amount of water used for crop irrigation purposes in the United States (other water inputs besides irrigation contribute to beef cattle production, so the numbers for beef cattle and crop irrigation are not coterminous). Remarkably, power-plant cooling requirements account for nearly half of all water use in the United States, and combined with irrigation accounts for 80 percent of all water use.

So drought and beef cattle production do not work well together. With droughts (and generally more extreme climate conditions) in recent years, cattle herds have gotten smaller, water has gotten more expensive, cattle feed has gotten more expensive, and the price of beef has skyrocketed, increasing 140% since 2010 and 70% since 2012.

McDonald’s, its suppliers, and its competitors have all benefited for decades from agricultural subsidies that have artificially deflated food prices and made possible the creation of that uniquely American phenomenon – fast food – and that uniquely American expectation – inexpensive food (Americans spend 6.4 percent of disposable income on food compared to 10 percent in the United Kingdom, 24 percent in Mexico, and 48 percent in India).

For illustrative purposes, let’s mention in passing a few of the more insidious consequences of our dependence on subsidized corn, each of which results from religious conviction about our inalienable right to inexpensive, processed food (which is not the same as the right to food security).

  • Obesity. Americans are fat, and they are fattest in populations that maintain a fast food diet (sometimes because they can afford no other). Like cattle, however, humans are not designed to subsist on corn alone. McDonald’s cannot evade its responsibility for the obesity debacle.
  • Gulf of Mexico Dead Zone. Nitrates and phosphates from crop fertilizer pour into the Gulf of Mexico, supporting a nutrient-rich, liquid monoculture of hypoxiating algae that leach oxygen and light from the Gulf’s depths and destroy all other marine life.
  • Crop Rotation. Food security requires biological diversity. Plain and simple. Distended corn production incentives threaten to overwhelm even the simplest rules of agricultural sustainability: rotate your crops, minimize soil tillage, avoid chemical fertilizers and pesticides.

However, nowhere are agricultural subsidies more disruptive, than with water rights. Consider some facts about the Ogallala Aquifer, the nation’s largest groundwater resource, lying beneath 8 Great Plains states encompassing 174,000 square miles, and the major source of water throughout the Western Plains.

  • Irrigation. The Ogallala feeds streams and rivers once known as The Ladder of Rivers, which made trade and travel possible for centuries prior to the arrival of European settlers. But the Ogallala also now waters 30% of U.S. irrigated crops and, since irrigation of this region commenced in the 1940s, hundreds of miles of these streams and rivers have dried up. Large parts of central Kansas and north Texas no longer have enough aquifer water to sustain irrigation. With current withdrawal rates, 69% of the aquifer’s water will be gone in 50 years. While the Ogallala recharges at less than ½ inch per year, in Kansas, irrigators can pump 40 times that amount.
  • Corn. Irrigated corn accounts for the largest water use in the aquifer region. In parts of Texas, this amounts to 22 inches of irrigation water each growing season. The government subsidizes corn farmers regardless of whether they live in Iowa, where it rains enough to grow it, or in western Kansas, where it must be irrigated. One-half of the nation’s corn becomes feed for livestock and feedstock for food ingredients such as high fructose corn syrup. Ethanol accounts for another 35%. Along with recent cycles of drought on the High Plains, ethanol mandates have created enormous volatility in corn prices and caused the nation’s corn acreage to expand by 20%.

The Bottom Line. The End of the Road. The Looming Storm. The Dust in our Burgers.

McDonald’s is literally the consumption veneer of the United States farm economy. Because we subsidize this consumption, to the degree that inexpensive food has become an end in itself, a religion masking as a right, McDonald’s is hoisted on its own petard. I have made this point. And so have other analysts. McDonald’s is so iconic that it cannot adapt to new realities except on the margins of its business. The company cannot appreciably raise prices and hike margins in order to reduce consumption. The company also cannot do a lot, at least in the short term, to shift consumer preferences away from beef, because it’s brand, quite simply, is cheap beef.

Americans consume more than one billion pounds of beef at McDonald’s each year. Producing a pound of boneless beef requires about 5.3 pounds of shelled corn (11 pounds of beef per bushel of corn). When one factors in other corn-based foods and beverages on the McDonald’s menu (corn appears 220 timesin the list of menu ingredients), we can safely assume that its food and beverage sales annually account for at least 200 million to 300 million bushels of corn, or about 3-4 percent of domestic production.

So when the next drought or water shortage occurs (and the next, and the next after that), and radical shortages of its feedstock emerge, and prices of these raw materials skyrocket, we will witness, like a flash flood sweeping through our drought-parched canyon, food costs skyrocketing to account for all of the concealed costs within those 300 billion hamburgers it has sold, the existence of which we’ve previously denied. In this moment of “cost flooding,” McDonald’s will simply writhe helplessly, perhaps temporarily shifting some burden of pain to its franchises, or to its customers, but surely and inevitably shrinking and contracting like the aquifers on which it depends.

For these reasons, from an investor standpoint, one cannot help but wonder if McDonald’s days are numbered. It doesn’t even matter if the company’s nutritional transparency and sustainable beef initiatives are legitimate. They represent efforts to spit into the wind. The company is simply, structurally and existentially, committed to the existing corned beef economy. But the corned beef economy is a gigantic sinkhole. Like Martin Luther, McDonald’s is at a Here I Stand, I Can Do No Other moment. Until the sinkhole opens.

While McDonald’s may tip at the brink of eternity to a greater degree than other restaurants, food processors, and grocers, please recall the canary in the coal mine metaphor. The entire food industry (beverages, confectioners, farm products, food distribution, grocery stores, restaurants, and packaged foods), with annual revenues exceeding $800 billion, lives on corn, and while there is clearly a high-end market for artisanal, organic, and local foods, the vast preponderance of food industry revenue derives from inexpensive food supported government subsidies at the base of the food chain, as well as processing and logistical efficiencies designed to maximize caloric and carbohydrate intake (otherwise known as energy density). If McDonald’s continues to suffer, it seems unlikely that even the Chipotles (NYSE:CMG) and Wal-Marts (NYSE:WMT) of the world will not require radical business model makeovers.

Food Security Survival Solutions for the 21st Century. Krill Anyone?

There is no fudging the crisis facing McDonald’s. That this crisis may play out over a relatively long period of time – perhaps 2 or 3 decades – in no way diminishes its alarming severity. The logic is simply ineluctable, the stakes vast.

Nonetheless, if I were McDonald’s CEO Don Thompson, I could imagine several strategic commitments that might help the company to sufficiently reinvent itself that it might survive the storm.

  • Nutritional Transparency and Beef Sustainability. I would ditch both of these fine-sound, but expensive and time-wasting initiatives. They are red herrings. McDonald’s customers don’t need nutritional transparency. They need nutritious food. And beef sustainability initiatives have already shown themselves to be extended and fruitless exercises in devising beef management “principles” that sound good in an executive summary or press release, but for that reason alone will never make any meaningful difference in addressing the looming global meat catastrophe. The humans (and livestock) of the world don’t need sustainable meat. They need less meat, better meat, healthier meat, more expensive meat.
  • Technology. If McDonald’s truly wanted to race ahead of the field and use its vast influence to lead the food industry into a future we can all imagine wanting to inhabit, I would also require the company to invest in technology. I would insist McDonald’s bet the farm on technology. And what would be the technology on which we would bet the farm? Micronutrients at the base of the food chain – found in seaweed, krill, algae, and insects – represent the next exciting frontier in food technology (sometimes known as third millennium farming). Synthetic (or in vitro) meat and liquid nutritional diets of the sort developed by Soylent also present exciting opportunities to reinvent the human food chain while retaining some of the convenience, and perhaps even some of the same taste sensations, of existing fast food establishments.
  • Resource Accountability. McDonald’s can only survive if it leads, and can only lead if it is honest about the most important existential issue it faces, which is that food is presently vastly oversubsidized, that hidden external costs of food are identical to the hidden external costs of fossil fuels, and that food security ultimately will depend upon a rigorous accounting of these costs, which include massive environmental, nutritional, and human capital deficits.
  • Real Estate and Renewable Energy. McDonald’s can also embrace the future by far more aggressively leveraging the massively profitable real estate portion of its business (you didn’t think franchise owners get to lease the restaurant properties for free, did you?) to generate renewable solar and wind power. McDonald’s can also wield its enormous influence among agricultural producers and policymakers to promote innovative use of farmland for siting renewable energy installations and for using that power to promote innovative agricultural R&D and production environments. McDonald’s can also actively and publicly lean on producers to incorporate the most advanced, environmentally responsible soil and water management farming methods (one example being the STRIPS perennial prairie plants “polyculture” approach).
  • Human Capital and Finance Capital. Finally, I would strip the current shareholder appeasement strategy of stock buybacks and unsustainable dividends (given current payout ratios). To be blunt, shareholders of all major corporations need to get over themselves (I’m talking to you, Carl Icahn). McDonald’s can lead best if it commits itself to its employees, provisioning a living wage, meaningful health insurance, and jobs that matter; sponsoring programs that educate and inspire young people to embrace a new food economy and culture; and generally making human capital investments the company’s highest investment priority.

 

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