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“McDonald’s is toasting buns and melting cheese to improve the quality of its Big Mac and other burgers as it looks to boost sales.” – Reuters, Apr 17, 2023.

 

My wife absolutely hates McDonald’s. She says that when she was younger, she had one during her homestay in Australia and got sick and she’s never had one since. I’m pretty sure she just wasn’t feeling very well at the time, but she insists that they are bad for you. Now, I would agree and I can’t say I’m a fan either. I could live out the rest of my life never eating a McDonald’s burger (I would miss the fries, though). However, sometimes, especially after a night out, I get the urge. And it’s unfortunate that there is one conveniently located near my station which I could easily wander into, probably with my mobile coupon in hand, and grab a small late-night snack which I could gobble up during my walk home with enough time to destroy the evidence. Needless to say, my kids love it (don’t all kids?). So, I’d have to wait until my wife was out with her friends when I can sneak them there where we would eat at the restaurant (the unique scent of McDonald’s fries would give it away if we ate at home).
 
However, ever since we watched “The Founder”, my wife came to unconditionally detest McDonald’s after seeing the portrayal of Ray Kroc and how he took over the original McDonald’s. Although I can’t say for certain (since it’s hard to trust anything online anymore), I’ve read that the depiction was fairly accurate (and I thought Michael Keaton did an awesome job). But because of the movie, my wife forbade me to take the kids there anymore; I guess she knew that I had been treating them occasionally. We have since switched to Mos Burger, a Japanese chain which I’ve always thought had much better burgers than McDonald’s but was, pre-pandemic, too pricey, probably because they use domestic ingredients. However, the aggressive price hikes by McDonald’s Japan during the pandemic have moved the prices relatively similar so I’m actually quite fine to switch (except I still miss the fries which is infinitely better at McDonald’s). Also, Mos’ operations are not as refined as McDonald’s so the wait is longer and the store locations tend to be a little inconvenient to reach, all probably reasons why McDonald’s Japan has twice the operating margins as Mos Burger (despite the fact that only 20% of Mos’s 1,300 domestic stores are directly owned while 30% of almost 3,000 McDonald’s Japan stores are directly owned and despite the fact that Mos’ gross margins are more than double that of McDonald’s Japan, I presume, due to royalties that McDonald’s Japan pays to its parent [I’m just guessing about the latter]).
 
McDonald’s has, what we would define as part of our Quality definition, “habit”. Despite the many varieties of food that they offer and continually cooking up new ones, I generally get exactly same thing, a double cheese burger (picking off the pickles), fries (large if I have an upgrade coupon which I usually do) with an extra batch of ketchup (I think McDs ketchup is the best), and a coke (the only time I drink Coca Cola). It comes from the comfort and convenience of knowing precisely what I’ll get under any circumstance and not having to think it through too much at, what used to be, reasonable prices. They also have economies of scale as well as what we call “operational excellence”. This can be mimicked but it requires a strong organization and will power. The never-ending drive for further optimization sounds easy but is very difficult to maintain consistently in practice. As Ray Kroc said, “We take the hamburger business more seriously than anyone else”. If one can really maintain that philosophy across 42,000 stores and 100 countries, that is one incredible franchise.
 
But, as a consumer, “Quality” is not a word I would use to describe McDonald’s. There has been a wave of new “gourmet burgers” that have swept Japan, I’d say, in the last decade or so. They started the Japan Burger Championship 2 years ago where many new gourmet burger shops compete whose winner would go on to represent Japan in the World Burger Championship in the US. I have eaten at the 2022 Japan Burger champion called the Shogun Burger and, as Jules says in Pulp Fiction, “Uuummm, that’s a tasty burger!” Still, they cost 3x that of Mos burgers, so I haven’t been back since. There’s also a good gourmet burger chain called Kua`aina Burger who claims to be the best burger in Hawaii, although I don’t think I’ve ever seen one in Hawaii. In either case, they too have really good burgers that are only twice the price of Mos burgers, so I go there sometimes (and, no, they are not called Big Kahuna Burgers, though they should have given the size). I also have a Shake Shack at my station but I find them too greasy and too small for the same price as Kua`aina’s big burgers, so I tend to avoid it despite the nicer ambience. But they are all MUCH higher quality than McDonald’s. If you were to use our Quality-Value matrix, Mos might be the same weight as Kua`aina but McDonald’s would fall out of our matrix.
 
Of course, everyone’s definition of Quality and Value are different so I’m sure many would disagree. My kids don’t like the onions in the Kua`aina burger while my wife thinks they are all too expensive or bad quality (although Mos Burger might clear her minimum Q/V consumption line). At current prices, McDonald’s would be inconsumable from my V/Q matrix perspective, though it must be well above most consumers hurdle, seeing how busy it always is. But I found it interesting that even McDonald’s decided to raise their Quality level (presumably in order to raise the Price such that they can continue to provide a consumable Quality-Value proposition).
 
We tend to think that Quality is relatively static, but Value varies (as a refresher, we define Value as the spread between Price, which moves daily, and the Intrinsic Value, which also moves over time as the uncertainty of future cash flows become more certain). A company has to be above the minimum Q/V line to be investible. While this is still true, I think we’ve found that Quality also changes, particularly in the past 2 years. This is not because management teams are learning to become better allocators of capital although nowhere near as much as the financial markets believe; it’ll take a little more than flag waving to change corporate mindset, even if that flag is being waved by the JPX, the FSA, and the (previous) Prime Minister. But the more important change that we’ve begun to see is from the effects of inflation and interest rate hikes (or at least the expected direction of both). Costs are rising whether it be cost of labor, materials, rent, or capital, none of which had risen in the last 3 decades. This has tested management's capability or willingness to raise prices.
 
Greenwald’s sustainable competitive advantage is just a framework to define “why”, and it is that “why” that makes a franchise strong. But we’ve found more cases where the “why” does not necessarily fit the framework, and yet a company has been able to raise prices, even if they are not the one with the highest margins nor with the highest “Q”-score. Conversely, we’ve found cases where the “why” could be clearly defined but price hikes had been difficult. In an era of indefinitely rising costs, if one believes, as we do, that inflation in Japan is permanent, one must have the ability to raise prices, whether it be through outright price hikes like McDonald’s Japan or better products like the gourmet burgers. Perhaps it could be better pricing strategies or better product mix. Or maybe it’s simply through operational leverage that allows other fixed costs to be controlled. Some industries will be able to raise prices more easily than others. If so, during this early stage of the new normal (for Japan), perhaps the entire industry will do well. In which case, the company with the highest margins already might not provide the best returns due to the lower gamma, but it has sufficient “Q”.

Ultimately, I think most industries will struggle to expand margins and competition will intensify. Those that adapt will be the last few able to stand while the working population ages and declines and industries consolidate. And I doubt it will be clear cut … there will be different stages of an inflationary Japan especially as the world is still adapting to the changes in geopolitics and socioeconomics. As such, while we will continue to use the basic Greenwald framework to define Quality, we must be cognizant of what it is we are ultimately looking for and, for now, it is those that can grow above and beyond their rising costs. And if that means innovating to improve your Big Mac in order to raise prices, I applaud you for the effort.

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But I hope the new Big Mac tasted better. I was never too crazy about the Big Mac, but I have noticed that McDonald’s Japan has constantly introduced bigger and bigger burgers (which is another way to raise prices). While the world may be trying to lower inflation, we in Japan need it so I like to see firms that can innovate to raise prices.

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“The man who invented the hamburger was smart; the man who invented the cheeseburger was a genius.” – Matthew McConaughey, American actor.

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A hamburger at McDonald’s Japan costs 170 yen but a cheeseburger costs 200 yen. I’m fairly certain that the extra slice of cheese didn’t cost them 30 yen. But, wow, that 30 yen is SO worth it! And that is innovation.

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