Motley Fool Hidden Gems Investing - McDonald’s Returns to Value

Episode Date: July 29, 2024

Eaters and investors are both happy to see the $5 value meal on the menu. (00:21) Asit Sharma and Dylan Lewis discuss: - 2024’s largest IPO – cold storage company Lineage – and whether the REIT is worth watching for investors. - McDonald’s Q2 earnings, the chain’s pivot to value-oriented menu items, and why the outlook for pinched consumers likely won’t get better any time soon. (17:44) CEO of Pacific Gas and Electric, Patti Poppe joins Ricky Mulvey to discuss PG&E’s turnaround and how her company is serving the growing electricity demand from data centers. Companies discussed: LINE, COLD, MCD, PCG Host: Dylan Lewis Guests: Asit Sharma, Ricky Mulvey, Patti Poppe Producer: Mary Long, Ricky Mulvey Engineers: Dan Boyd Learn more about your ad choices. Visit megaphone.fm/adchoices

Dylan Lewis We're checking in on the business of food and how it gets to you. Motley Fool Money starts now. I'm Dylan Lewis, and I'm joined over the airwaves by Motley Fool analyst Asit Sharma. Asit, thanks for joining me today. Asit Sharma Hey, Dylan, good to be here. We've got a rundown on the biggest IPO of 2024 and fresh results from McDonald's. We'll start with the big debut. Asit, 2024's largest public offering dropped last week, but I'm guessing a lot of investors missed it. Kind of an under-the-radar company, cold storage and logistics operator Lineage.

They raised $4.5 billion on its way to a $20 billion valuation. I think we're going to have to dig into this one a little bit for listeners. What exactly does Lineage do? Dylan, Lineage owns temperature-controlled warehouses. It centers on the refrigerated food industry, the logistics of getting food from basically a cold point to your refrigerator or your freezer. It also serves the pharmaceutical industry. This is a roll-up. For those of you who are familiar with that term, it's basically grown by acquisition, started by two interesting, youngish founders, Adam Forstie and Kevin Marchetti. Really, their idea was to go into an industry which hadn't seen a

lot of efficiency and modernize the logistics of moving food. It's so interesting to me because we've been dealing with this problem for centuries. Cato the Elder, Dylan, had a treatise on agricultural methods to preserve food. Rome was on the ancient Silk Route. You can track these ancient writings about keeping food cold using snow from mountains, etc. We come to today, things haven't changed that much. This is still an industry which is going to be around for a long time. The question is, can you make money providing these services? I was not expecting a Classics reference to kick us off this Monday morning, Asit. I appreciate it. As you mentioned, this is a business that has been highly acquisitive.

I think they've made over 100 acquisitions since 2008. That has helped them dramatically scale what they have in terms of storage space. At present, it's about 3 billion cubic feet of temperature-controlled storage. That is up from 1 billion back in 2018. They've dramatically grown. They're quite a bit larger than some of the other players in the market. I think the closest comp that we get is AmeriCold, which is a publicly traded company. They have about 1.5 billion cubic feet of storage. This industry and this business, to me, has all of the hallmarks of, if you lay out that

capex spend, you establish a moat for yourselves, and also, you start to actually benefit from the economies of scale that this business really needs to have. I would agree with that. Dylan, they're concentrated a little bit in the United States. They have 482 warehouses. I think globally, upwards of 300 of those are located in North America. If you look at a map, and they provided one in their investing prospectus, most of their concentrations are in these high-density cities, and not a lot of playing to less dense corridors within the United States and Canada. I think that's smart, because you're mentioning something

extremely important to this business. It costs so much money, not just to keep things in cold storage, but then to transport them. If you want to do it efficiently, you actually should start in densely populated cities where the point-to-point transportation is something you can use and control. You can add routes where you have density. You can also start working on loads in trucks. This is one of the things that a Wall Street Journal article mentioned about the founders. They saw the potential to cut down on some of the waste in this industry. If you have truckloads that could go to capacity but are less than full, they started working on acquisitions that would combine the loads of various customers

together. I think this idea of utilization, economies of scale that you're talking about should help. Having said that, it's not yet a profitable company by Gap, although they are positive on a funds from operations basis. For those of you who are familiar with the estate world and also a net operating income basis. Here, I'm leading to something that you pointed out, Dylan, before we started taping. This is not simply a company that you're investing in for its logistics and warehouse. It's structured as a real estate investment trust. Yeah. I think we need to adjust accordingly when it comes to our expectations. We are not going to be looking at necessarily high-flying

growth with a business like this, but more predictable and stable cash flows. That said, this is a business that has been subject to a lot of the major consumer whims that we've been seeing a lot of the retailers and food sellers talk about. Not surprising, because they count Kraft Heinz, Olive Garden parent Darden, and Walmart, which is, I think, the largest grocer in the United States, if not one of the largest. Their business is, to some extent, going to move a bit with general trends when it comes to consumer wallets. Sure. They got into this business during the Great Recession. It was an opportune time to make acquisitions. They have seen

fits and starts. Think about COVID happening. As the economy expands, contracts, I think there's opportunity here on the acquisition side, but also on filling out scale as more consumers use local shipping, point-to-point grocery delivery, etc. There's opportunity here. One question, though, that I've got when you look at this big picture is, how fast can this industry really grow? Maybe they've already optimized. They've been at this for quite a few years. So, we'll see. As an IPO, this is one that I'm curious to watch and learn more about. I wanted to point out something, too, that's interesting, if you're thinking of reading through this prospectus or maybe buying shares. The use of proceeds. That's

something that I always look at, Dylan. We've talked about this before. It's such a great control F. You don't have to be the deepest financial analyst to do this trick. Pull up the prospectus from the SEC site of a new company that's gone public, and just control F, this phrase, use of proceeds, that'll tell you where the company is going to put the dollars that it's raised in its IPO. And where's this money going? Well, they're paying down some debt because all those acquisitions cost a lot of money. Now, this is a company that has raised money from various private investors over time. The founders put in some of their own. Their cost of capital is pretty high. So, while it may seem like those who buy shares, and I haven't bought any shares,

but theoretically, those of you who may be interested in buying shares, it may seem like you're paying down that debt on the company's behalf, and they don't have any fresh capital to use. But really, what they're saying makes sense. The way they've presented this prospectus, they're going to have a lower cost of capital going forward, meaning that now they're a big publicly traded company. They can issue debt, which will be lower cost versus rising private debt from investors. They can issue more shares in the future if they need to, which in the near term dilutes shareholders, but can be beneficial if they invest it wisely. I think this is a company that is going to grow at a decent pace. Maybe the gist here is what you're pointing to, Dylan,

is that ability to increase the earnings component that could get investors excited. Before we move over to McDonald's earnings, I do want to zoom in a little bit on that point you made about why they came public. It's a bit different than what we were seeing from a lot of companies over the last five or so years. No one's mad that they're raising capital and able to shore up their balance sheet a little bit. But I think, especially if you rewind to the years leading up to the pandemic and the immediate aftermath, we saw a lot of companies that were very high growth seize that growth and seize the valuation that they can attach to that growth to raise capital, it almost feels like the incentives

are being flipped a little bit right now for companies in this high interest rate environment. They're saying, you know what, we can go out to the markets and raise capital, and it's probably going to be a little bit more affordable to us than if we were to go out there and finance some of the stuff with debt. Yeah, it's sort of crazy, Dylan. The high interest rate environment has been normalized in investors' minds. This year has been unusual for the appetite for corporate debt, even though it's at a higher rate. You would think that would make people a little more scared, because the higher interest rate you pay, potentially the sketchier it can be if your financials deteriorate and

you've got those higher interest payments to make. But investors and also people who are coming to the markets seeking capital understand that if you've got a business proposition where the cash flow is positive, and you can understand the story going forward, and you're not hanging by a thread, sure, we'll take that. We'll pay for you to keep going in the marketplace, issue debt at a much higher interest rate than you might have three to four years ago. This is what happens when these conditions normalize. Actually, we saw this in the 1980s, when we had hyperinflation and sky-high interest rates. After a while, people became used to in the private world, 6% to 7% mortgages. After a while, corporations that were getting

1% to 2% interest on their debt years before got used to raising capital at a higher cost. All goes to say that the business model that works still has a place in the market for investors to come in and support it. We're going to switch gears and look over at the earnings results for the week and actually focus on a company that maybe knows a thing or two about cold storage. We got an earnings update from McDonald's to get things started. Asit, revenue and earnings below expectations. The company posted comps declines globally and across all of their major divisions. Shares up 5% today. What's going on? People woke up this morning, they're interested in flat earnings and comparable

store sales that aren't going anywhere. I don't know. OK, I do have a theory on this, Dylan. McDonald's only recently rolled out this $5 value meal. It was interesting, on their conference call, an analyst called them out and said, hey, you've got more data on this than anybody else in the world. What's going on with the consumer? You saw this coming. This was very politely asked, but why did it take you so long to go downmarket again? You guys were the people who brought the value meal into existence, and McDonald's has been slow to move on that front. Basically, the answer from management was that, look, it is complicated. You have some segments of our base who are still spending. We know our lower-income customers, they're pulling back

because there's a growing delta, growing difference between the cost of eating out and grocery. Now, grocery still seems expensive to me. I'm hurting every time I go and buy groceries, but their point is well taken. If groceries seem expensive to you, you're going to eat out less. With McDonald's, they had so many different pockets that were still showing strength. I think it wasn't until a couple of quarters ago where they finally started to see these weird things rising, like large families in Europe, in Germany, starting to pull back from spend. They have all this granular data and that prompted them to push this value meal. Really, Really, what people are enthusiastic about this morning is just the fact that Matchman said,

we see good uptake of the $5 meal. I mean, normal people like you and me are like, duh! Yeah, I was going to say, I have been to a McDonald's recently, and I got the new $5 meal. I think they released that with a few days remaining in this quarter, so it didn't really wind up showing up too much in the results. But I will say, sandwich, small fries and drink, four-piece McNuggets, $5, that's what I want from McDonald's. That's what I've come to expect from McDonald's growing up. It's great for the consumer, probably not too great for McDonald's and the franchisees that operate so many McDonald's. Right. There was some very careful wording on the call where management basically said,

and we're splitting costs of this with our franchisees, but we're working to help them on the operations side to make them more productive and to save some money on the cost side because, Basically, we know this is really squeezing our franchisees to sell this stuff at $5. But yeah, I think they're doing a fairly decent job in this endeavor. And I wanted to call out something you just mentioned. So you bought some McNuggets when you got the value meal. McDonald's is really loving chicken these days. Sales of chicken have risen to the level of beef sales at McDonald's.

Just sort of crazy to think about. But I like the way they're leaning into this. They have their variants that go after Chick-fil-A, the McSpicy. They're solid on chicken nuggets. That's a nice margin business for McDonald's. Actually, I would guess it may, at the end of the day, be as good for the bottom line as beef. They're leaning into that. I also think that that lends itself better to profit. I could be totally wrong on this. I follow one or two incognito franchisees on ex-formerly Twitter who will talk about costs and margins of being a McDonald's franchisee. But my guess is, that helps the franchisees for them to lean into chicken.

Lastly, they also talked about loyalty. That's a growing component of the business. Not the thing that moves the needle the most, but they're seeing good uptake on those who are in the McDonald's loyalty program. I want to dig back into one piece of commentary from management that we got this quarter related to something you were talking about earlier. McDonald's U.S. President Joe Erlinger saying, we expect customers will continue to feel the pinch of the economy and a higher cost of living for the next several quarters in this very competitive landscape. What I'm hearing there is, this is going to continue. All these moves that are a little

bit more value-oriented that McDonald's is making right now is, we have to maintain mindshare with consumers. Is that essentially what we're seeing? We need to get people in the stores, we need people to be coming in. Don't expect financial results to be great while that's happening. But once things rebound, we want to be in that position where we have the loyalty associations, the we-immediately-go-there type decision-making for consumers. Yeah, I think you just described the specific situation. Right now, the average ticket for that $5 value meal we talked about is $10. So, you're coming in at $5, but you're spending $10. Now, not necessarily you, Dylan. You're a young guy, and you're pretty fit. So,

I don't see you adding on a bunch of stuff to your order. I don't mean to imply anything about people who aren't as fit as Dylan adding something. I mean, we should all feel free to to up our ticket a bit. They want the traffic. They want to maintain that level of traffic. Because when the economy improves, if they haven't lost that flow of people coming in physically to the restaurant through the drive-thru, then they've got a little bit of pricing power. They have, let's say, an LTO, a limited time offer, they'll put right in front of you. You might shift your decision-making if you're feeling a bit more wealthy. You might yourself feel like, Hey, I can afford to add on an apple pie today. It's a subconscious mechanism, but

they're correct to make sure they keep the traffic. Even if it hurts for a few quarters, what you don't want is for people to spend again and you've lost them. They're going to a competitor. And I actually heard a little bit of nice fear in management's voice that they, they used to be the number one by far when people thought about value and they're, they're still number one, but they mentioned how they've lost a little bit of that mindshare to your point, Dylan, and they want it back. Austin Sharma, thanks for joining me today. Next $5 value meals on me. Promise. Awesome. Can't wait, Dylan. You just found out that your sales team is at risk of missing quota. Don't panic. Just ask

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rippling.ai slash fool. Coming up, we've got a look at what might be one of the most difficult turnarounds in corporate history. The CEO of Pacific Gas & Electric, Patti Poppe, joins my colleague, Ricky Mulvey, to discuss PG&E's difficult path forward and how her company is serving the growing electricity demand from data centers. Patty Poppy is the CEO of Pacific Gas and Electric, a utility serving 16 million people in Central and Northern California. Patty, I think you've got a tough job,

but I really appreciate you joining us on Motley Fool Money. Hey, Ricky, no problem. I'm happy to be here and talk to all your listeners. One thing you said on the earnings call that I really want to get into first is that over this past heat wave in July, unplanned and sustained outages were down more than 50%. The duration of those outages were down more than 85% compared to September of 2022. I think that's fairly remarkable given all of the ways that heat waves can create outages and it shows more resiliency in the system that you're leading. So, give us the story. What's happened within the past two-ish years? Well, I'd say two things have happened,

Ricky. Number one, we have implemented something we call our performance playbook, and it's part of our cultural transformation and operational transformation here at PG&E. And that performance playbook makes problems visible. That's one of the fundamental goals, and then teaches people how to solve problems so that we can set a new standard of excellence. And my team has embraced this lean, fundamental operating system design. And what it did is it helped us show our vulnerabilities in certain areas, in certain parts of our system, so we could get ahead of the heat. We know that the weather's changing. We know that it's getting more extreme. We can build and modify and upgrade our equipment and our infrastructure so it's more climate resilient.

And this is a great example. It's just a great proof point of how that yields real benefits for customers. So I'd say that's the first thing. And the second thing is my team has just gotten very tenacious about wanting to deliver on high reliability on high heat days. And so when you combine our performance playbook with a really strong desire to achieve, the team really stepped up and delivered for our customers. I was proud of them. Someone who's worried about the future of investing in utilities is Warren Buffett. And he wrote about it in his latest shareholder letter. I'm now quoting, the fixed but satisfactory return pact has been broken in a few states and investors are becoming apprehensive that such ruptures may spread. End quote. He's questioned

who's paying for these underground transmission projects at Pacific Gas and Electric. I know you're planning to put 10,000 miles of wire underground. He's saying, this used to be very easy for investors to project, but given more fires, climate change harming the system, it's become costly for investors to be in this game. In fact, he's called it a costly mistake. What's your response to the investors who may be listening to Buffett on this? Well, as much as I respect Warren Buffett, I must respectfully disagree. He got it wrong here in California. He had some outdated information. Since then, we've been working closely with his team to make sure they have the updated information, and we're learning a lot from

each other. But there's some fundamental things that have changed in California that he did not reflect in those comments. Number one, we have regulatory and legal construct that has been implemented that protects investors in the event of a catastrophic wildfire. And so that's a very fundamental change. And so the risk, the financial risk is dramatically reduced. And we're proving that out every day. And so, that's been a big change. Assembly Bill 1054 was passed. It provides liquidity protections. It sets a new standard of prudence. It was a fundamental change in the legal construct here in California specifically. But then secondly, this notion, and a lot of people get this wrong, they think investing in infrastructure is too expensive, and particularly

undergrounding infrastructure in our highest risk miles. Let me give you a couple stats on that that kind of bust the myth. Number one, that the undergrounding that we're talking about doing, though it sounds like a lot, 10,000 miles, that's less than 8% of our total system. So it's a small percentage of our miles, but they are the miles that are in the highest risk area and incidentally the most expensive place to maintain. So where those miles are, are in places like the Sierras, up in the mountains that are very expensive to inspect and very expensive to trim vegetation around those lines. We do tree trimming on a massive scale. And so that's an annual expense that gets borne by customers. Whereas if we can invest in the permanent infrastructure,

we can actually lower the cost for customers. There's a positive NPV over the life of the assets and a real-time reduction in costs and a more affordable system. In fact, let me give you one stat. People are worried about affordability in California right now. And some people are worried that the reason the California or specifically PG&E's bills are high is because of undergrounding. Let me just tell you this. $1 a month is in a customer's bill for undergrounding, but $20 a month is in that same bill for vegetation management. What we need to do is fix vegetation management and build. That's a Band-Aid. That's an annual maintenance repair that you're doing that's temporary that you have to repeat and repeat and repeat, what we need to

do is build infrastructure that's fit for purpose. Infrastructure that's climate resilient for extreme weather. Not only are there wildfires in these places where we need to bury the lines, but there's blizzards and massive snowpack that takes the poles down every single year. That's not good infrastructure for that purpose. So that undergrounding is a much more affordable pathway to higher customer outcomes, better customer outcomes. And so we're really standing by our position that we're going to bury those lines and we're going to continue to improve how we do it and lower the cost to do so. We've implemented some really innovative technologies to lower the cost of burying those lines and that's getting passed along to customers. Expense is something

that I want to be mindful of, especially for your customers. From December 2023 to March of this year, the average bill has gone up from $260 a month to $308. This is expected to decrease in a couple of years based on some large-scale infrastructure projects being completed. You mentioned that undergrounding was just a part of that, but is that still on track? Is that something that PG&E customers should expect their energy bills to decrease in the next few years? You know, we're working to first stabilize those bills. Our customers have felt, and we know that it's created some real challenges, felt the costs of wildfire mitigation and of our solar net energy metering program have raised costs for customers here because of these policy, legal, and

infrastructure-related decisions. And so we're working hard with policymakers to help build a construct that allows us to stabilize those bills. We're doing a ton of work inside the company to do more for less. Just like I talked about burying those lines for less, we're also saving money on how, and as I mentioned, saving money on how we do vegetation management. We're reimagining how we do inspections and saving money there. I want our customers to know that we are implementing a lean operating system at PG&E. This is not, you know, their grandfather's old PG&E. This is a new modern operating system that is improving the operations of the company and lowering our structural costs. Let me give you one stat that some of your listeners might find interesting.

The average utility spends about $1.40 on infrastructure for every dollar of maintenance expense every year. So $1.40 of what we would call capital for a dollar of expense. The best utilities with the highest customer satisfaction, the most affordable rates, spend over $2 of capital for every dollar of expense. At PG&E, we spend 80 cents on capital for every dollar of expense. When I got here and when I was walking those forests and then I was riding in trucks and looking at how we do work and analyzing our financials, I could see that our work is biased to repairs and Band-Aids and reacting to problems and emergencies versus preventive infrastructure investment that is lower cost for customers because it gets spread out over time

instead of an annual expense, repeat, repeat, repeat, more sustainable infrastructure that is fit for purpose, and then reducing that annual expense and reaction kind of mindset. We were very good at chasing disasters, we needed to start preventing disasters. Investing in infrastructure for California is the best way to do that. And it lowers costs for customers. So that is our pathway to lowering bills for customers. In addition to load growth, which I'd be happy to talk about if you're interested, you know, the mega trend of data centers and increased load. We can talk about that if you're curious. You talked about data centers. Silicon Valley is well within your purview. Got a lot of data

centers gearing up for more electricity with artificial intelligence demand. You've also got a lot more electric cars placing strain on the grid. What are you doing to prepare for the surging electricity demand that's already here and continues to come? Let me first make sure that you know, Ricky, that I am so bullish on this mega trend. It is the best thing that's ever happened to the grid. And I think this will be a huge enabler to us being able to lower costs for customers, and let me tell you why. First of all, the data center demand will increase our fundamental utilization of our grid. What a lot of people don't know is they'll hear about strain on a grid on a hot summer day. Yes, that's true. On a peak day, residential air conditioning drives

almost, in our case, a doubling of demand on a handful of days a year, five to eight here in California days, this year has been a good test of our peak demand. But every other day of the year, we have about 45% excess capacity on the grid. We have the ability to serve 45% more load. And so those data centers help raise that average load. We've had an increase of about three times the number of data center applications this year over last. We're doing something we call a cluster study. So we're working with those data centers. We right now, we shared in New York with investors that we had a potential pipeline of 3.5 gigawatts of additional demand from data centers. That's on top of our peak of about 20 gigawatts. So that's meaningful. But we know that we don't want to

serve that load if it's unaffordable for the rest of our customers. In other words, if building out the infrastructure to serve that load creates higher bills for our residential customers, we would call that bad load. But what we're discovering is that when we can do the engineering of that demand concurrently, all of those studies at the same time, we can optimize it and serve that which is good load or beneficial load. And so beneficial load is when what we have to invest to build the infrastructure is offset by the new revenue that is earned by those, that new load that actually fundamentally reduces the bill for everybody else. That's the load we're adding. And we have the optionality to be able to choose which load we would add and which load we

wouldn't at that kind of scale. So we're working with those big providers to figure out of that 3.5 gigawatts, how much of it is beneficial load and we'll build that. And that's beneficial to customers. The other EV thing, I do want to bust a myth here on EVs. A lot of people think that EVs are putting strain on the grid. I would tell you EVs are the best thing that ever happened to the grid. EVs are the first dynamic demand that can also serve as supply. There's never been anything like it. Until now, when it gets hot, air conditioning comes on. When it gets dark, lights come on. When the factory starts, the motors run. We've been demand takers. And so we build this great big grid to serve the peak day plus some reserve margin, maybe 15%, 17%

for that one day a year. And we don't utilize it at its full potential any other day of the year. So in that scenario with EVs, we can send the right price signal to EV owners so they charge at the right time. Every day in California, we have excess power because of solar. In fact, we're exporting power. Even on the hottest days, this last couple of weeks, we were exporting power out of the state because we have too much of it, those cars fill what we call the duck curve, the belly of the duck. They fill up that belly of the duck, and then they can charge, they can discharge back to the grid.

That's what's next for EVs, bi-directional charging. So on that peak hour, a couple days a year, they can provide mobile storage to the grid combined with the 10 gigawatts of storage california has already added big bulk storage that is a wonderful combination that allows us to add all those new megawatts of the data centers and evs and be sure that the peak does not increase at the same rate that that belly of the duck increases so all that means dot dot dot all the way to the end of the equation lower costs for customers, because the unit cost of electricity goes down when we more fully utilize our existing assets. The best thing that's ever happened to the grid.

As always, people on the program may own stocks mentioned, and The Motley Fool may have formal recommendations for or against, so don't buy or sell anything based solely on what you hear. I'm Dylan Lewis. Thank you for listening. We'll be back tomorrow. Thanks for watching!