McDonald’s Sales and Margins Continue On A Declining Trajectory

McDonald’s Corporation (NYSE: MCD) delivered another disappointing quarter of Q1 fiscal 2014, following a weak performance last year. It reported a 1% dip in consolidated operating income despite a marginal rise of 0.5% in global comparable sales and 1% growth in consolidated revenues. Diluted earnings per share also declined by 4% to $1.21. Comparable sales or same-store sales, is an important measure to gauge a restaurant’s performance since it only includes restaurants operating for more than a year and excludes the effect of currency fluctuation.

We have a $99 price estimate for McDonald’s, in line with the current market price.

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Comparable Sales Continue to Wither

McDonald’s comparable sales declined by 1.7% in the U.S., owing to negative guest counts due to the severe winter weather. The company tried to optimize its menu and modernize customer experience, but the efforts have not shown positive results. Introducing a number of new items led to confusion on the part of customers and a dip in same-store sales. This year, McDonald’s is focusing on its core menu offerings, which include the Big Mac, Egg McMuffins, Fries etc. and contribute 40% to the total sales.

In addition, with competitors such as Starbucks, Taco Bell and Burger King introducing breakfast items and offers, McDonald’s dominance in the breakfast segment is under threat. Since coffee is an important breakfast item, Starbucks could leverage its brand strength in coffee to attract morning customers. Such competition in the breakfast segment, which has been the strongest significant contributor to McDonald’s revenue, does not bode well for the company’s sales.

Comparable sales in Europe rose by 1.4% driven by increase in traffic in U.K., France and Russia offset by negative same-store sales in Germany. While the breakfast segment is helping spurred sales in UK and France, in Germany growth is stifling due to a mismatch between menu offerings and customer preferences. McDonald’s leadership is set to focus on Germany, one of its priority markets, and it believes that growth in the country could prove a game-changer for its European division.

The Asia-Pacific, Middle East and Africa (APMEA) region recorded a comparable sales growth of 80 basis points for the quarter, driven by a 6.6% sales growth in China and partially offset by a dismal performance in Japan and Australia. The company plans on tapping the growth potential in China by increasing its number of restaurants by 300 in 2014. On the other hand, Japan continues to record a declining guest count due to increasing competition. For this, McDonald’s plans on optimizing its menu offerings in the country.

For 2014, the company is focusing on reviving its ailing performance in its priority markets of U.S., Germany, Japan and Australia. It is now working on focusing on bridging the gap between customer expectations and the company offerings, and boosting its sales in the way. If the operational and marketing decisions are taken in a customer-centric manner, we believe that McDonald’s can pull up its sluggish sales.

Thinning Margins

About 81% of global McDonald’s restaurants are franchised outlets. This allows McDonald’s to enjoy high margins driven by steady stream of franchise fees and royalty. Since these charges are a percentage of the franchise revenue, McDonald’s margins are directly affected by the top line growth of its outlets. The declining comparable sales along with rising inflation is leading to a decline in McDonald’s margins. In Q1, the consolidated franchise margin dropped by 60 basis points to 81.1%.

The company operated stores reported a 16.1% operating margin, a 10 basis points dip over last year. McDonald’s believes the decline was driven by rising commodity, labor and occupancy expenses. Commodity costs rose by about 3% in the first quarter in the U.S. Such inflationary pressures are expected to continue in both the U.S. and international markets. Despite these pressures, McDonald’s has not yet raised its menu prices, leading to shrinking margins. Since the price rise affects the whole industry, moderate hike in menu prices would not have a major impact on the company’s sales.

The operating margins in Q1 were also hurt by a 4% rise in the General and Administrative Costs owing to McDonald’s sponsorship of the Winter Olympic games held in Sochi in February this year.