Negative Customer Traffic & Operational Headwinds In Eastern Markets Summarize McDonald’s Poor Q3 Results

On October 21, McDonald’s Corporation (NYSE:MCD) reported yet another disappointing quarterly result, as the company’s consolidated revenues declined 5% year-over-year (y-o-y) in the third fiscal quarter. McDonald’s financial model is dependent on comparable store sales growth to drive profitability, and the company has been struggling to deliver strong comparable store sales consistently for the last few quarters now. In Q3 2014, the company’s global comparable store sales declined 3.3% y-o-y, primarily due to declines in customer traffic and headwinds in the eastern markets. ^[1]

In the U.S., the company’s biggest market, the comparable sales declined 3.3% y-o-y, driven by strong competitive activity in the restaurant industry for the breakfast market share, as well as stiff competition from the fast-casual restaurants. Consequently, this led to a 10% decline in the operating income, forcing the McDonald’s U.S. segment to implement new initiatives aimed at improving financial results.

We have a $103 price estimate for McDonald’s, which is about 14% above its market price.

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McDonald’s third quarter results were negatively impacted by a number of internal and external factors, as the company’s diluted EPS declined 28% in constant currencies to $1.09. McDonald’s supplier issues in China and Japan due to the meat scandal, temporary store closures in Russia and Ukraine, and higher tax rate due to an increase in tax reserves in certain foreign markets together contributed to the company’s sluggish performance in terms of revenue and earnings growth.

Poor Performances In China & Russia Drags Down Comparable Sales Growth

• China Meat Scandal Drags Down McDonald’s Growth In Asia

As soon as China’s meat scandal came to light, China’s government issued a ban on import and sales of products processed by Husi Food Group. ^[2] As a result of the ban, sales of McDonald’s popular chicken nuggets and chicken fillets were suspended in many Shanghai branches. (See McDonald’s faces declining sales in Asia after China food scandal) However, McDonald’s China unit was able to restore full menu to all the impacted restaurants in mid-September, as the company was able to find alternative product sources for all the restaurants in less than a month period. Nonetheless, the damage was done as the region saw decline in customer traffic. As a result, the comparable store sales for the APMEA segment decline by 9.9%.The company has launched a brand trust campaign in these markets to regain the lost customer base.

The company estimates the tax effect of China’s supplier issue to be in the range of $0.15 to $0.20 per share and expects a negative impact of $0.07 to $0.10 per share by the same in the fourth quarter.

• Situation In Russia Does Not Seem To Resolve Sooner

In August, Russia’s food safety watchdog ordered the temporary closure of five McDonald’s restaurants in Moscow and Southern Stavropol region on claims of alleged sanitary violations. ^[3] However, experts are skeptical that the decision comes as a result of tense U.S.-Russian political ties over Ukraine. (See Temporary Shutdown Of Outlets & Agricultural Ban In Russia To Worsen McDonald’s Sluggish Growth) As a result, McDonald’s witnessed a decline in operating margins, coupled with decline in consumer sentiment and weakening currencies in these markets. The company believes that the unstable condition due to political tension between the two countries is expected to continue for the next few months and could probably affect its operations in 2015 as well.

Higher Commodity Costs To Pressure Margins

Rising commodity costs and escalating prices of beef & other meat products have forced quick service restaurants (QSRs) such as McDonald’s (NYSE: MCD), Yum! Brands, Subway and Burger King (NYSE: BKW) to raise their menu prices. According to USDA (United States Department of Agriculture), the production of beef declined 6% year-over-year in the 8-month period from January to August in 2014, whereas the red meat production dropped 4% in the same period. ^[4] Moreover, the agency expects the production of beef and other meat products to fall further in the next year. ^[5] As a result, the prices of meat products are expected to rise further, due to prevailing drought and mad cow disease. The Agriculture Department forecasts prices of pork and beef to rise by 6.5% to 7.5% in 2014, whereas the poultry, fish and meat category as a whole is expected to rise by 4%to 5%. ^[6]

Considering the current dining habits and consumer demand, the company is taking steps to improve the operational efficiencies, such as:

• providing customized and personalized meals with locally relevant ingredients, with contemporary inviting ambiance
• launching a ‘Made For You’ operating platform, where a customer is provided with convenience in ordering and serving
• launching multiple order point strategies in France and Australia at self order kiosks; mobile order and payment facilities
• launching a new concept of ‘Create Your Taste’ to provide enhanced dining experience with relatively more choices in menu

These concepts and strategies are expected to be launched by September 2015 in the U.S., whereas in countries such as Australia, the U.K. and France, the company is trying to scale up the initiative. The main focus of the company is to revive its lost customer traffic and rebuild the trust and loyalty of the core customers for the brand.

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1. McDonald’s Q3 2014: Earnings call transcript [↩]
2. McDonald’s misled Hong Kong food safety authority about rotten meat [↩]
3. Russia is closing McDonald’s restaurants over health concerns [↩]
4. USDA Red meat and poultry production, September 30, 2014 [↩]
5. WASDE report, September 30, 2014 [↩]
6. Meat prices continue to rise, www.nytimes.com)) In comparison to this, overall inflation is reported to be around 2% for a wide range of food products.

   In the U.S., the commodity cost rose 3% for McDonald’s in the third quarter, primarily driven by high beef and dairy prices. On the other hand, the commodity cost in Europe remained relatively flat for the company. Additionally, the company expects the pressure to continue in the fourth quarter. As a result, the company revised its full year outlook for the increase in U.S. basket of goods to a range of 2.5% to 3%. In response to the increased commodity costs, the menu pricing was about 2% higher at the end of third quarter compared to food away-from-home inflation of 2.5%. As a result, the company’s net income declined 30% y-o-y.

   The company’s prior focus is to drive the customer count and profitability, and therefore, plans on keeping the menu pricing lower than the food away-from-home index. If the commodity inflation does not stabilize, the company margins might further decline.

   Gaining Customer Confidence: McDonald’s Top Priority

   Amid all the changing industry dynamics, top fast food restaurants had to face strong competition from fast casual segments and rising commodity prices, which led to a decline in customer traffic. In the third quarter, McDonald’s witnessed a negative customer traffic growth, which was one of the primary factors responsible for the company’s sluggish growth. According to the recent NPD’s food-service market research, the customer traffic growth in QSRs was considerably flat during the year ending June 2014, whereas the visits to fine dining restaurants rose 3% during the same period. ((Income gap and shrinking middle class take a toll on restaurant industry [↩]