McDonald’s Stock Gains This Year Look Overdone As Challenges Remain

The last few months have been mediocre for McDonald’s (NYSE:MCD). It has consistently posted negative comparable sales, something which it hadn’t done in years. The management has often blamed the disappointing comparable sales, or comps, on a weak macro economic environment and difficult year-over- year comparison. After seeing a decline of 1% in the first quarter, McDonald’s comps again dropped 0.6% in April. ^[1]

Although the shares have gained about 15% in 2013, they still trail the broader market indices. While there have been a few green shoots lately, it is still not enough to justify the share rally witnessed lately.

Comparable sales, or same-store sales, is an important measure to gauge a restaurant’s performance since it only includes the restaurants open for more than a year and excludes the effect of currency fluctuation.

See full analysis for McDonald’s Corporation

The Conundrum

Beginning in fourth quarter of 2012, the company upped its focus on lower priced value meals (such as the Dollar menu) to address faltering sales. Some of the additions to the Dollar menu include the Grilled Onion Cheddar burger and the Hot ‘n Spicy McChicken. The problem with the Dollar menu is that it eats up into the profits since these items generally have the lowest margins. McDonald’s hopes once the discretionary consumer spending rises, the same customers will purchase its premium-priced products.

This excessive reliance of McDonald’s on lower price points is a worrying trend. It is important to note that McDonald’s pricing is already one of the lowest in the industry. Therefore, if customers are shunning away from the more expensive items on the restaurant chain’s menu, that surely is not a good sign. There are other restaurant chains too such as Chipotle Mexican Grill (NYSE:CMG), Dunkin Donuts and even Starbucks (NASDAQ:SBUX) whose menu products are more expensive compared to that of McDonald’s, but are doing much better. Therefore, blaming the disappointing sales on an uncertain macro economic environment isn’t entirely justified.

There is also a possibility that once consumer spending improves, a portion of its existing customers might move on to other restaurant chains. The only reason why they are visiting McDonald’s at present is because there are very few chains that can compete with McDonald’s when it comes to prices.

Moreover, this strategy has also led the franchisees complaining about their margins squeezing as they are the ones who have to bear the brunt of additional food costs. On the other hand, McDonald’s revenues are a percentage of the franchisee sales. Even if the Dollar menu (or other lower priced products) is able to raise the total sales, McDonald’s might be the only beneficiary and its franchisees could be left to battle low profits. Thus, the company also has to address the growing discontent among franchisees arising due to this conflict of interest.

Other issues have popped up as well, such as the world’s largest fast food chain not being able to serve its food fast enough. The number of items on McDonald’s menu in the U.S. has swelled from 85 in 2007 to about 145 currently. However, that has led to a slowdown in service, affecting its overall sales. And therefore, McDonald’s is considering trimming down some of the less popular items on its menu. It recently removed Angus burgers and Fruit & Walnut salads from its menu and some others such as Caesar salad, McSkillet Burrito, and the Southern Style Biscuit might follow suit. ^[2]

There is no fixed formula to optimize sales (or profits) at a restaurant. The fact that McDonald’s is taking reactive steps to turnaround things is a good sign. However, it remains to be seen if the new, trimmed menu might cause some deterioration in the guest count. We’ll keep an eye on how the trends play out in the upcoming months.

As of now, we have a $96 price estimate for McDonald’s, which is about 5% lower than the current market price.

Understand How a Company’s Products Impact its Stock Price at Trefis

1. MCD 8-k [↩]
2. Has McDonald’s Menu Gotten Too Big?, May 20, 2013, businessweek.com [↩]