McDonald’s Brewing Up Big Coffee Plans

McDonald’s Corporation (NYSE:MCD) is getting serious about coffee. The company recently announced that generating more coffee-driven visits will be one of the focus areas in the next 2-3 years. McDonald’s drip coffee is popular but there is a scope to increase the sales of its espresso and specialty coffees. ^[1] The move comes at a time when the company is struggling to boost sales at its 35,000 restaurants globally. Same-store sales fell 0.1% in the quarter ending December 31, 2013. For the full year, sales were flat. ^[2] 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.

We have a $96 price estimate for McDonald’s, in line with the current market price.

Big Plans Brewing Up

Late in 2013, McDonald’s announced that it will soon introduce packaged coffee under the McCafe brand. The company tied up with Kraft Food Group, which will be responsible for distributing and marketing the packaged products. While the overall restaurant industry has stagnated, coffee is one of the growing segments. An estimated 83% of U.S. adults consume coffee presently, up from 78% in the previous year. ^[3]

The company hopes that selling coffee at grocery stores could boost coffee sales at its restaurants. Right now, McDonald’s does not instinctively remind customers of coffee, but once the company builds a psychological connect with them, the idea of buying coffee at its restaurants might appeal to a greater number of customers.

However, not everyone is welcoming this move since serving espressos and specialty drinks could slow down the overall service. McDonald’s was already under pressure to improve the speed of its service. In fact, long queues seen at McDonald’s stores, especially at drive-thrus, was one of the reasons cited for sagging sales. Franchisees are not too keen to spend money on espresso machines either, since they can cost as much as $13,000.

There is also the fear of brand dilution as the company forays into newer segments. McDonald’s is to burgers what Starbucks is to coffee. By focusing more on alternative segments such as salads or coffees, the company has something for everyone but in doing so, it might lose its core set of burger and fries loving customers. The company’s major menu additions in 2013 – Mighty Wings and Chicken McWraps – failed to create the desired impact. This is a cause for concern.

Need to Generate More Sales

Pressure is piling on McDonald’s to generate more sales after reporting disappointing sales in the recently announced earnings. Moreover, the company also announced that sales in January were trending flat. McDonald’s stock price hasn’t seen a major deterioration since the cash flows are still solid. However, if same-store sales continue to stay persistently low, there will be pressure on the company to renegotiate the rent/royalty rates. Since more than 80% of McDonald’s restaurants worldwide are franchised, any change in rent/royalty rates is going to affect the cash flows significantly.

McDonald’s generally rents/leases land to its franchisees. It then collects rent as well as royalty (both as a % of franchisee sales), along with a one-time initial fees from its franchisees. Not all of the franchised restaurants may have the land owned by McDonald’s. In this case, franchisees only pay royalty and initial fees. Such franchisees are called developmental licensees.

McDonald’s has accelerated its global store expansion in the last couple of years, with plans to add another 1,000-1,100 stores in 2014. The company might have no other option but to accept lower rates in the wake of weakening sales. This can hurt McDonald’s long-term royalty/rent rates and consequently profits.

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1. McDonald’s Seeks to Out-Latte Starbucks in Coffee War, January 29, 2014, bloomberg.com [↩]
2. MCD 8-k [↩]
3. Coffee Consumption Increases in U.S., Association Survey Shows, March 23, 2013, bloomberg.com [↩]