McDonald’s Earnings Preview: Declining Sales, Rising Prices and Growing Competition May Hold Back Margins

McDonald’s Corporation (NYSE:MCD) will announce its Q1 2014 earnings on April 22. After the company’s disappointing performance last year, there is much skepticism surrounding its upcoming earnings. The company has been struggling to record good comparable sales figures. After a mere 20 basis point rise in comparable sales in 2013, it rose 1.4% in January, only to drop to -0.3% in February. Moreover, the rising commodity costs and relentless competition in the breakfast business may further lead to thinning margins.

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

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Comparable Sales To Remain Flat

Comparable sales have failed to accelerate in 2014, with unimpressive January and February figures. The figure has suffered mainly in the U.S. and Asia-Pacific/the MiddleEast. Comparable sales or same-store sales, is an important measure to gauge a restaurant’s performance since it only includes the sales at all restaurants open for more than a year and excludes the effect of currency fluctuations.

In the U.S., sales dipped 1.4% in last quarter, followed by 3.3% and 1.4% dips in January and February this year. The introduction of ‘Dollar Menu & More’, aimed at offering greater variety to consumers and improving restaurant profitability at the same time, has yet to find traction in the market.

In Asia-Pacific, the Middle East and Africa (APMEA), the company saw a decline of 2.4% in comparable sales in Q4 2013. There was a 5.4% rise in January followed by a 2.6% drop in February. The rise in sales in January, an outlier in the trend, was mainly due to a shift in timing of the Chinese New Year which led to higher sales in China, offsetting the generally ailing performance in the region. China , Japan and Australia , the markets which contribute significantly to APMEA’s sales, are struggling with declining sales and low profits. Among these, Japan seems to be the most affected. Out of the 3,000 McDonald’s outlets in Japan, 74 outlets have been closed down in the wake of dwindling customer demand, rising product prices due to weakening yen and increasing competition. Taking note of the state of affairs in APMEA, we expect the region’s comparable sales to be on the lower side this quarter.

In Europe, the negative performance in Germany was compensated by the positive response in the U.K., France and Russia. The zone recorded a 1% rise in comparable sales in the last quarter, followed by a 2% rise in January and a 0.6% rise in February. The sales can be expected to remain flat unless the consumer confidence builds up in Germany and Southern Europe.

Price Rise, Competition To Affect Margins

Since competitive pricing is one of the biggest assets of McDonald’s, any changes in menu prices will inadvertently affect the consumer purchasing decision. Rise in prices of commodities, labor and occupancy can put immense pressure on McDonald’s margins.

The U.S. Department of Agriculture forecasts the inflation for food at home and away from home to be 2.5% to 3.5% respectively. Prices of beef, veal and eggs are expected to rise by 3%-4% ( USDA CPI forecast for 2014) . In its 10-K filing in February, McDonald’s forecast its total basket of goods price to rise by 1% – 2% for 2014.  Although the price rise will affect the whole food industry, McDonald’s may find it tough to retain its stand among the most affordable fast food chains. It will have to come out with a smart pricing strategy to be able to protect both its margins, and yet please its price-conscious customer segment.

Competition in the breakfast business is putting pressure on McDonald’s top line in the U.S. With Taco Bell, Starbucks, and Burger King also launching their breakfast menus, McDonald’s breakfast dominance could be under threat. McDonald’s is trying to protect its turf by emphasizing on beverage and coffee, locking horns with Starbucks on the way. With many of the chains announcing new breakfast offers this quarter, their relative performances are to be seen in the upcoming earnings seasons.

Number of Outlets to Increase

During 2013, McDonald’s increased its global store count by 949 stores. Despite disappointing sales, McDonald’s feels it is under-represented in international markets. In January, McDonald’s CFO, Pete Bensen, announced plans of investing around $3 billion in opening 1500 to 1600 new restaurants in 2014. With 250 outlets coming up in U.S., 320 in Europe and 830 in APMEA, the global count of McDonald’s restaurants is expected to cross 35,500.

If McDonald’s succeeds in obtaining a significant market share in the breakfast business and stimulates its sales through  menu optimization and improving customer experience, it can go on to gross higher margins.