McDonald’s Earnings Preview: Food Inflation Could Hurt Top Line Growth

McDonald’s Corporation (NYSE:MCD) is scheduled to announce its second quarter earnings report on July 22. The burger giant has been reporting disappointing results in the last few quarters with a comparatively weaker performance last year. In the first quarter, the company 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. In the U.S., McDonald’s biggest market, comparable sales decreased 1.7% and operating income declined 3%. Moreover, the last quarter’s top line results reflected negative customer traffic growth amid increasing competition from the fast-casual segment, challenging industry dynamics and harsh winter weather. ^[1]

The June quarter has been a tough period for McDonalds, or any other major fast food brand. Fast food restaurants such as McDonalds, Subway and Burger King (NYSE: BKW) have to tackle the rising food and meat prices on one hand, while facing tough competition from fast-casual restaurants such as Chipotle Mexican Grill (NYSE:CMG) and Panera Bread on the other hand. McDonald’s also faced protests from minimum wage employers in May, which severely affected the company’s operations in 150 cities across the United States and more than 30 countries. On the positive side, McDonald’s was one of the major sponsors for the recently held FIFA World Cup 2014 in Brazil.

We have a $103 price estimate for McDonald’s, which is about 2% above its market price.

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McDonald’s expects its second quarter EPS to be minimally impacted by foreign currency translation with a full year negative impact of about $0.03 to $0.04. The company set a guidance to open 1,500 to 1,600 new restaurants in 2014, including 500 in affiliated and developmental licensee markets. The company witnessed a 4% increase in general & administrative (G&A) expenses, but anticipates a more significant G&A increase in Q2 due to cost related to initiatives such as restaurant growth, capacity enhancements and digital capabilities.

Rising Food Costs Could Hurt Margins

Food inflation has been threatening the restaurant industry since the onset of this year. Commodity cost in the first quarter rose by 3% due to higher protein costs. Rising meat prices have put a huge pressure on the input costs. McDonald’s already raised prices of its top selling items such as Hamburger, Double Cheeseburger, Big Mac and McBacon in the first quarter of 2014. This cost is being passed on to the customers, leading to an increase in average spend per visit somewhat offset by a significant decrease in customer traffic, but resulting in a slower growth of overall revenues.

Decrease in revenue might translate to lower margins for the whole financial year. However, according to Bureau of Labor Statistics, U.S. consumers paid 2.6% more at eateries (food away from home) in 2013, while food prices were 6.2% higher at supermarkets or retail stores. ^[2] Consumers get a wide idea of price inflation for the core items and they are less likely to react against rising menu prices at restaurants. As a result, restaurants can raise prices as long as they do not exceed prices for food-at-home items. In this case, McDonald’s might be able to sustain its margins, but not for much long.

McDonald’s projects the food away from home, as well as food – at-home inflation index to be up 2.5% to 3.5% for the full year. The company considered the input costs pressure at the start of the second quarter, and decided to raise menu prices and focus more on the core menu items including the Big Mac, Egg McMuffin and fries.

Tough Competition from Fast-casual Restaurants

Fast-casual restaurants such as Chipotle Mexican Grill have started eating into the market share of leading fast food restaurants for the last couple of years and have generated considerable industry attention. According to Technomic’s 2014 Top 500 chain restaurant report, sales for fast-casual chains rose 11% and store count rose 8% in 2013. Although Chipotle generated $3.2 billion in revenues in 2013, which in comparison to McDonald’s seems to be a much smaller figure, the revenue growth has been consistently at around 20% for Chipotle for five  years now.

The traffic growth in the fast-casual segment surpassed that of every other segment for the fifth consecutive year. ^[3] According to the NPD group, the fast-casual segment saw an 8% rise in the guest count in the 12-month period ended in November last year, whereas traffic count was flat for fast food restaurants. This consumer shift is primarily due to the fact that people with higher disposable income are inclined more towards higher quality and hygenic methods.

In 2013, average customer spend per visit per restaurant for McDonald’s reached $3.88, up by mere 0.6% over the prior year. On the other hand, the average customer spend per visit for a Chipotle restaurant stood at $11.56, with a growth rate of 1% over the prior year.

The second quarter was very crucial for McDonald’s as the industry was reacting to increasing commodity prices on one hand and changing consumer preferences on the other.

Protest From Minimum Wage Employees Affect Operations

In May, McDonald’s witnessed protests from its employees in over 33 countries and 80 cities. The workers in the U.S. were demanding a $15 per hour wage from the company. According to the Bureau of Labor Statistics, the 3.5 million fast food workers in the U.S. earn $8.83 per hour on an average. In reply to the strike, McDonald’s CEO, Don Thompson mentioned that the company would raise the minimum wage hike to $10.10 an hour from $7.25.

The worldwide protests affected the company’s operations and services. However, increase in minimum wage of workers might cause the company to lay off workers as wage expenses would hurt margins.

FIFA World Cup’s Sponsorship:

McDonald’s was one of the prime sponsors of the FIFA World cup 2014 held in Brazil from June 12 to July 13. During the mega event, the company changed the packaging design of one of its most popular menu item – french fries – which went down well among the customers. ^[4] Apart from this, McDonald’s offered various discount deals on its popular menu items and launched a football related mobile application. The World Cup provided the company a huge opportunity to attract customers with offers, and to showcase its brand appeal on a huge scale. The ‘McDonald’s Fantasy football league’, an online fantasy game, was a huge success among the football fans worldwide.

Overall, McDonald’s is poised for mixed results in the second fiscal quarter without much positive factors to drive revenue growth significantly.

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1. McDonald’s Q1 2014: earnings call transcript [↩]
2. Eateries to lift prices to catch food-at-home inflation [↩]
3. Fast casual leads traffic growth again, NPD group [↩]
4. McDonald’s kick off FIFA World Cup with packaging redesign [↩]