McDonald’s Earnings Preview: Headwinds In Eastern Markets Might Deliver A Huge Blow To Top-Line Growth

McDonald’s Corporation (NYSE:MCD) is scheduled to announce its third fiscal quarter earnings report on October 21. The fast food giant’s bad phase does not seem to end, as the company faced some major operational headwinds in the last couple of months. For the last 2 years, quick service restaurants (QSRs) such as McDonald’s, Yum! Brands, Burger King (NYSE: BKW) and Dunkin’ Brands (NASDAQ: DNKN) have been facing stiff competition from fast-casual restaurants in terms of customer traffic. Since the onset of this year, the industry has been witnessing commodity inflation at a higher rate. While most of the restaurants managed to recover from the scenario, McDonald’s situation continued to worsen. The company faced problems in its eastern markets with the ‘China meat scandal’ followed by the temporary restaurant shutdowns in Russia. McDonald’s stock has dropped 12% from its year-high of $103.5 in May.

In the second quarter, the company continued to deliver disappointing results, as the comparable store sales remained relatively flat and the reported consolidated revenues grew just 1%. In the U.S., comparable store sales decreased 1.5% while operating income rose 1%. ^[1] The company’s second quarter results reflected negative comparable guest traffic, rising commodity prices and increasing competition in the industry.

We have a $103 price estimate for McDonald’s, which is about 11% above its market price.

See Our Complete Analysis For McDonald’s Corporation

Problems In The Eastern Markets To Hamper Revenue Growth

• China Meat Scandal

In July, Shanghai Husi Food, the company’s major meat supplier in China, was accused by Chinese authorities of using expired and contaminated meat products. Nonetheless, McDonald’s decided to continue its 50-year long business with the food processing group by using a different plant. ^[2] Soon after the issue came to light, China’s government issued a ban on import and sales of products processed by Husi Food Group. ^[3] As a result of the ban, sales of McDonald’s popular chicken nuggets and chicken fillets were suspended in many Shanghai branches.

The impact of this incident was visible in the company’s monthly sales report. In August, McDonald’s reported that its global sales for the month of July dropped 2.5%, with 7.3% drop in the APMEA segment. ^[4] The company operates over 2,000 restaurants in China, of which most stores in Northern and Central China witnessed plummeting sales due to the unavailability of beef and chicken products, whereas restaurants in Southern China were unaffected. The scandal has built a negative reputation among the Chinese customers, leading to a drastic decline in customer count.

Moreover, the incident also affected McDonald’s Japanese unit, as 20% of the meat for chicken items in McDonald’s Japan were supplied by the Husi Food Plant.  As a result, McDonald’s Japan lowered its annual guidance at the end of July, on account of declining consumer confidence in Japan. ^[5]

Considering that Japan and China together account for 10.5% of the company’s net revenues, we might witness a significant drop in company’s revenue growth in the third quarter, as well as for the whole fiscal year.

• Temporary Closures In Russia

After facing a food safety scare in China, the Golden Arches has been facing temporary shutdowns in Russia. 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. ^[6] This count rose to 12 by the end of August. However, experts are sceptical 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)

Russia has become an important operational market over the last five years, as the company believes that the country is one of its top seven major markets outside North America. For the last two years, growth in the European region is primarily driven by positive comparable sales in the U.K. and Russia, and partly by expansion in Russia. As a result of the Russian goverment’s decision, the company might witness decline in net sales and customer count from this region.

Declining Customer Count To Affect The Top-Line Growth

According to the NPD’s foodservice market research, the restaurant industry has been negatively impacted by the changing dining habits in the U.S., primarily driven by changing economic and cultural conditions. The increasing income gap between the high-income groups and middle-class groups is taking a toll on quick service restaurants (QSR) in the U.S. 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. ^[7]

Fast-Casual restaurants, such as Chipotle Mexican Grill (NYSE:CMG) and Panera Bread, are gradually stealing the market share from QSRs with more average spend per visit and better customer traffic growth. A decline in customer traffic would result into drop in comparable store sales, which might consequently lead to sluggish growth for the company.

McCafe’s Canada Expansion To Boost McDonald’s Coffee Portfolio

Over the last three years, breakfast has become the highest grossing and fastest growing daypart for the quick service restaurants (QSRs). The most popular breakfast item in western markets is coffee, which has been introduced as a major menu item in all the top quick service restaurants. In September, McDonald’s announced the introduction of McCafe ground coffee in Canadian grocery and retail stores. ^[8]

After its plans for introducing McCafe in the U.S., the company decided to expand the reach of its coffee product in Canada to counter the bitter competition in the breakfast market. The company thinks that it has less than fair share of the coffee market; McCafe accounted for less than 13% of the U.S. market in 2013. However, considering the fact that McDonald’s coffee sales have increased 70% since the introduction of McCafe specialty coffees in 2009, McCafe is the company’s best bet to capture some breakfast market share, by attracting new customers in a country where retail prices are slightly higher. This in turn can give a boost to the company’s average spend per customer visit.

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1. McDonald’s Q2 2014: Earnings call transcript [↩]
2. McDonald’s China will continue to use scandal-ridden meat supplier OSI Group [↩]
3. McDonald’s misled Hong Kong food safety authority about rotten meat [↩]
4. McDonald’s global sales drop amid China food scandal [↩]
5. McDonald’s Japan withdraws profit guidance after China food scare [↩]
6. Russia is closing McDonald’s restaurants over health concerns [↩]
7. Income gap and shrinking middle class take a toll on restaurant industry [↩]
8. Amid coffee rivalry, McDonald’s Canada to sell java in grocery stores [↩]