2014 Year in Review: McDonald’s

Quick service restaurants (QSR) is one of the largest segments of the food industry, and top fast food chains, such as McDonald’s Corporation (NYSE:MCD), Burger King (NYSE: BKW), Subway, and Yum! Brands, accounted for 31% of the total fast food market in the U.S.in 2013. ^[1] The Golden Arches dominated the market with 17% value share, boosted by its coffee portfolio and value meals. The fast food segment is expected to grow at an annual rate of 3% to reach nearly $245 billion in sales in 2018. (Ref: 1) However, looking at McDonald’s stunted growth over the last couple of years, it is likely that the burger giant might struggle to capitalize on this growth. Moreover, the negative impact of overseas issues in the eastern markets, coupled with stiff competition in the restaurant industry, is taking a toll on McDonald’s financial performance this year, as the company witnesses declining customer traffic and diminishing brand appeal. The issues in China, Japan, and Russia might take a lot of time to resolve, as gaining the trust and loyalty of customers is not an overnight job.

McDonald’s has been reporting 2% average growth in revenues over the last two years, with a significant decline in comparable store sales. The company started the year 2014 with disappointing financial performance, as it 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. Diluted earnings per share also declined by 4% to $1.21. The decline in customer traffic in the first quarter was primarily due to the severe weather conditions in North America. (See: McDonald’s Sales and Margins Continue On A Declining Trajectory)

Later on, in the second quarter, the rising commodity costs dragged the company’s margins down, as the operating income in the U.S. rose just 1%, whereas in Europe, operating income decreased 4% in constant currency terms. A focal point of the year was the company’s problems in the Eastern markets, which hampered net revenue growth significantly.

We have a $96 price estimate for McDonald’s, which is roughly 2% above the current market price.

See Our Complete Analysis For McDonald’s Corporation

Declining Guest Count Hampers Comparable Sales

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 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. ^[2] A decrease in low-income customers, who prefer going to low-cost fast food restaurants, is affecting the revenue growth of the QSRs. Moreover, customer traffic in the fine dining restaurants is not enough to make up for the declining traffic count. As a result, these restaurant chains are depending on middle-class groups to fill the void.

• Stiff Competition In The U.S.

People in the U.S. are gradually changing their dining preferences and drifting towards organic food items and healthier food options. As a result, the customer traffic is drifting more towards fast casual restaurants, such as Chipotle Mexican Grill (NYSE:CMG). According to NPD group, in 2013, fast casual restaurants witnessed an 8%  growth in  customer traffic, whereas the QSRs had a flat guest count. As a counter measure, most of the fast food chains are introducing organic food items in their menu and making the seating environment more like the fast casual setup.

On the other hand, there is  strong competition in the industry for the breakfast market share.  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. Although, McDonald’s still leads the breakfast market in the U.S., the company is looking for new  options to maintain  customer traffic. As a result, McDonald’s decided to expand its coffee portfolio not only in the U.S., but in the coffee loving neighboring country, Canada, as well. In September, McDonald’s announced the introduction of McCafe ground coffee in Canadian grocery and retail stores. ^[3] 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.

Decline In Customer Confidence In China

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. ^[4] Soon after the issue came to light, the Chinese government issued a ban on import and sales of products processed by Husi Food Group. ^[5] As a result of the ban, sales of McDonald’s popular chicken nuggets and chicken fillets were suspended in many Shanghai branches.

As a result, in August, McDonald’s reported that its global sales for the month of July dropped 2.5%, with a 7.3% drop in the APMEA segment. ^[6] Moreover, the company’s global comparable sales declined 3.3% y-o-y in Q3, primarily due to a decline in customer traffic and headwinds in the eastern markets. 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.

The company mentions that its China unit is diligently working to restore customer confidence by introducing various lucrative value meals and other meat items to attract the fast food lovers. Moreover, the fast food chain might introduce customized and personalized meals with locally relevant ingredients, with contemporary inviting ambiance. However, with commodity inflation, lowering menu prices might hamper its margins, but the company might opt for this risky option in order to drive long-term growth.

MCD stock rose from $97 to $103 in the month of May, before declining to as low as $88, as a result of the sluggish performance of the company in the latter half of the calendar year. Currently the company’s  stock is trading at $94.

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1. Fast food in the U.S. [↩]
2. Income gap and shrinking middle class take a toll on restaurant industry [↩]
3. Amid coffee rivalry, McDonald’s Canada to sell java in grocery stores [↩]
4. McDonald’s China will continue to use scandal-ridden meat supplier OSI Group [↩]
5. McDonald’s misled Hong Kong food safety authority about rotten meat [↩]
6. McDonald’s global sales drop amid China food scandal [↩]