McDonald’s Earnings Preview: Issues In Eastern Markets To Hamper Growth

McDonald’s Corporation (NYSE:MCD) is slated to announce its annual report for the fiscal 2014 year on January 23. ^[1] McDonald’s is the first of the top fast-food restaurant companies to report its quarterly results. The current consensus for EPS is $1.23 and that for revenue is $6.7 billion. However, 2014 has been a hard period for the company in terms of operations and financial performance.  Even though the Golden Arches dominated the restaurant market in 2014 with a 17% value share, boosted by its coffee portfolio and value meals, there were three major factors that highly affected McDonald’s performance in 2014.

1. Tough competition in the U.S. restaurant industry
2. Declining consumer confidence in Asian Markets
3. Headwinds in Russia

As a result, the company witnessed decline in customer traffic due to decreasing consumer confidence and trust. McDonald’s has been reporting 2% average growth in revenues over the last two years, with a significant decline in comparable store sales. The figures below indicate the year-over-year growth of the company in revenues and comparable store sales in the first 9 months of 2014.

We have a $96 price estimate for McDonald’s, which is roughly 5% above the current market price.

See Our Complete Analysis For McDonald’s Corporation

Breakfast Battle Takes A Toll On McDonald’s

Over the last three years, the breakfast market has become a top priority for all the top quick service restaurants in the U.S. Moreover, some of the fast casual restaurants, such as Chipotle Mexican Grill(NYSE:CMG), are stealing the already diminished customer traffic, as customers gradually drift away from fast food dining habits to healthier options. According to Technomic’s report, the fast casual segment witnessed an 8% increase in comparable store sales in the third quarter of fiscal 2014, compared to 1.9% and 1.2% for casual-dining and QSRs respectively. ^[2] The report also mentioned that the consumers, with increased jobs and more disposable income, are more likely to spend their extra cash by trading up from fast casual restaurants to casual dining outlets for higher quality food, rather than going to cheaper alternatives — such as fast food chains. In this scenario, McDonald’s, who struggled the entire year, continues to witness a decline in customer traffic, whose impact might be visible in its Q4 result as well.

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 sustain its customer count. 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.

Weakness In Asian Markets To Affect Annual Results

Probably one of the major turning points for McDonald’s in 2014 was its operational headwinds in China and Japan. 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.  However, McDonald’s decided to continue its 50-year long business with the food processing group by using a different plant, located in Thailand. ^[4]

This issue led to a ban on import and sales of products processed by Husi Food Group, resulting in the temporary ban on the sales of McDonald’s popular chicken nuggets and chicken fillets in many Shanghai branches. As a result, in August, McDonald’s reported a 2.5% drop in its global sales for the month of July, with a 7.3% drop in Asia/Pacific, the Middle East, and Africa (APMEA). Moreover, the company’s October and November comparable sales were disappointing as well, with -0.5% and -2% decline respectively. ^[5] The scandal has built a negative reputation among  Chinese customers, leading to a drastic decline in customer count.

Apart from this, the scandal 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. McDonald’s stores in Japan, the company’s second biggest market, have suspended their imports from China and are using substitutes such as Tofu and fish for their nuggets. Before this scandal, the company was already facing a hard time in Japan with McDonald’s Japan reporting a significant 60% year-over-year (y-o-y) decline in net income and a 4% decline in sales for the six-months ended June 2014, due to store closures. ^[6]

The company’s China units took several measures over the last couple of months to restore consumer confidence by introducing various lucrative value meals and other meat items to attract fast food lovers. Moreover, McDonald’s 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.

Before the company could handle this setback, another problem jolted the company’s operation in Japan. In the first week of January 2015, there were reports that a piece of vinyl was found in the chicken nuggets at one of the outlets in Aomori, Japan. ^[7] The company’s Japan units started getting meat supply from three plants in Thailand, after the Shanghai Husi group was accused in the China meat scandal. This issue might not only result in a sharp decline in sales for the company in Japan, but might also hamper the company’s effort in restoring overall consumer confidence.

Russian Economic Situation To Affect Margins

In the third quarter, the company not only faced tough situations in Asia, but also in Russia, where a dozen of the company’s stores were temporarily closed on claims of alleged sanitary violations. This issue led to a decline in revenue generation for Q3, which might worsen in the fourth quarter. Meanwhile, Russian economic conditions deteriorated, as the Russian Ruble depreciated from 45 RUB per 1 USD in November, to 74 RUB per 1 USD in December, forcing the international brands to hike prices. As a result, McDonald’s raised the price of the Big Mac by 2.2% to 94 Rubles ($1.77) in December, holding the economic conditions and rising costs of raw materials and electricity as the reason for the hike. ^[8]

Considering all the above factors, we can expect December sales on the same lackluster trend, indicating another sluggish yearly performance may be looming for the burger giant.

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1. McDonald’s fourth quarter 2014 earnings conference call webcast [↩]
2. 5 foodservice stats to toast at the close of 2014 [↩]
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 reports global comparable sales for November [↩]
6. Meat Scandal takes a bite out of McDonald’s sales in Japan [↩]
7. McDonald’s Japan faces fresh problem with chicken nuggets [↩]
8. McDonald’s raises Russian Big Mac price amid plummeting Ruble [↩]