Is Japan Situation A Warning Sign For McDonald’s?

Can McDonald’s (NYSE:MCD) defend its dominance in the fast-food industry? It is a question that has been hovering in the minds of investors lately. After the unfortunate headwinds faced by the company last year, many speculated that the company would lose share in the industry, and the gap in the market share figures between McDonald’s and its closest competitors might just shrink. The most hard-hitting blow to the company came from its Asian markets, where the meat scandal of July 2014 negatively affected the company’s operations in China and Japan, with declining customer traffic and customer trust. Now the more important question is whether McDonald’s can turn around its present position in the Asian markets in the near future.

For the past 12 months, MCD’s stock has been fluctuating between $90 and $100, with the turnaround plans of the new CEO, Steve Easterbrook, providing stability during the last 3 months. Interestingly, the company’ stock has been trading in direct correlation with the S&P 500 index over the last one year.

With a current dividend yield of 3.54%, the stock is currently trading at around $96. However, before the recent cut in Chinese interest rates, the stock was stably trading close to $100, all thanks to positive overall guidance for the third quarter. With a current market cap of $90 billion, and annual revenues of $27 billion in 2014, the stock is trading at 3x revenues and has a P/E ratio of 20x for 2015. ^[1]

We have a $99 price estimate for McDonald’s, which is slightly above the current market price.

See Our Complete Analysis For McDonald’s Corporation

Should McDonald’s Still Worry About Japan & China?

• Are Recovery Efforts Too Slow?

Since the start of this year, the company has been trying to revive customer trust in Japan through strict recovery efforts, such as changes in cooking techniques to improve taste and hygiene, introduction of promotional offers, and the use of better cooking ingredients. Nevertheless, the food safety scandal and supplier issues have significantly dented customers’ perception of the hygiene and quality of the food prepared by McDonald’s. Moreover, with many fast food brand substitutes, the food lovers in Japan and China opted for other fast food options. As a result, the customer decline in these two nations, which collectively account for roughly 10% of the company’s system-wide sales, led to a major decline in comparable store sales in the Asia/Pacific region. McDonald’s comparable sales in Asia/Pacific, Middle East, and Africa (APMEA) declined 12.6% and 4.4% in January and February 2015 respectively. ^{[2] [3]}

Despite the company’s claim that the recovery efforts in these regions are proving to be productive, the comparable sales growth in the Asia-Pacific region is still on the negative side of the spectrum. Evident from the fact that McDonald’s comparable sales in Japan decreased 23.4% in June 2015 (down for the 17^th consecutive month) after a 22% decline in May, the situation in Japan does not seem to be getting any better in the near term. ^[4] The decline in customer traffic in Japan slowed to just 10.4 % in June compared to a 14.2% decline in May. However, it was offset by a faster decline in sales per customer.

• Full Year Guidance Paints A Clearer Picture

In the first half of 2015, McDonald’s Japan reported 85.28 billion Yen in sales, down nearly 30% over the same period last year. The recovery efforts in Japan were unable to revive the guest count, which was down 18.8% year-over-year (y-o-y) for the first half of 2015. Consequently, comparable store sales for the first half of 2015 slumped 27.7% over the same period in 2014. ^[5]

 

McDonald’s Japan	Jan-Jun 2015	Jan-Jun 2014
Net Revenue	85.28 billion Yen	121 billion Yen
Operating Profit	-18.2 billion Yen	3.5 billion Yen
Gross Profit	-26.22 billion Yen	1.85 billion Yen

 

With more than 3,100 restaurants, most of which are company owned, Japan is the company’s second largest market after the U.S. ^[6] Hence, the financial performance by Japan in the first half is a serious topic of concern for the company. For the fiscal year 2015, McDonald’s expects its Japan unit to post a net loss of 38 billion Yen, with an operating loss of 25 billion Yen, which in any scenario is still a huge setback for the company. Considering the fact that McDonald’s expects this performance after claiming the success of its recovery efforts, one can estimate the gravity of the company’s present perception among Japanese food lovers, and the effort the company needs to put in. Trefis estimates the net revenue from McDonald’s company-operated restaurants to decline nearly 3% y-o-y to $17.6 billion in 2015, with most of the expected decline attributed to the Japan unit.

• Has The Market Factored In All The Drivers?

Despite the disappointing end to the last fiscal year, and unfavorable top-line performance, MCD’s stock was not as bearish as expected. Moreover, the investors were content with the company’s full year guidance, and the stock price took a major U-turn, rising 12% within a gap of one month from $88 to $99. Since March 2015, the stock has been fluctuating between $94 and $100, and didn’t see any major drop despite a poor comparable sales report every month.

Analysts were then speculating that the market might have factored in all the possible scenarios, and even a slightly better report might just provide a push to the stock price. This speculation was further strengthened when the stock gradually jumped more than 5%, breaking the barrier of $100, after Steve Easterbrook announced the company’s new turnaround plan in May. ^[7] The September-ended quarter will be the first quarter after the turnaround plan, and it will further confirm whether the new reporting structure did have any positive impact. Additionally, it is possible to believe that any small good news, whether in terms of financial performance or in terms of positive customer response in Japan, might be a power-booster for the stock. If in that case, McDonald’s beats its guidance numbers for Japan at the end of fiscal 2015, we might possibly see a 5% to 8% upside in the stock.

However, factoring in the market estimates for the entire fiscal year 2015 and the stagnant growth in customer traffic in the Asian markets, we can clearly state that the company needs to gear up its revival efforts in order to meet its minimum basic target numbers for its Japan unit.

The Comeback Strategy

Clearly, the recovery efforts have not been strong enough thus far for McDonald’s. Furthermore, the stiff competition in the U.S. among fast food restaurants, as well as from the fast casual segment, is having an impact on McDonald’s. Since the situation in the domestic market is a long-term headwind, the company needs to pay most of its attention to the Japan turnaround.

Other strong players in the industry, such as Yum! Brands, Subway, and Restaurant Brands International Inc (NYSE:QSR), have capitalized on this opportunity and attracted more customers in the Asian markets, stealing the market share; however they are still far behind McDonald’s in terms of the number of stores. McDonald’s can use the fact that it has more presence in the region in its favor.

First, the primary aim of the company is to regain the lost trust and bring back the large customer footfall that it enjoyed a couple of years back. No doubt, the burger giant is working on this strategy, but clearly it is taking much more time than it hoped. McDonald’s not only needs to pace up, but reinforce its campaigns regarding the use of hygienic and fresher ingredients in food items.

Secondly, the company surely needs to lure its customers using innovative and tempting offers, in spite of the fact that it might hamper the margins. This is one of the trade-offs that the company has to do, in order to enjoy a slightly better period next year.

Finally, as we have discussed earlier, Japan and China have entirely different food trends than some of the biggest markets. In these countries, apart from other international fast food brands, local fast food brands and street-side vendors enjoy a huge portion of the customer traffic; the differentiating factor is the use of local ingredients and tastes by these local brands in their food items. McDonald’s has already recognized this trend in other nations, such as Australia, and has come up with ‘Create Your Taste’ initiatives, which is reaping greater profits for the company from that segment. A similar strategy in China and Japan might be a huge hit.

These are some of the strategies that can help McDonald’s reposition itself  in the Asian markets, leading to better revenue growth and strong comparable store sales growth in the next fiscal year.

See the links below for more information and analysis:

• McDonald’s confident on positive comp. sales in third quarter, after beating market expectations in Q2
• Fifth consecutive negative comp. sales quarter looming over McDonald’s
• McDonald’s: Better days ahead?
• Trefis Analysis: Average customers per restaurant annually at McDonald’s
• Trefis Analysis: Average spend per customer visit at McDonald’s franchised restaurants
• Trefis Analysis: Average spend per customer visit at McDonald’s company operated restaurants

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More Trefis Research

1. McDonald’s estimates, www.nasdaq.com [↩]
2. McDonald’s Reports Global comparable sales for January [↩]
3. McDonald’s Reports Global comparable sales for February [↩]
4. McDonald’s Japan sales down 23.4% in June [↩]
5. McDonald’s Japan unit posts loss in 1H, Retains view [↩]
6. List of countries with McDonald’s restaurants [↩]
7. McDonald’s announces initial steps in turnaround plan including Worldwide business restructuring and financial updates [↩]