McDonald's Posts Disappointing Sales; Profitability Hurt

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McDonald's Corporation 's ( MCD ) third quarter earnings failed to enthuse investors as the company reported a weak set of numbers. Total revenues for the quarter rose 2% to $7.3 billion, helped primarily by new restaurant additions. The net income jumped 5% to $1.5 billion or $1.52 per share. Shares of the company were flat in the post market trading.

We have a $97 price estimate for McDonald's , which is slightly above the current market price.

Weak Sales Cause For Concern

McDonald's same-store sales could only manage to grow 0.9%, highlighting the woes of the fast food giant. The company blamed weak consumer sentiment in its major markets as the primary reason for the tepid sales. However, some of the other restaurant chains such as Starbucks, Dunkin' Donuts, Chipotle etc. have been performing better than McDonald's. Therefore, blaming the disappointing sales entirely on a precarious macroeconomic environment raises the doubt if the management is struggling to get its strategy right.

McDonald's weak same-store sales during the first half of the year were justified since the restaurant faced a difficult year-over-year comparison. Now that the comparisons have eased, weak sales are a cause for concern. The results also highlight that the recent introduction of Chicken McWraps and Mighty Wings have not lived up to expectations.

Comparable sales, or same-store sales, is an important measure to gauge a restaurant's performance since it only includes the restaurants open for more than a year and excludes the effect of currency fluctuation.

Margins Under Pressure

The reported margins for company-operated margins declined 40 basis points to 18.7%. Operating margins have been under pressure since the last year due to a greater proportion of sales coming from lower margin products such as from the Dollar menu. Beginning from the second half of 2012, McDonald's added a number of items to its Dollar menu such as the Grilled Onion Cheddar Burger and McChicken sandwich in order to entice more customers.  However, sales haven't grown at a rate the company would have ideally wanted it to.  This has consequently resulted in margin erosion. Weak sales also cause the fixed costs (such as labor, occupancy etc) to spread out over a lower base, thereby putting a downward pressure on the margins. For the full year, we expect the margins to decline ~50 basis points in 2013.

McDonald's expects the cost of raw materials to rise at a modest 1.5-2.0% for the full year. Therefore, if the company can somehow manage to generate the incremental sales, the fastfood giant should see its margins rebounding to the previous levels.

Franchised margins fell 40 basis points to 83.0%, primarily due to a combination of weak sales and yen devaluation. McDonald's has about a tenth of its franchised stores in Japan and a weaker yen translates back to fewer dollars. The yen has depreciated almost 25% ever since the country's new PM Shinzo Abe stepped into the office in December last year. Beginning from the first quarter of 2014, the year-over-year impact of yen devaluation should get offset.

Franchising is a low revenue, high margin business since the company derives only a fraction of the franchisee sales and does not incur operational expenses such as labor, occupancy or cost of raw materials.

Restaurant Addition Continues

More than 80% of McDonald's worldwide restaurants are franchised. McDonald's is spending $3 billion in 2013 to add 1,200 net store (1,500 total store additions and about 300 closures) and reimage 1,600 restaurants globally. In the first nine months of the year, the company has so far added only 443 stores to take its total store count to 34,923. Therefore, we can expect a significant number of openings in the fourth quarter.

McDonald's is looking to bolster its presence in China, India, Russia and East Europe where the restaurant chain is still under penetrated and has an opportunity to grow.

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of The NASDAQ OMX Group, Inc.



This article appears in: Investing , Investing Ideas , Stocks , US Markets

Referenced Stocks: CMG , DNKN , MCD , SBUX

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