Taco Bell And Starbucks Challenge McDonald's Morning Dominance With New Breakfast Menus

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McDonald's Corporation ( MCD ) has been facing tough days with sales flattening and margins shrinking. Same-store sales rose a mere 0.2% in 2013. The start to 2014 was only slightly better with sales up 1.2% in January. 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.

McDonald's is the dominant player in the breakfast segment with a market share of over 30%. However, it now faces serious competition as a number of rivals have stepped up their game in the breakfast segment. Some of the well established fast food giants such as Burger King, Taco Bell and Wendy's have little presence in the breakfast segment. Moreover, sales of these restaurant chains face stagnation and therefore the companies have no other option but to foray into the breakfast hours. Till now, breakfast was like a safe haven for McDonald's. Over the years, a number of companies have tried to replicate the success of the Egg McMuffin but have failed so far. But with a number of companies making a serious effort, this could very well change.

We have a $96 price estimate for McDonald's , in line with the current market price.

Waking Up Early  

The latest chain to enter the fray is Taco Bell, which is introducing a new breakfast menu to include Waffle Taco, A.M Crunchwrap and Cinnabon Delights . These are items that can be held in one hand, keeping in mind the preferences of on-the-go millenials. This also fits in well with the take-away culture prevalent in the morning. These items have already been tested at 850 restaurants for more than a year and a half, and will now be extended to nationwide restaurants. That means more than 5,500 Taco Bell stores across the U.S. will start serving these breakfast items at 7 am.

In addition, Starbucks is in the process of reinvigorating its breakfast menu with the help of baked goodies launched under the La Boulange brand. In fact, Starbucks will introduce new breakfast sandwiches beginning from March. The items at Starbucks, as you would expect, would be priced higher though. Examples include Ham And Swiss Croissant and C iabatta With Vegetables, Egg and Fontiago Cheese, both priced at $4.45.

McDonald's has for long considered extending the breakfast hours. But given the kitchen space constraints, serving both lunch and breakfast items at the same time is not feasible. As a result, the company has so far refrained from serving breakfast beyond 10:30 am.

Potential Impact  

With a close to $10 billion in sales, the breakfast segment accounts for about 30% of McDonald's U.S. sales. If any competitor were to steal McDonald's morning share, the impact would surely be felt company wide. Furthermore, if sales continue to stay persistently low, there will be pressure on the company to renegotiate the rent/royalty rates. McDonald's generally rents/leases land to its franchisees. It then collects rent as well as royalty (both as a % of franchisee sales), along with a one-time initial fees from its franchisees.

 

Since more than 80% of McDonald's restaurants are franchised, any change in rent/royalty rates is going to affect the cash flows significantly. For example, if the rent/royalty rates declined by 0.3%, there could be a 5% erosion to McDonald's valuation.

 

Moreover, such is the nature of the business that a reduction in sales will inadvertently lower the margins as well, since costs tend to be relatively fixed in the franchising business. If the margins decline by 3% from the current level of 86%, there could be a 5% downside to the stock price. Thus, the aggregate impact of weak sales could be as much as a 10% erosion to the valuation.

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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: MCD , SBUX , CMG , DNKN

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