McDonald’s Corporation (NYSE:MCD) will announce its Q3 earnings on October 18, 2012. The fast food giant’s second quarter earnings were impacted by currency headwinds and higher G&A (general and administrative) expenses, and these trends are expected to continue into the third quarter as well. The stock is down around 10% since the start of the year as weak comparable sales data and significant exposure to Europe have resulted in skepticism regarding the company’s profit generating ability.
Subdued Top-Line Growth
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Revenues will have limited upside for a couple of reasons. Firstly, a greater proportion of restaurants opening up are franchised, and this limits the top-line growth since only a fraction of the sales are reflected on the company’s income statement. Traditionally, McDonald’s receives an initial fee, royalty and rent from its franchisees as the company also owns the land on which the restaurant operates. However, we have recently seen a surge of developmental licensees. Under this model, McDonald’s receives only the initial fees and royalties (and no rent) since it does not own the land. Hence, revenue addition is again limited in this model since the company does not receive rent from the franchisees. On the bright side, this model has a low capital requirement.
Secondly, a strong dollar is negatively impacting McDonald’s overseas revenues, which account for about 65% of its total revenues.
The headline margins might expand because, as already mentioned, a greater proportion of restaurants opening up are franchised. Margins for franchised restaurants are much higher than those for company-operated restaurants as you can see below:
However, by comparing the performances of franchised and company-operated restaurants individually over the previous year, you might see some margin erosion due to higher input costs. McDonald’s expects the cost of commodities to rise by 3.5%-4.5% in the U.S. and 2.5%-3.5% in Europe for 2012. Similarly, margins will be hurt this quarter due to the recognition of one-time expense associated with the London Olympic and Paralympic games sponsorship (estimated at $50 million) in the third quarter. So, the margins will remain tight for the remainder of 2012 as well.
At the same time, there are a few things that are working in favor of the company:
a) Comparable Sales: Data for comparable sales has generally trailed market expectations in the last few months, but it is important to note that comparable sales growth in the first eight months of the year was 4.4% – certainly not as bad as most people think. 
The U.S. has been the strongest performing region for McDonald’s in 2012 in spite of its near ubiquitous presence in the country. The company has been able to maintain steady growth in the U.S. through a combination of new product offerings and restaurant refurbishments. Comp sales have grown 4.8% through August.
Europe has been rather resilient for the company with comparable sales rising 3.5% through August in spite of a crippling economy. The countries in Southern Europe (Spain, Greece, Portugal), in particular, have fared badly which is not surprising given the uncertainty regarding their state of economies.
The APEMA (Asia/Pacific, Middle East and Africa) region has disappointed as the faster growing economies of Asia and Africa were expected to post strong comparable sales numbers. Instead, comp sales growth was a lowly 2.4% through July. However, in August, the number rebounded to 5.8%. It is too early to comment right now but last month’s performance gives hope for optimism. 
b) One-time expenses: In total, McDonald’s estimates higher G&A expenses (related to Olympic sponsorship and IT investment) at $100 million for 2012. These are one-time expenses, so the company should benefit from lower expenses 2013 onward.
c) Quantitative Easing: The recently announced Fed’s policy of extending the quantitative easing is likely to weaken the U.S. Dollar. A weak U.S. Dollar will benefit McDonald’s as its overseas revenues and profits will translate to a higher dollar value.
We have a $96 price estimate for McDonald’s, which is about 5% higher than the current market price.Notes: