McDonald’s Q2 Earnings: Decline In Customer Traffic & Rising Commodity Costs Drag Sales Growth

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McDonald’s Corporation (NYSE:MCD) continued its streak of disappointing results when it reported its Q2 earnings report on July 22. The company’s financial model is dependent on growing comparable store sales to drive profitability and has been struggling to deliver strong comparable store sales consistently for the last few quarters now. In Q2 2014, company’s global comparable store sales were relatively flat and reported a 1% increase in consolidated revenues. In the U.S., comparable store sales decreased 1.5% while operating income rose 1%. [1] Comparable sales or same-store sales, is an important measure to gauge a restaurant’s performance since it only includes restaurants operating for more than a year and excludes the effect of currency fluctuation.

Like the last quarter result, second quarter’s top-line result reflected negative comparable guest traffic, rising commodity prices and increasing competition from the fast-casual segment. Diluted earnings per share increased by 1% to $1.40, while the consolidated operating income decreased by 1% in constant currencies.

We have a $103 price estimate for McDonald’s, which is about 2% above its market price.

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Rising Commodity Costs Affected Top-line Growth

Food inflation has been threatening the restaurant industry since the onset of this year. Although inflation differs from region to region, it was high in almost every operating unit, negatively impacting the net top-line growth. In the U.S., commodity costs were 3% higher than the same period previous year, whereas in Europe, commodity costs were higher in Russia and Ukraine due to weaker currencies. Moreover, rising coffee and milk prices especially hurt the McCafe segment of the company. Rising input costs forced the company to raise its menu prices. The price hike increased the average spend per customer visit for the company, but the operating margins saw a decline.

  • Slight Increase in Average Spend per Customer Visit

In the second quarter, pricing had more impact on average spend per visit than the product mix. However, the negative guest count offset the increase in average check and led to relatively flat comparable sales.

  • Decline in Operating Margins

In the U.S., operating income saw just a 1% rise, whereas in Europe, operating income decreased 4% in constant currency terms. Even in Asia-Pacific, Middle-east and Africa (APMEA), where the company delivered the most positive performance in terms of comparable sales, operating income declined 2% year-over-year.

Higher commodity costs dragged down operating margins. In the U.S., commodity costs rose 3% resulting in a 40 basis points decrease in operating margins, by higher labor costs. In Europe, company operated margins decreased 80 basis points to 18.6%, due to higher commodity costs in Russia and Ukraine, as well as poor performance in Germany. Russia and Ukraine account for nearly 50% of the company’s commodity imports in Europe. Overall, in the second quarter, both the franchised restaurants and company operated restaurants witnessed a 60 basis points decline in operating margins respectively.

McDonald’s also witnessed protests from its minimum wage employees in over 33 countries and 80 cities. The company has planned a minimal wage increase in several states in the second half of the fiscal year, resulting in higher labor expenses. This might affect the company-operated margins in the next couple of quarters.

Negative Guest Traffic Growth

Amid all the changing industry dynamics, top fast food restaurants had to face strong competition from fast casual segments and rising commodity prices, which led to a decline in customer traffic. In the second quarter, McDonald’s witnessed a negative customer traffic growth, resulting in flat global comparable store sales. The most affected region was the U.S., where the comparable sales decreased 1.5% due to negative guest traffic. Moreover, the comparable store sales in Europe declined by 1% due to weak results in Germany and a slowdown in Russia.

  • Tough Competition From Fast-Casual Segment

Fast-casual restaurants such as Chipotle Mexican Grill have started gaining momentum and people are shifting towards healthier and hygienic food items. The fast casual segment has started eating into the market share of leading fast food restaurants for the last couple of years and has generated considerable industry attention. According to Technomic’s 2014 Top 500 chain restaurant report, sales for fast-casual chains rose 11% and store count rose 8% in 2013. Although Chipotle generated $3.2 billion in revenues in 2013, which in comparison to McDonald’s seems to be a much smaller figure, the revenue growth has been consistently at around 20% for Chipotle for 5 years now.

Even though fast-casual restaurants lag their fast food counterparts in overall revenues and value, they are closing the gap every quarter. However, when it comes to healthier options and quality of food, fast casual restaurants clearly have an edge over all other restaurant segments. Moreover, people with higher disposable income are inclined more towards high quality, fresh and good-tasting food, even if it is expensive by a few bucks. This has led to decrease in customer traffic gradually.

  • Menu Price Hikes Kept The Customers Away

Aware of the rising commodity costs and possibility of further increase in near future, McDonald’s raised prices of some of its top selling items such as Hamburger, Double Cheeseburger, Big Mac and McBacon. This cost is being passed on to the customers, leading to an increase in average spend per visit partially offset by a significant decrease in customer traffic. With fast casual segment gaining popularity and fast food outlets such as McDonald’s raising its prices, customers are ready to pay that extra money for a rather fresh and high quality food in an up-scaled ambiance, which is provided by the fast casual restaurants.

  • Increasing Competition In The Breakfast Segment

All the top restaurants in the QSR segment are fighting for a share in the breakfast market. McDonald’s has to fight other top brands such as Starbucks (NASDAQ: SBUX), Dunkin’ Brands (NASDAQ: DNKN) and Burger King (NYSE: BKW), but still leads the breakfast segment by a far margin. Other brands are catching up by introducing new and innovative items on their menu. The increasing competition in this segment has resulted in a slight decline in customer traffic.

Expansion Still Remains A Focus

McDonald’s ended the quarter with 35,683 restaurants worldwide, with more than 14,000 restaurants in the U.S. Over the last couple of quarters, the company has been witnessing weaker performances in markets such as Germany, Japan, U.S. and Australia. These four markets remain focus of attention for the company. Even with mediocre performance, the company continues to generate significant amount of cash and plans to invest this cash in opening 1,500 to 1,600 new restaurants including about 500 restaurants in affiliated and developmental licensee markets, such as Japan and Latin America, and re-imaging over 1,000 existing locations in 2014.

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Notes:
  1. McDonald’s Q2 2014: Earnings call transcript []