Can McDonald’s Product Evolution Offset Rising Input Costs?

McDonald’s (NYSE:MCD) competes with Wendy’s (NYSE:WEN), Burger King  and Yum! Brands (NYSE:YUM) in the fast food market and is the market leader with about 19% share. The company also competes with Starbucks (NASDAQ:SBUX) in the specialty coffee market.

McDonald’s owns and franchises restaurants across the globe with over 32,000 restaurants in 117 countries. Of these, roughly 80% were operated by franchisees, with the balance being company-owned. We estimate that franchisee rent & fees accounts for 62% of McDonald’s stock value with franchisee royalties generating an additional 29%. The remaining 9% comes from company-owned restaurants.

We currently maintain a price estimate for McDonald’s stock at $78.40.

McDonald’s released its 4Q results earlier this week, stating that its global comparable store sales increased by 5% as compared to the same quarter last year. The comparable store sales in the U.S. increased by 4.4%, largely due to customer-focused initiatives to enhance product offerings. ^[1].

Rising Input Costs

In the U.S., the price of food items, both grocery and restaurant, is expected to increase 2-3% in 2011. The projected increase is largely due to increasing commodity and energy prices, in addition to a low base effect as food price inflation was relatively low for most of 2009 and 2010. ^[2]. In order to offset rising input costs, McDonald’s will likely increase prices of food items at its outlets by 2-3%, according to a report from RBC Capital Markets. ^[3].

We’ve previously discussed the impact rising costs could have on profit margins at McDonald’s. (See: McDonald’s Profit Margins Could Suffer on Rising Agricultural Prices)

Product Line Expansion

McDonald’s has been able to consistently improve sales through evolution of its product line, even during the recent economic downturn. It now offers a variety of coffee products as well as smoothies and other healthy food options. Oatmeal is the newest product offering after launching nationally earlier this month.

The introduction of new beverages and light snacks has enabled McDonald’s to increase sales, even during off-peak hours like early morning and evening. The introduction of low calorie food items and value-priced items has help McDonald’s to grow its customer base by expanding its product range to meet the needs of health-conscious consumers. December 2010 McCafe sales notably increased 20% YOY, exemplifying the success of new product launches.

Gross Margin Impact

Can McDonald’s product line expansion product line and ability to reach new consumers offset the gross margin impact from rising commodity costs?

We currently forecast that company-operated restaurant EBITDA margin will remain flat at roughly 24% in the years ahead. Drag the trend line in the modifiable  chart above to see the affect of various EBITDA margin scenarios on McDonald’s stock value.

1. McDonald’s Delivers Another Year of Strong Results in 2010 [↩]
2. Food CPI and Expenditures: Analysis and Forecasts of the CPI for Food [↩]
3. Three Challenges to McDonald’s Growth [↩]