MCD: A CULTURE OF NO BAD NEWS?

McDonald’s is a great company but, alas, it is still a company – subject to the same factors as other restaurant companies.


I did not learn anything on the earnings call that alters my bearish thesis on MCD.  There was some noise in the quarter, but EPS was reported at $1.16 versus consensus of $1.16.  Global comparable restaurant sales came in at +5.0% versus consensus +5.1%.


MCD reported global comparable restaurant sales growth of 5% for the fourth quarter.  A more detailed breakout of the comparable restaurant sales results is shown in the table below.  The December numbers posed some as Global +3.7% vs. consensus of +3.9%.  US +2.6% vs. consensus of +3.8%, Europe (0.5%) vs. consensus of +3.0% and APMEA +8.9% vs. consensus of 5.6%.

 

MCD: A CULTURE OF NO BAD NEWS? - mcd comps

 

Europe trends were adversely affected by weather in the month of December, as were trends in the U.S.  Management estimates that the impact of weather was 5% and 2% on the Europe and U.S. markets, respectively.  While restaurant level margins increased year-over-year, the trend is certainly not favorable heading into 2011 and what I believe will be a difficult inflationary environment for MCD.  From a sales perspective, comp compares will become progressively more difficult in 1Q, 2Q, and 3Q10.  Margin comparisons also step up next quarter, and remain difficult for the first three quarters of the year.  The quadrant chart below shows where we expect the company to trend operationally over the next four quarters. 

 

MCD: A CULTURE OF NO BAD NEWS? - mcd quadrant

 

Management is acutely aware of the current trend in input costs that several Hedgeye teams have been highlighting for months.  As such, they have raised their commodity inflation outlook.   For the full year 2011, the total basket of goods cost is expected to increase 2-2.5% in the U.S. and to increase 3.5-4.5% in Europe.  Prior guidance was for inflation of 2% in the U.S. and 3% in Europe.   On the earnings call, management expressed their capacity to raise prices as commodity and other cost pressures become more pronounced throughout the year.   Given how important value has been for MCD traffic growth, raising prices enough to significantly offset increases in input costs may be detrimental to comps.  MCD has obsessed over driving guest counts and maintaining 2010’s momentum while passing on inflation may be difficult.

 

Another measure that management presented to help buttress margins was 24 hour openings.  While the rolling out of 24 hour operations in some markets may have coincided with increase in margin previously, I am unconvinced that this initiative is fail-safe given the disparate results quick service restaurant operators have experienced through 24/7 opening hours. 

 

The beverage business can be a high margin business and much of MCD’s margin success in 2010 was due to the sales of frappes and smoothies in 2Q and 3Q along with commodity cost favorability.   Lapping these benefits in 2011 will prove difficult, in my view.  While management underlined the growth in coffee sales as a percentage of total sales, from 2% “a few years ago” to 6% today, it is important to remember, as I illustrated in the Hedgeye MCD Black Book earlier this month, that beverage marketing as a percentage of total marketing spend has increased to 43% in 2010 from 3% in 2008.   That is an unsustainable trend.

 

Variable labor costs increased in the fourth quarter and I believe that the company’s ever-expanding menu and focus on beverages and other small check items (dollar menu) are significant parts of the problem. 

 

Much of the sentiment around this stock continues to purport that MCD can defy gravity.  I would argue that the year-over-year margin compares, compounded by last year’s leverage to beverage sales and parabolic commodity price increases, together with slowing sales in the U.S. will eventually convince the investment community that a culture of “no bad news” is generally misleading!

 

MCD: A CULTURE OF NO BAD NEWS? - MCD ratings chart

 

Howard Penney

Managing Director


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