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Including today’s performance MCD is down about 1% year-to-date and has underperformed the S&P 500 by roughly 5.0%. 

The underperformance is testing the willpower of the BULLS as we are headed into a very tenuous time for the company - the reporting of 1Q11 EPS.  Before we learn about earnings, we will get one more monthly reading on same-store sales trends for February. 

Yesterday, Bloomberg ran an article that highlighted one of primary our concerns for MCD, which is that the advertising strategy for the company has moved too far away from the core customer and is now too focused on selling a drink rather than a burger.

The article focused on Ronald McDonald and the company’s move away from using him as part of the advertising strategy.  While I agree with the premise of the article, the focus on Ronald McDonald misses the point.  Kid’s meals have been declining in importance for 20 years as evidenced by the removal of most playgrounds from suburban MCD stores six years ago.  In addition, Happy Meals have become an afterthought on the marketing calendar.  Ten years ago you would hear rumors that one market or another ran out of a particular toy in the middle of a promotion; that doesn't seem to happen anymore.

Lastly, when was the last time you heard management give credit to a Happy Meal promotion for increased same-store sales growth?

We have seen in some markets that MCD has been pushing to sell the basic Happy Meal for $2.99 instead of $3.50 to help improve sales; this price reduction won't be implemented nationally because with rising food costs and the cost of toys, the Happy Meal becomes a money loser for franchisees.  Since Happy Meals are a low profit sale for the company, it’s just not a focus.  In addition, a parent can spend less by ordering off the dollar menu. 

As I highlighted in the MCD Black Book, the dollar spend on beverages has shifted significantly over the past three years.  Advertising on beverages as a percentage of the company’s total U.S. marketing spend has gone from 3% in 2008 to 43% in 2010.  As hard as MCD tries, they are not going to be as successful as Starbucks in creating that third place.  Consumers are just not going to use the restaurant the same way. 

Domino’s new and inspired pizza launch is the most recent example of a successful new product that can’t “comp the comp.”  MCD’s smoothie/frappe launch will fall prey to the same phenomenon.  To recall, I estimate that the incremental frappe and smoothies sales combined contributed about 5.7% of the reported 2Q10 3.7% U.S. comp growth and 5.9% of the 5.3% growth in 3Q10.  If my estimates are close to being correct, that would imply a decline in the company’s core business of about 2.0% and nearly 1% in 2Q10 and 3Q10, respectively. 

Given MCD’s consistently strong performance, a negative comp for MCD is a bigger deal than it is for Domino’s (DPZ has only reported five quarters of positive domestic company-operated comp growth after eight quarters of declines).  MCD has spent significant time and effort trying to grow its beverage franchise.  With the “hot” part of the McCafe strategy already a bomb, any concern about the “cold” side will have an outsized impact. 

MCD has one more month of easy comparisons in the U.S. in February.  Come March, the comparisons get much more difficult and we would not be surprised to see the company report negative monthly comp growth.  And, the comparisons get increasingly more difficult during the summer months when MCD laps its smoothie/frappe launch from last year.  I am currently modeling negative U.S. same-store sales growth in Q2, Q3 and Q4 of 2011.  Even if my estimates prove overly bearish, MCD’s U.S. comp momentum will likely slow in 2011.

Howard Penney

Managing Director