It is tempting to say that the worst is over for McDonald’s, but we don’t think that it is. Our view is that domestic sales trends in June are continuing to be soft and the outlook for the summer is not positive.
Soft Traffic Trends
In early March, we wrote a note titled, “MCD – THE NEW VALUE MESSAGE”, which discussed the changes the company was making to the menu at the time and the importance of the April sales release for investors. We wrote, “investors will be watching closely for an indication of whether or not the new menu strategy is working.”
The April and May sales releases have suggested that the new menu strategy is not working as well as the company might have hoped, with management warning yesterday that “customer traffic will be difficult to grow near term”. On the positive side, the company did highlight an emphasis on staffing to grow the peak lunch rush hour from Noon to 1 o’clock yielding an improvement in guest count growth year-to-date through May.
If customer traffic is flat-to-down but the core lunch business is showing some improvement, where is the slow down coming from? Two thoughts:
- The core menu implemented in March has caused slower traffic as the company’s effort to force consumers to trade up from the $1 menu
- There is little-to-no growth in the afternoon day part
Difficult Summer Comps
Going forward, we are concerned about the ability of the company to comp the comps. Summer 2011 was a period of rapid growth for McDonald’s in the U.S. with beverages being a key driver. Changes on the margin are all-important and we see the decrease in emphasis on beverages as a strategy going forward as being important. While management said that “the U.S. also continues to strengthen its position as a as a beverage destination”, total beverage units were only up 6% versus up 20% in 4Q11, 16% in 3Q11, and 29% in 2Q11. In fact, the word “beverage” was only mentioned twice on the 1Q12 call. The 4Q11, 3Q11, and 2Q11 calls included 4, 8, and 18 mentions of the word “beverage”, respectively. The word “McCafé” was mentioned twice on the 1Q12 call. The 4Q11, 3Q11, and 2Q11 calls included zero, 7, and 11 mentions of the word “McCafé”, respectively.
The evidence suggests that beverages are increasingly becoming a less important part of the vocabulary from McDonald’s’ management team. With that in mind, foremost in our thoughts is what the company’s strategy will be to maintain top-line momentum over the next few months.
Below is our note from March 9th which described our initial concerns about the new menu strategy.
MCD – THE NEW VALUE MESSAGE 03/09/12 02:49PM EST
Some incremental changes coming to a MCD menu near you – what are the implications?
As first reported by Reuters, McDonald's “will be tweaking and expanding their value-priced items” at the end of March. MCD has not discussed this with the street due to competitive reasons.
As we learned in conversation with the company, they are focusing the menu on four tiers (not including combo meals):
- Premium: $4.50-$5.50+
- Core: $3.50-$4.50
- Extra Value Menu (new): $1.20 to $3.50+
- Dollar menu
In trying to understand the implications of what McDonald’s is doing, a restaurant industry consultant and associate of ours had this to say: “I get a kick out of these corporate guys at WEN and MCD pretending they have some magical formula for value pricing. It's 100% driven by food costs and customer behavior.” Given that MCD is seeing increasing inflation in 2012, we believe they are trying to manage check and margin by forcing consumers to trade up to the “extra value menu” from the “dollar menu.” This makes more sense when we consider that one of the biggest changes is to remove small drinks and small fries from the dollar menu and replace those items with fresh baked cookies and ice cream cones.
HEDGEYE: We see this as a big risk for MCD. If customer preference is to have the drink and fries as part of the dollar menu then there is a risk that this change negatively impacts customer satisfaction. The company told us that a “mini-combo meal” offering may bundle the fries, burger, and drink but a decision has not been made on that yet. Still, ordering the $1 items individually is being taken off the table.
The new "Extra Value Menu" will be advertised on March 26th. According to Reuters, “the new menu will include 20-piece chicken McNuggets, double cheeseburgers, chicken snack wraps, Angus snack wraps, medium iced coffees and snack-sized McFlurries, plus up to four regional options, that were previously listed elsewhere on its menu.” The idea for McDonald’s is to streamline and change what is highlighted on the menu. The company likes to phrase this differently, saying that they are, “making it easier for customers to find them [‘Extra Value Menu’ items]”.
HEDGEYE: From our perspective, the big problem is that the "Dollar Menu" has been around for a very long time. Inflation has made it an unprofitable but necessary evil. Customers, also pressed by inflation, have been migrating from the combo meals on the core menu, which can cost $6-7, over to the Dollar Menu where the value customers get is almost double from a price perspective. We view this latest change as an attempt by the company to stem this flow of business from the core menu to the dollar menu. This adds an extra emphasis on the importance of April sales; investors will be watching closely for an indication of whether or not the new menu strategy is working.