MCD - DECELERATING

MCD’s U.S. same-store sales growth remained surprisingly strong throughout 2008 despite the tough economic environment. The company states that half of this comparable sales growth has been driven by traffic with the remainder coming from increases in average check. The growth in average check in 2008 was driven solely by MCD’s 3%-4% price increase, which was partially offset by negative mix contribution in each quarter. Please refer to the charts below, which assume 50% of MCD’s quarterly U.S. comparable sales growth is driven by traffic and 3.5% pricing for each quarter in 2008. One obvious explanation for MCD’s negative mix in the U.S. is that customers are trading down to the Dollar Menu, which has also helped to support traffic growth. Management has said, however, that the Dollar Menu has remained within its historical range of 13%-14% of sales.

Instead, management commented on this negative mix issue on its 3Q08 earnings call, saying, “I wouldn’t call it negative mix. The problem with an average check is you have a lot of different transactions in there. So our breakfast business, as we have said, in the U.S. continues to grow faster than the rest of the day and breakfast is a lower average check but a higher margin transaction. The same way with drinks. We were strong in our drink promotions through the summer, as we have talked about. Coffee is up more than 30% and a lot of those end up being transactions that are during off-peaks which are also smaller average checks, or they are only individual versus family purchases.”

When asked earlier this week about its pricing plans for 2009, management said in reference to Europe that MCD will most likely not be taking the level of pricing in the first half of the year that it normally would because “you’ve got to consider how the consumer is feeling and during these times the consumer is looking for deals and we want to make sure that we’re out there.” Although the company did not make any specific comments about pricing in the U.S., I believe the same line of thinking must hold for the U.S. as consumers are under increased pressure. I do not think the company will reduce its pricing but it may be become more difficult going forward to maintain its 3%-4% price increases. In 2008, MCD relied on these price increases to offset its negative mix and support same-store sales growth.

Also hurting average check in 2009 will be the increased contribution from specialty coffee sales. I continue to believe that MCD is launching its specialty coffee platform at exactly the wrong time (with people cutting back on these more discretionary purchases) and that it will not provide the expected sales lift. The bulls on MCD continue to believe that the company will be able to flawlessly execute on the launch of this new beverage platform, but specialty beverages are just that for MCD; a new platform. The company is not maintaining its strict focus on its core products, and I think these beverages will add complexity to a system that in the recent past has consistently improved its operations. That being said, increased coffee sales have resulted in lower average checks in the past so I would expect any incremental off-peak specialty coffee sales to put further pressure on average check growth.

Going forward, MCD’s ability to maintain its same-store sales momentum in the U.S. may be at risk as it becomes more difficult for the company to raise prices and as its average check is hurt by increased Dollar Menu, breakfast and coffee sales. Although increased breakfast and beverage sales would be good for margins, investors have become accustomed to consistently superior same-store sales results. Additionally, it should not go unnoticed that some of MCD’s biggest competitors, Wendy’s and Sonic in particular, are increasingly focused on their value offerings, and based on its recent success, MCD has the most to lose should these companies experience improved traffic growth. Remember, the restaurant industry is a zero sum game!

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