McDonald’s shares have recovered well since the November lows and are outperforming the S&P 500 year-to-date but management has plenty of work to do to ensure EPS growth in 2013.
McDonald’s same-restaurants sales in November were sequentially stronger than October’s, albeit aided by the calendar shift, but December will offer a more meaningful indication of the health of the company’s business heading into 2013.
Latent Issues Remain
We’ve had concerns about the operational complexities that have manifested themselves over the past 5-6 years. Like Yum! Brands, McDonald’s has difficult top-line comparisons, from a same-restaurant sales perspective, over the next three months. Even if our concerns over the operational side of the business are unfounded, we believe that staying on the sidelines for the next three months is worth considering.
Consensus is expecting sales to recover in 2Q13 but, if our contention about over-complexity in the operational setup is even half-accurate, consensus could be early on the turn. Street expectations of 5% revenue growth and 9% EPS growth are overly optimistic, in our view, with food inflation running in the low-to-mid single digits. This, along with ongoing pressure in Europe, represents a risk to earnings growth expectations.
- We believe that 5% revenue growth could prove to be aggressive by 150-200 bps, in our view
- The margin recovery story, that the street buys into, seems less and less likely to materialize
Move to Value Has Failed Before
In 2003/2004, McDonald’s made an aggressive move to value that failed to gain traction with consumers and we struggle to understand how value will put sales trends on the right track in 2013. The company needs to take price or shift mix in order to mitigate margin erosion due to beef price inflation.
Increasing complexity in the back of the house can present challenges to restaurant companies. Management has disagreed with our view that this is happening at McDonald’s but we think three areas need to be addressed to help sales and margins recover:
- Menu Optimization: A typical McDonald’s in the United States carries out more than 1,000 transactions per day with many items carrying 10-30 transactions, daily. At a point, the complexity in the menu hampers efficiency to the degree that some of the less popular items need to be taken off the menu.
- Espresso-Based Beverages: The biggest loser on the menu is the line of espresso-based McCafé drinks. Given that the Chief Executive Office was the primary champion, internally, of placing these items on the menu, we see little chance that management will change course. More and more advertising dollars need to be pulled away from the McCafé line as, over time, pressure will build on management to invest less and less in an under-performing business
- Removing the Angus Burger: The Angus Burger has failed to meet expectations. With promotions, restaurants tend to sell roughly 70 per day in US markets. Without promotions, that number falls to less than 40. While the $4 price tag helps average check, that the company had to go to the McRib for December implies that Angus burgers are failing to meet expectations. Removing the Angus could prove to be an operational improvement given the additional features of the Angus versus other burger offerings (extra patty, extra bun)
What is the Company Focusing On?
The company’s global priorities are:
- Optimizing the menu
- Modernizing the customer experience
- Broadening accessibility to our Brand
The menu has not, as of now, been optimized to the degree that it needs to be. The pricing structure was changed but that strategy has not been positive. The modernizing of the customer experience is a given, in 2013, and remains an ongoing process. Broadening accessibility to the brand seems to be an exhausted approach for McDonald’s; increasing accessibility at this point could involve lower returns.
The McRib has always, since 1983, been a three-to-four week promotion, which began this year in November. While many markets began selling McRib in November, the advertising started in mid-December and it appears that a number of markets are still selling it in January.
Other than the aggressive global value message, details are few and far between on 2013. The company plans to “relaunch” the Big Mac this year, with the commissioning of a 10-ad special campaign, reintroducing the Big Mac to America.