In mid-February, we pulled MCD from our Best Ideas list as a short due primarily to easy comparisons and the likelihood of a future financial engineering event. Despite this, we believe the McDonald’s business continues to have underlying issues that, at this point in the game, are not easily addressable. This morning’s press release and subsequent earnings call validated our thoughts.
McDonald’s reported disappointing 1Q14 results this morning, missing top line and bottom line estimates by 25 bps and 222 bps, respectively. Although system-wide same-restaurant sales beat estimates by 10 bps, the global business continues to be bogged down by the most important market – the U.S. Europe and APMEA same-restaurant sales exceeded expectations, but both markets continue to have issues. Overall, the McDonald’s system generated negative traffic in the quarter, driven by its four primary markets: U.S., Germany, Japan and Australia. Until performance in these markets turn meaningfully, the system will be hard pressed to generate notable earnings growth.
System-wide same-restaurant sales were +0.5%, beating estimates of +0.4%
U.S. same-restaurant sales missed estimates by 30 bps, driven by negative traffic. Management attributed most of the miss to unfavorable weather (note: CMG just put up a +13.4% comp) and, to a lesser extent, challenging industry dynamics (note: challenging for MCD). As a result, company operating margins fell 10 bps to 17.3%. Part of the margin compression can be attributed to higher commodity basket, led by proteins, that was up +3% year-over-year. Management expects this commodity pressure to persist throughout 2Q, before easing in 2H14. Guidance for the full-year grocery basket continues to imply a 1-2% increase.
MCD has identified several opportunities (enhanced marketing, enhanced customer experience, stronger core/promotional balance) to help strengthen the U.S. business. While the opportunities are apparent, the plan to execute and capitalize on them is less clear. We expect all domestic restaurants to have new kitchen equipment installed by mid-year, but the effect of the high density prep tables is largely unknown and franchisees have reported mixed feelings. Domestic restaurants will also implement a reset in the first half of 2014, focusing on staffing and scheduling, which could benefit peak hour throughput. A new, innovative marketing message could help the brand generate some modern day relevance and the company is hoping the new CMO will be able to deliver this. Management emphasized the importance of its breakfast business and denied any claims of competitive pressures affecting the daypart in 1Q.
U.S. same-restaurants sales were -1.7%, missing estimates of -1.4%.
Europe same-restaurant sales beat estimates by 20 bps, driven by strength in the U.K., France and Russia. Company operating margins improved 30 bps to 70.3%. Despite this, negative same-restaurant sales and traffic momentum continued in MCD’s most important European market – Germany. The brand continually struggles to offer affordability and connect with customers in this country. We need to see this market turn before we become bullish on this region. In accordance with Hedgeye’s Macro view, management acknowledged that economic indicators in the region appear to be stabilizing, but cautioned that quarter-to-quarter results could remain volatile.
Europe same-restaurant sales were +1.4%, beating estimates of +1.2%
APMEA same-restaurant sales beat estimates by 30 bps, driven by strength in China, due primarily to a one-time benefit as the country lapped last year’s supply chain issue. Japan and Australia, however, weighed down the overall performance of the region. Company operating margins decreased 60 bps to 14%, as sales momentum wasn’t enough to fully mitigate cost pressures and the negative impact from new restaurant openings in China. Management continues to believe this region offers the potential for significant growth.
APMEA same-restaurant sales were +0.8%, beating estimates of +0.5%.
On the earnings call, management highlighted four opportunities for improvement in their priority markets. These initiatives, which could be applied to other markets as well, include:
- More effectively bridging consumer insights into the right plans and actions
- Delivering a stronger, more resonant marketing message
- Enhancing affordability platforms
- Better balancing focus on core menu items and LTOs
There’s nothing wrong with these initiatives. In fact, we understand the basic rationale behind all of them, but that alone doesn't give us confidence in management's plan. The issue is they are not easily achievable or measurable and will be difficult to tailor to each diverse market. McDonald’s is not nearly as nimble as it used to be. We like that management is acknowledged some of the concerns we have raised, but none of these initiatives offer game-changing solutions.
As we cautioned several months ago, the real, more immediate opportunity for value creation is in the form of a future financial engineering event. Management didn’t go into much detail, but they did reinforce that they are continually looking at ways to improve shareholder returns. As CFO Pete Bensen briefly mentioned on the call, this could include optimizing the capital structure, re-franchising activity (particular in international markets) and reallocating general and administrative expenses.
We’d rather not speculate at this point, but we assume this event will be a positive catalyst for the stock. Management plans to release more details surrounding this development prior to the closing of the second quarter. As it stands, we believe the stock remains disconnected from the fundamentals and until we see a material improvement in system-wide trends, particularly in the U.S., we continue to believe this event will provide another nice entry point on the short side. For the time being, we remain on the sidelines.