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The MCD conundrum is a common problem in this environment and the road ahead may have some potholes.

The second quarter results from McDonalds were strong on many fronts; U.S. comps remained resilient in June, traffic was up (check was down), and margins were up with a favorable outlook remaining in place for costs in the U.S. for 2010.  The earnings call provided some interesting commentary on the company’s strategy to continue to drive sales in a soft macroeconomic environment.  Although, some caution is merited going forward.

Looking back over the 2006-2008 time period the McDonald’s system rose prices 3-4% per year to drive top line sales.  In late 2008 and early 2009 the economic climate would not allow the system to continue the same strategy.  During that same 2006-2008 period, MCD saw a slowdown in transaction growth.  In many markets across the US sales would be up for a given month, let's say 3-4% and transactions would be flat or down.  Knowing that TC’s (transactions counts) are an integral part of the overall corporate strategy this made management nervous, but overlooked it as they were getting the sales increases they needed.

Without the ability to raise prices, senior management saw the need to drive incremental TC’s in late 2008 and early 2009 with the slowdown in the economy.  As with every company I follow, MCD’s earnings call was punctuated with references to the softening macroeconomic environment.  Unemployment remains a pressing concern for MCD and, along with inflation in food-away-from-home and food-at-home; unemployment is one of the key metrics management monitors when considering pricing in the menu. 

As a result, for the past year it's been all about TC’s to buoy comps through the recession at the expense of check.  For the time being, declining commodity prices have mitigated the margin impact of the lower check.  Thus the McDonald’s CONUNDRUM - how do you balance the negative impact of lower menu prices on margins with the benefit of lower commodity prices going away in 4Q10 and 2011?    

In the United States, the Dollar Menu at breakfast continues to generate growth in guest counts and sales, but is putting significant pressure on the average check.  The decline in average check at breakfast is rumored to be as much as 10%.  Check is also being dragged down by an increase in one and two-item visits versus the normal four average items per visit in the U.S.  As a side note, a similar situation is found with CAKE – traffic is being driven by low cost items and there is evidence of check management on the part of consumers.  Both MCD and CAKE were down significantly following the reporting of 2Q10 earnings.

The recent rollout of smoothies has certainly provided plenty of buzz in the market and management stated that their expectations for smoothie’s sales have been exceeded and the margins have helped to offset some of the margin pressure.  

I would have liked more specificity around the McCafe strategy to ascertain the ROI the company is gaining from the venture.  Premium products may be raising the profile of the brand, or offering more variety, but these higher margin premium items have not been driving incremental customer visits.  As management stated on the 2Q10 earnings call, the entire boost in margins over the past three quarters was commodity driven.

McCafe and premium Angus snack wraps are not the way forward for MCD sales trends in this environment.  Should the commodity environment turn unfavorable over the next few quarters, MCD’s margins are highly vulnerable.  While commodity costs remain favorable, as the benefit to the MCD food basket reverses, margin erosion will surely ensue.

As you can see from our SIGMA chart on MCD, the company is operating in Nirvana (positive sales and positive margins).  In short order (1-2 quarters), the company will be headed down to the “trouble brewing” quadrant.  This will begin to limit the upside potential for EPS and also suggests that valuation will contract and not expand.  

One telling disclosure from management, on the slightly softer Europe comps in June versus May, was “our branded affordability proposition helps us tremendously across Europe.  We have also got some great premium products that we’ve implemented”.  Whatever the intention of this statement, it sums up the true dynamics behind MCD’s overall sales – value is still driving traffic, premium products are not.

Another CONUNDRUM for the company; franchisees keep complaining that when average check drops each customer becomes more expensive to service.  This is not a “high quality” problem. 

MCD – THE MCDONALDS CONUNDRUM - mcd sigma

MCD – THE MCDONALDS CONUNDRUM - MCD US

MCD – THE MCDONALDS CONUNDRUM - mcd eu

MCD – THE MCDONALDS CONUNDRUM - MCD APMEA

Howard Penney

Managing Director