We thought things would be bad in the near-term for McDonald’s (MCD) and Yum! Brands (YUM), and they certainly were.
Let’s put it this way: McDonald’s third-quarter performance was ugly. The company’s quarterly results reflected revenue pressure across the globe coupled with lower operating income and earnings per share. Management fully admitted in the press release that “by all measures (its) performance fell short of expectations.” Consolidated revenue fell 5% in the period, while consolidated operating income fell 14%. Diluted earnings per share of $1.09 fell 28% in the quarter.
McDonald’s global comparable sales decreased 3.3% during the period, reflecting negative guest traffic in all major segments. Ongoing headwinds as a result of health concerns related to the sourcing of meat in China hurt performance in the APMEA (Asia Pacific, Middle East, and Africa) segment considerably, where comps fell ~10%. Operating income in the APMEA region was cut by more than half in the period.
Yum! Brands wasn’t spared by the Shanghai Husi debacle either, with its China Division system sales declining 9% in its third quarter, as 6% unit growth was offset by a 14% same-store sales decline. Yum Brands had little choice but to cut its earnings outlook for 2014 to 6%-10% growth, below prior guidance of 20% growth. We don’t think anyone was modeling in the Shanghai Husi event. Our fair value estimate for Yum! Brands is $70 per share.
At McDonald’s, weak performance in Europe (particularly Germany), ongoing government intervention in Russia and Ukraine–perhaps in response to economic sanctions from the West (safety regulators are inspecting over 200 McDonald’s locations in the country)–and soft operating performance in the US continue to stand out as material concerns. With the exception of the UK, where comparable sales and operating income increased during the period, there were few, if any, bright spots in McDonald’s quarter.
Pricing pressures from Burger King (BKW), which is offering 10-piece chicken-nuggets for $1.49 (well below the price at McDonald’s), the resurgence of Yum Brands’ Taco Bell in the breakfast arena, ongoing preference of millennials (teenagers and young adults) for fast-casual locations such as Chipotle (CMG) and Panera (PNRA), and competition from Starbucks (SBUX) in premium coffee has created a perfect storm of pain for McDonald’s in the US. Even Chick-fil-A could be taking a bite out of McDonald’s market share in the US, with the restaurant recently becoming “the most favored restaurant destination for families (source).” All of this raises some serious competitive and image concerns for the restaurant bearing the Golden Arches, and franchisees aren’t happy either. Many franchisees are banking on the Monopoly promotion and McRib comeback to help ease the pain.
McDonald’s outlook suggests troubles will continue, with management expecting global same-store sales to be negative in the month of October. We don’t think McDonald’s will post positive global same-store-sales for the fourth quarter either, given both internal challenges and external headwinds, pretty much across the board. Re-imaging efforts, a simplified menu, pushing decision-making to people with local market expertise (“back into the field”), enhancing the digital strategy, and a revamped marketing playbook to regain trust may slow the pace of declines, but McDonald’s may have to do a lot more to get things back on track. Its image has taken a hit amid the political battles regarding minimum wage in the US, and the competitive environment perhaps has never been more intense.
McDonald’s knows it must do something and is rolling out a new concept: McDonald’s Experience of the Future – “a comprehensive restaurant execution concept that elevates the menu and customer experience elements that are hallmarks of the McDonald’s brand.” Yum Brands is trying out a number of new concepts as well: Bahn Shop (Vietnamese), Super Chix (chicken sandwich concept), US Taco Co. and Urban Taproom (fast-casual tacos). It’s too early to say if any of these will ever pan out.
Despite the negatives, McDonald’s is still a strong brand, with significant profit-generating capacity and a sustainable dividend (the firm yields ~3.7%)–though we note growth prospects of the dividend have soured as of late. Given McDonald’s tremendous success during the past several years thanks to an ongoing focus on innovation, it should not be too surprising for the company to give back some of those gains amid the heightened competitive environment. We don’t think the board of McDonald’s is thinking about replacing CEO Don Thompson as a result of ‘this fiasco of a quarter,’ but something must be done strategically to repair the operating damage, which continues. Recently-elected President of McDonald’s US, Mike Andres, has a lot of work to do.
We’re not rushing to add McDonald’s to either the Best Ideas portfolio or Dividend Growth portfolio anytime soon. Our fair value estimate is $93 per share. Yum! Brands remains absent from both portfolios as well. We’re watching developments at both companies closely.