Shares of McDonald's (MCD – Free McDonald’s Stock Report) were little changed after the restaurant operator delivered first-quarter sales and earnings that fell short of investors' expectations. Revenues rose a little over 1% on a year-to-year basis in the March period, to $6.700 billion, versus our $6.775 billion call. Unfavorable currency movements weighed on the top line, and the advance would have been closer to 3% in constant currencies. Global comparable-store sales climbed 0.5% in the quarter, as overseas operations and a higher average check offset weakness on our shores.
Indeed, the United States was the weak link in the first quarter, as comparable-store sales here fell 1.7%. Traffic was negative, reflecting intense competition in the quick-service restaurant space and harsh winter weather that blanked much of the country in the first quarter and kept would-be diners at home. Conditions were better in other corners of the globe, however, and same-store sales in the region comprised of Asia/Pacific, the Middle East, and Africa moved up 0.8%. Performance in China was solid, although gains there and in other nations were partially offset by weakness in Japan and, to a lesser extent, Australia. Management cited premium product innovation, affordability, and convenience for the gains. Europe delivered an even better performance and was once again the standout. Comps advanced 1.4% on the Continent, thanks to solid growth in France and Russia, that was somewhat offset by softness in Germany. Sales in the United Kingdom also did well. Limited time offerings, as well as the company's barbell strategy of having premium menu items alongside more affordable, everyday options, seemed to resonate with consumers.
Taking a closer look at the income statement, total operating costs and expenses as a percentage of revenues ticked higher by 62 basis points, due in part to an uptick in SG&A costs. Higher interest expenses also took a toll, although the bigger culprits were unfavorable currency movements, which shaved about $0.03 a share from the bottom line, and a 235 basis point increase in the tax rate. A lower share count helped to mitigate these headwinds, but at the end of the day, earnings came in at $1.21 a share, a nickel below both the year-earlier tally and our estimate.
Looking ahead, management said that global comparable-store sales should be modestly positive in the month of April. While weather-related challenges should ease, fundamental issues still remain. Competition in the quick-service restaurant sector is apt to remain fierce as peers try to steal market share from McDonald's, especially in the breakfast segment. Coffee shops are selling more food, as Starbucks (SBUX) rolls out more of its La Boulange pastries and Dunkin' Brands Group (DNKN) expands west of the Mississippi. Even unlikely participants, such as Yum! Brands' (YUM) Taco Bell, have entered the fray. McDonald's management also has to focus on customer service and throughput, as its increasingly large and complex menu leaves more room for customization, resulting in longer wait times. The company knows it needs to steady the ship, and its near-term efforts are primed to stabilize key markets like the U.S., Germany, Japan, and Australia, through efforts like more effective marketing, a focus on the core menu, and repositioning the affordability platform should help. New, more efficient kitchen preparation stations and reassessing staffing and scheduling during peak mealtimes are also under way.
Overall, our outlook for McDonald's hasn't changed too much. Commodity cost inflation is still expected to be modest (up 1%-2% in the United States and Europe), while new stores and slight price increases should add to revenues. Still, we have shaved a dime off of our 2014 earnings call, which now stands at $5.75 a share, to reflect items such as the first-quarter miss and more modest margin expectations.
Although the road ahead is apt to be bumpy given stiff competition and the still uneven economic recovery, as well as the internal issues mentioned above, we believe that MCD stock offers intriguing risk-adjusted total return potential out to 2017-2019, as management's focus on modernizing restaurants, expanding the store base, improving customer service, optimizing the menu, and buying back stock should lead to better share-earnings growth down the line.
About The Company:McDonald's is a quick service restaurant with over 35,000 locations in more than 100 countries (as of March 31, 2014). The majority of the restaurants (over 80%) are operated by franchisees or affiliates. The company is best known for its hamburgers and French fries, but it now has a diverse menu that includes breakfast items and an array of coffee-based drinks.
At the time of this article’s writing, the author did not have positions in any of the companies mentioned.