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McDonald’s Corporation (NYSE:MCD) is scheduled to announce its earnings on July 22. Shares of the world’s biggest fast food company have traded in a narrow range in the last three months as the monthly announcements of same-store sales figures highlight the difficulties that the restaurant chain is facing.

McDonald’s same-store sales have improved lately although that boils down mostly to a more favorable year-over-year comparison. McDonald’s global same-store sales surged 7.3% in the first quarter of 2012 and that is why the global comparable sales stood at a negative 1% in the first quarter. This time around, the corresponding figure should be better (McDonald’s global comparable sales were -0.6% and 2.6% in April and May respectively). June sales will be announced along with the earnings release. [1]

Can Profitability Show An Improvement ?

The big question will be if the fast food giant can grow its margins. McDonald’s profitability is getting hurt due to excessive reliance on the less expensive value meals. Due to flagging comparable sales in the second half of 2012, McDonald’s had upped its focus on value meals such as the Dollar meals to boost footfalls. Value meals generally have lower margins and are used by the company to attract more customers.

Margins for the company-operated restaurants were down 130 basis to 16.2% in the first quarter. The company also expects the cost of raw materials to increase 1.5-2.5% in the U.S. and 3-4% in Europe in 2013. [2] Until the time McDonald’s incremental sales are dependent to a large extent on the value meals, margins will remain under pressure.

For restaurants that are run by franchisees, McDonald’s doesn’t have to bear the food costs. Therefore, the company is relatively insulated from margin pressures among franchisees. However, if franchisees are hurting, it can limit McDonald’s bargaining power when renegotiating new contracts (e.g. future lower royalty rates). This effect will not be visible in the near term results but is a longer term trend we are watching.

There were also some reports a couple of months back suggesting that there were growing differences between McDonald’s and its franchisees. Even if the Dollar menu (or other lower priced products) is able to raise the total sales, McDonald’s might be the only beneficiary (since its revenues are a function of the franchisee sales) while its franchisees could be left struggling with lower profits. Thus, the company also has to address the growing discontent among franchisees arising due to these dynamics.

Meanwhile, the fast food chain’s global expansion will continue particularly in Asia/Pacific. It opened 970 new restaurants in 2012, out of which 241 were in China alone. In 2013, McDonald’s plans to accelerate the global additions to 1200-1300. It is spending a whopping $3 billion this year on building new stores and refurbishing the existing ones.

We have a $96 price estimate for McDonald’s, which is about 5% lower than the current market price.

Notes:

  1. McDonald’s May sales rise 2.6 percent; shares up, June 10, 2013, reuters.com
  2. MCD 10-Q

Disclosure: No positions

Source: McDonald's Preview: Margins Under Pressure But Same-Store Sales May Improve

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