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McDonald’s Corporation (NYSE:MCD) is scheduled to announce its Q4 and full year earnings on January 23. Although 2013 has generally been a disappointing year for the company, its shares have managed to trade in a narrow range. Expectations are low from McDonald’s on the back of tepid comparable sales figures, which were up only 0.4% through November. [1] Comparable sales, or same-store sales, is an important measure to gauge a restaurant’s performance since it only includes the restaurants open for more than a year and excludes the effect of currency fluctuations.

We have a $97 price estimate for McDonald’s, in line with the current market price.

Downward Pressure On Profitability

Through the three quarters of 2013, margins of the company-operated restaurants are down 70 basis points. [2] Operating margins have eroded partly due to a greater proportion of sales coming from lower margin products such as those from the Dollar Menu and partly due to weak sales. Higher sales help spread out the fixed costs over a bigger revenue base and consequently improve margins.

McDonald’s is trying to improve its product mix through the introduction of the "Dollar Menu and More" and other premium products such as the Mighty Wings. The upcoming results will help investors gauge the level of progress made by the company.

McDonald’s expects the cost of raw materials to increase 1.5-2.5% in the U.S. and 3-4% in Europe in 2013, which is a moderate increase. [2] However, in the event that sales remain stagnant, any jump in food costs is likely to put a strain on the margins. Overall, we expect the margins of the company-operated restaurants to decline 50 to 60 basis points in 2013.

Moving on to the franchised business, McDonald’s franchised margins generally tend to remain in a narrow range since the company doesn’t have to incur food and labor expenses for these restaurants. However, weak store sales limit the company’s ability to negotiate royalty and rent rates, which is detrimental to the company in the long run. Weak store sales hamper the profitability of McDonald’s franchisees who in turn are likely to pressurize the company to lower its royalty/rent rates. In the upcoming earnings release, we expect some deterioration in the franchised margins due to a yen devaluation, combined with overall weak company-wide sales.

Currency Fluctuations: Mixed Bag

Currency fluctuations could also play a key role in its results. The euro has gained against the dollar in the last few months. In the fourth quarter of 2012, the euro was trading below $1.30. [3] However, in the fourth quarter of 2012, the euro has stayed upwards of $1.35. Thus, expect the European headline sales figure to remain strong in the upcoming earnings release. Europe is McDonald’s biggest market, in terms of revenue, contributing almost 40% to the top line. A strong euro translates to more dollars.

On the other hand, the yen devaluation is likely to play a spoilsport. On a year-over-year basis, the yen has devalued more than 25% against the dollar. Since nearly 10% of the franchised stores are located in Japan, fluctuations in yen are likely to make an impact on a company-wide basis.

International Expansion Continues

Despite disappointing sales, McDonald’s feels it is under-represented in international markets. The company is spending $3 billion in 2013 to add 1,200 net stores (1,500 total store additions and about 300 closures) and refurbish 1,600 restaurants globally. The company feels it needs to make its stores appear a little more upscale in order to compete against fast-casual restaurants such as Chipotle Mexican Grill (NYSE:CMG) and Panera Bread (NASDAQ:PNRA). Through the three quarters, McDonald’s has so far added 443 net restaurants but it usually accelerates store additions in the last quarter. [4]

Despite a string of weak monthly sales figures, McDonald’s shares have traded in a narrow range. This is mainly because a strong brand name combined with the opportunity to expand further into developing markets provides downside protection to the stock even during times when the company is not doing particularly well.

Notes:
  1. MCD 8-k
  2. MCD 10-Q
  3. dollars.com
  4. MCD 8-k

Disclosure: No positions

Source: McDonald's Q4 Earnings: Sales To Remain Weak But Margins May Improve