McDonald's Can't Grow

Jan.23.14 | About: McDonald's Corporation (MCD)

Shares of McDonald's (NYSE:MCD) were flat as investors digested another disappointing quarterly earnings release (press release available here). While the stock market has enjoyed a tremendous rally, McDonald's has been flat over the past twelve months as the company tries to deal with taste shifts in the United States and weakness in Asia. Going forward, I expect the company to remain dead money over the next twelve months as the dividend supports the stocks but struggling sales cap any potential upside.

In the fourth quarter, McDonald's earned $1.40, which bested expectations by $0.01. Revenue was a mild disappoint at $7.09 billion while analysts were looking for $7.11 billion. EPS was up $0.02 year over year while revenue was up 2%. However, same-restaurant sales in the quarter fell by 0.1% as global traffic declined; the street was actually hoping for a mild increase in same-restaurant sales. Problems in Japan continue to plague it as its Asia, Middle East, and Africa unit saw same-restaurant sales fall 2.4% year over year. This missed expectations for a 1.3% decline in the region. Europe continues to show improvement as the economy recovers though the 1% gain missed expectations for a 1.1% rise. The United States continues to be a drag on results as young consumers flock to other restaurants. Sales fell 1.4%, much worse than the expected 0.2% decline.

Basically, McDonald's underperformed in every region it operates in, and management needs to figure out a way to engage with new customers to get them to go to McDonald's rather than upstart fast-casual offerings. With a major marketing push alongside the Olympics, the company has a perfect opportunity to reframe its brand and change negative perceptions. Whether it does so remains to be seen.

In the U.S., management says the company is focused on its value proposition with the launch of the "dollar menu and more" menu to get customers in the door, though many dollar menu offerings have tighter margins. McDonald's has been focusing on value enhancements in Europe where sales are rising, which may be why management is hopeful about the strategy in the United States. However, the European economy is no longer in a death spiral with nations like the U.K. and Russia performing much better.

Interestingly, Germany was one of the weaker European nations. In terms of economic performance, Germany has been performing more like the U.S. than other European nations over the past five years. It is worth noting that this value enhancement strategy isn't performing as well in the U.S. and Germany as it is in the rest of Europe. This makes me feel more confident that improvement on the continent is driven more by recovering consumers than a changing menu as the menu hasn't moved the needle in stronger economies. In fact to win younger consumers back in the United States, McDonald's needs to enhance premium offerings like Wendy's (NYSE:WEN) has to compete more on quality.

Now the company has tried this once with the launch of "mighty wings." This initiative was a complete disaster, and the company has 10 million pounds of unused chicken wings. McDonald's hoped to attract fast casual oriented consumers with wing, but they are interested in the experience as much as the food. Consumers have flocked to Buffalo Wild Wings (NASDAQ:BWLD) as much for the sports bar environment as for its wings. Offering competing wings and nothing else was doomed to fail.

Younger consumers who have left legacy fast food restaurants for fast casual restaurants are willing to spend a little more rather than find the cheapest food (which is great for margins), but they have different demands. Issues like fair trade, sustainability, freshness, and food quality are more important than just having the cheapest offering, which is why McDonald's focus on value propositions is failing to bring in new customers. Consumers are paying up for Chipotle (NYSE:CMG) and Starbucks (NASDAQ:SBUX). Until McDonald's offers premium options while maintaining its value proposition for existing customers, sales will remain stagnant.

Frankly, the only reason to be in McDonald's is for capital returns. In 2013, management returned $4.9 billion to shareholders in dividends and buybacks. In 2014, the company expects to return $5 billion and will likely increase the dividend by another 3-5% in late 2014. While the yield of 3.4% may be attractive, EPS growth will be lackluster until the company can start to grow sales again. At 17x earnings, the stock is fully valued and there is little potential upside. Investors would be better off in Wendy's or Starbucks. I would continue to rotate out of MCD.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.