Headlines Really Impressive
McDonald's Corp. (NYSE:MCD) "blew away" expectations in their Q4'15 earnings report, reporting 5.6% U.S. same store sales, operating income up 7% (16% in constant currencies) and diluted earnings per share up 16% (26% in constant currencies). Major focus of the company release as well as conference call comments was the acceleration in U.S. comp sales, benefiting from the rollout (with heavy advertising) of "All Day Breakfast" and ,"to a lesser extent" better weather. The company executives took a well-earned bow, but were quick to say: "while we are pleased with recent momentum in the U.S. , we'll take at least six more months in comparable sales and growth….for the turnaround….and traction….to take hold." The Company went on to outline the improvements they continue to work on, around the world, in customer service, food quality, and increased differentiation of the dining experience. Tests include customer customization ("have it your way") and table service. In terms of specific product marketing initiatives, not much was specified other than continuing to emphasize the All Day Breakfast platform and the "McPik 2 for $2" recent promotion. China was called out as the most important growth market, similar to Starbucks (NASDAQ:SBUX) in that regard. Of note was the weakness in Europe, in the wake of terrorist activity, but other markets, Australia, China, Russia and Japan in particular, were noted to be moving forward nicely.
Details Not Nearly So Impressive
The Headlines were powerful: 4th quarter results included: Global comp sales up 5%, Consolidated revenues increase of 5% in constant currencies, Operating income increase of 16% in constant currencies, Diluted EPS up 26% in constant currencies.
Full year results were less impressive, as expected, since most of the operational initiatives implemented by new CEO Steve Easterbrook started to take hold in the second half.
Our following remarks are not intended to diminish the effort or the results of the new regime at McDonald's. There is no question that the brand is more dynamic and innovative than in quite some time. However, the celebration may be premature.
Reading beyond the headlines: Price Increases of about 2% helped to produce the impressive same store sales results. Operating Income was up 7%, as was Income Before Taxes, but that was after non-recurring items that reduced expenses by $60 million ($42M after taxes). Net Income After Taxes of $1206.2M vs $1097.5M (up 9.9%) would have been up 6.1% were it not for the non-recurring positive swing. The EPS comparison (reported, with the non-recurring benefit) was up 16% but that was helped by 5% by the large share buyback. Importantly, behind the impressive headlines, and the stated success of All Day Breakfast, traffic in Q4 was virtually flat. The company didn't say so, and the analysts on the conference call chose not to ask, but the traffic was disclosed after Q3 of '15 to be down 3.1% for nine months. The supplemental information provided with Q4 indicated traffic to be down 2.3% for the full year. Solving for the Q4 number that provides the "improvement from the end of Q3 to the full year provides a traffic number that was UP a minimal 0.1% in Q4, virtually flat. Of course this "flat" result was after better weather, heavy promotion of Breakfast All Day, the food quality enhancements such as buttered muffins and a new searing process for the quarter pounder, throughput initiatives at the drive-thru, and even the troubles at Chipotle (NYSE:CMG) which might have contributed one or two tenths of a percent to MCD. Putting it another way, and taking nothing away from management's vision or implementation, they gave it a heck of a shot, had their best result in years, remain dedicated and confident of the ongoing turnaround, but U.S. traffic was no better than flat. Reading between the lines of the Q4 conference call, management seemed to provide adequate caution going forward, saying "our financial performance in the coming year is not likely to be linear...we expect some variability in our quarterly results due to uneven prior year comparisons and some headwinds that exist, including macroeconomic issues in some of our High-Growth Markets and challenging guest counts in the U.S., Germany and France." Separately, to be sure, the currency hit is included in the reported numbers, and that may or may not continue. Some analysts are in fact recommending MCD as a "weaker dollar play".
Overall, it obviously seems to this observer that the headlines paint a prettier picture than the fundamentals support. I must quickly add that McDonald's is far from the first, or last, company to put a "happy face" on results, and the tone here is more justified than is often the case.
Where Do We Go From Here? Promote, Promote, Promote?
My other (call it "sobering" if you like) concern here is the promotional program McDonald's has embarked upon. While they work hard to improve the quality of their offerings and the dining experience in general, the name of the game in the near term is clearly aggressive discounting and movement toward the $1 menu of yesteryear. The Breakfast All Day initiative brought the traffic trend from several points negative to flat, materially improved same store sales, and didn't hurt the average ticket including add-ons, but the McMuffin is still more of a Value offering than a Premium Product. Continuing in that same vein, I for one do not judge the "McPik 2 for $2" exactly a "brand builder". It has admittedly been designed to counteract the "4 for $4" offering from Wendy's and the "10 Chicken Nuggets for $1.99" of Burger King. Here in Manhattan, it's "Pik2 for $3" and though the chicken sandwich and double (small) cheeseburger are kid's portions, it turns out to be an acceptable meal for many adults. It was even more interesting to me that the receipt with my "McPik 2" included a bounce-back (7 days) BOGO (FREE) Quarter Pounder w/Cheese or Egg McMuffin. So that's what the Golden Arches are offering: Breakfast All Day, McPik 2 for $2, Buy One Get One Free Quarter Pounder (a "signature" sandwich) during the next seven days. I can't help but wonder which member of the big three burger chains will be first to pull the trigger on the next traffic building initiative. Steve Easterbrook has been given justifiably high marks for the new energy he has instilled at MCD.
In summary, McDonald's is very strong financially, and a 3% dividend is not to be ignored. Furthermore, in addition to hundreds of millions of G&A efficiencies, MCD can do a lot of financial engineering by way of their real estate holdings, their plan to re-franchise 4,000 stores, and a ongoing stock buyback program. I suspect that, over the next couple of years, these elements will be more important to the stock performance than sustainable traffic increases at their stores. Last I looked, large competitors such as Burger King (BKW), Wendy's (NYSE:WEN), Jack In the Box (NASDAQ:JACK) are not standing idly by, and upstarts like Shake Shack (NYSE:SHAK), Habit (NASDAQ:HABT), Five Guys and Smashburger take market share as well.
Disclosure: I/we have no positions in any stocks mentioned, but may initiate a short position in MCD over 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.