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McDonalds (NYSE:MCD) report: Market share, margins on the rise

November 16, 2010, Tuesday, 05:15 GMT | 00:15 EST | 10:45 IST | 13:15 SGT
Contributed by Fat Prophets


The recovery in McDonald’s same store sales growth rate surprised the market when the company reported its third quarter earnings. In addition, the world’s biggest burger chain has been gaining market share from its rivals as menu changes are biting. International sales are maintaining good momentum and the company’s cost control is contributing to higher margins.


Even as unemployment remains stubbornly high in the US, McDonald’s has been able to convince consumers to venture into its stores and spend money. It has done so with an improved breakfast menu and the introduction of new frappe drinks. The combination of these things has been sufficient for McDonald’s to not only regain momentum in its same store sales growth, but to take market share from its rivals.


The market had been anticipating same store sales growth of approximately 3.8% in the third quarter ending 30 September. Instead, McDonald’s surprised analysts when it reported growth of 6.0% worldwide. Especially encouraging was the 5.3% increase in US same store sales growth, demonstrating an improving trend throughout the year.


The company is expecting the run-rate of 5-6% to continue in October. The following chart shows the slowdown experienced in the 2008 period affected by the GFC. Since the first quarter of 2010, however, the trend is clearly returning to its previous level.

 

 
When looking across the company’s regions, the same trend is evident although Europe’s growth rate at 4.1% still has further to recover than the 8.1% reported for the Asia Pacific, Middle East and Africa region. At approximately 40% of total sales, the European region is the most important to McDonald’s, so a recovery here remains necessary to really boost group sales.


The Asia Pacific region includes China where it requires little explanation that consumerism is growing rapidly. McDonald’s has 1,217 restaurants in China as at the end of September and plans to have about 2,000 restaurants within the next three years. McDonald’s has had a presence in China for over 20 years but trails its US ‘informal eating out’ competitor, Yum Brands which has 3,700 (mostly KFC) restaurants.


One theme McDonald’s will need to closely monitor on its Chinese expansion is the cost of labour. This has been rising typically between 8-10% per annum. It is not clear at what level it is rising from, but McDonald’s reports that its payroll and employee benefits expense represents approximately 25% of its company-operated restaurant revenue.


Anecdotally, costs are rising quickly for many Chinese residents. In Hong Kong for example, the cost of hosting a wedding has become such a burden for some that McDonald’s is offering a ‘McWedding’ service at three of its restaurants next year. We doubt the company is straying from its core business but is merely using the idea as a clever promotional tool.


In the US, the promotion of the new breakfast menus and the new frappe drinks has been very successful in drawing more customers. McDonald’s market share has been rising throughout the year as a consequence. The following chart shows the market share of selected competitors:

 


 

Rising commodity prices have also impacted the sector, particularly in coffee. In September, Starbucks announced it could no longer resist boosting prices after coffee prices reached a 13-year high. The world’s biggest coffee chain nudged prices up in some of its menu items and its packaged coffee. The top US packed coffee maker, J.M Smucker Co. passed on a 9% rise in prices in August (after a 4% increase in May) which was quickly followed by Kraft Foods raising prices for its Maxwell House brand.


McDonald’s, however, has resisted increasing its prices which were already set below Starbucks. This could lead to further market share gains if the company decides to avoid raising prices of coffee-based drinks.


Across the sector, third quarter sales results appeared to confirm this as Yum Brands noted an 8% decline in KFC US sales, although its total same store sales growth for the quarter came in at 1%. Same store sales at Buffalo Wild Wings rose 2.6% in the period, but fell 1.7% in the four weeks since the end of the quarter at franchised restaurants. Burger King no longer reports its results as it is now privately owned.


The improving customer metrics are flowing through to operating profit margin improvement for McDonald’s, despite higher commodity costs. Operating profit margin increased to 33.3% in the third quarter, a solid improvement on the 31% second quarter mark and 32% recorded in the same quarter a year ago. McDonald’s has averaged operating income growth of 12.6% per quarter for the financial year to date.


The company is on track to report a reasonably good full year result with consensus earnings estimates placing it 11.5% ahead of the previous year.


Even as expectations look quite positive, the market is still not pricing McDonald’s as richly as its peers. The following table looks at the forecast PE ratios of some of the company’s competitors:

 

 
Looking at the weekly chart of McDonalds we can see one of the most impressive five year charts in the market that shows no sign of a Global Financial Crisis. The strong move higher continues with MCD breaking to new highs once more, registering a new 52 week high of $79.48 on October 21. The weekly MACD is still in bullish territory and suggests the trend will continue.

 


 

Taking a look at the daily chart of MCD we can see that the share price has pulled back from the recent high as the daily RSI has registered an overbought sell signal. We would expect the 50 day moving average which is currently at $75.32 to act as support should we see more selling. We would view such a pullback as a potential buying opportunity given the long term strength of the uptrend.

 


 

In our view, McDonald’s remains an interesting play on the recovery in US consumer spending. We will continue to hold the stock in the Fat Prophets Portfolio.

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