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McDonald’s Sells Off for Now, but Believers May Be Back

The Exchange

McDonald's (MCD) continues to see weak same-store sales, downtrodden economies in some of its largest markets and an inability to raise prices substantially, factors that ultimately led to revenue and earnings shortfalls in the second quarter and likely will linger in the months ahead.

McDonald's: Credit Reuters

Don Thompson, McDonald's president and CEO, said in a prepared statement Monday that the overall informal dining market is struggling in general as "economic uncertainty is pressuring consumer spending." The Oak Brook, Ill., restaurant chain is expecting its results for the rest of 2013 to "remain challenged."

Following the earnings report, investors sent the stock down 2.7% to $97.50 on heavier than normal volume. For the year, the shares were up 11% coming into the week and even hit an all-time high in April at $103.59. That marked a recovery for McDonald's, which fell 12% in 2012 after having doubled in the prior five years.

However, this post-earnings re-evaluation of what Ronald & Co. is worth may prove to be temporary. Among large fast-food chains, McDonald's price-to-earnings ratio remains in its favor, with a forward P/E of 16.8. That's below its smaller competitors Burger King (BKW), Wendy's (WEN) and Jack in the Box (JACK), as well as Domino's Pizza (DPZ) and Yum! Brands (YUM), the owner of KFC, Taco Bell and Pizza Hut. All of these have P/Es above 20. McDonald's also has a dividend yield, at 3.1%, that exceeds the group.

McDonald's earned $1.38 a share in the second quarter, falling short of the Wall Street consensus profit target by 2 cents. Sales rose 2% to $7.08 billion, though they came in a touch shy of analysts' estimate.

In the prior five years, sales growth has been 3%, negative 3%, 6%, 12% and 2%. This year, the top line is forecast to improve 3% to $28.46 billion, a pace not especially unlike the recent past. Considering McDonald's has proven itself to be a stalwart in the food arena, and its dividend earns it plenty of income-loving fans, irked shareholders may well prove willing to forgive the slight disappointments. Misses in recent quarters did drag on the shares, but it has more than bounced back.

McDonald's 5-Year Chart

That said, what is changing markedly are the comp sales, which are a direct result of traffic and order sizes, and that's a notable trouble spot. Since the middle of 2012, same-store sales have been through the worst stretch in years, with several months turning in negative showings. Until last year, that hadn't happened in nearly a decade.

Germany weak, Russia strong

Concerns about the health of the world's economies, in the U.S. and elsewhere, date back to the 2008 financial crisis. As has been the case for a few years, the economic picture remains mixed at best. The bigger worry for McDonald's, which grew its sales and share price amid the downturn, is how to continue pulling profits from its massive restaurant base and extending its reach.

In the latest quarter, worldwide same-store sales rose 1%, better than the 0.9% increase carried on FactSet. Still, the U.S. had growth itself of only 1%, short of the 1.3% anticipated gain. The United States is McDonald's largest market, serving as home to over 14,000 of the more than 34,000 locations worldwide.

Europe's comparable sales were down 0.1%, hurt by Germany, its third-biggest country, and France. The U.K. and Russia were stronger performers in the region, though the latter in particular is a small part of McDonald's, with only 356 restaurants at the end of last year.

In the Asia/Pacific, Middle East and Africa segment, comp sales were down 0.3%, mainly because of weakness in China, Australia and Japan, the last of which has the second-largest number of McDonald's.

McDonald's says it's maintaining or expanding market share in many key countries. That's the good news for stockholders. The bad news is its ability to hike prices has been hindered by the fact that in multiple markets around the globe, customers are too financially strapped to deal with more expensive items, hence the same-store sales raggedness. (The Dollar Menu accounts for about 13% to 14% of restaurant revenue.)

Thompson said he believes the "informal eating-out" category of which McDonald's is a part has been hit a bit harder than retail overall. "What we have to do is make sure that we institute and continue to have solid value," he said.

Raising prices ... somewhat

In order to do so, it will have to come amid the company's expectations of a flat to declining performance in the industry, the need to keep menu items affordable, commodity costs pressuring its results and heightened competition, from not only Burger King and Wendy's, but also the higher-end fare sold at Panera (PNRA) and Chipotle (CMG) that's often perceived as healthier.

Chief Financial Officer Peter Bensen said changes in the rate of inflation for food away from home and food at home will be influential with regard to McDonald's future pricing structure. The food at home index has only risen 0.9%, while both it and the away from home index are expected to increase 2.5% to 3.5% for all of 2013, he said on a conference call.

"We will definitely be looking at those as we move throughout the year," Bensen said. "The grocery store is a competitor, and that does impact the industry's ability to pass on price [increases]." In short, that means higher prices can only be implemented to the extent restaurant traffic isn't diminished.

In June, prices at McDonald's were about 1.5% ahead of last year.

Though McDonald's doesn't give profit expectations, it did say it was cutting its expansion plans a bit, lowering its capital spending projection by $100 million to $3.1 billion for 2013. That will mean it will open about 50 fewer locations this year than it had projected. China, where 300 new units were going to be built, will be most affected. Coming into the year, McDonald's said it would open 1,500 to 1,600 restaurants in total.