Strong Dollar Weighs on McDonald's

By Peter Pham - July 28, 2012 | Tickers: FXY, JJA, MCD, YUM | 0 Comments

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Back out the extremely strong U.S. dollar and not just versus the Euro in the past 5 months and the results from Q2 2012 from fast-food giant McDonald’s (NYSE: MCD) were very good.  According to the financials the strength of the greenback accounted for $0.07 loss in earnings turning a $0.03 miss into a $0.04 gain.  Now, of course, a multinational like McDonald’s has to deal with this variability every quarter and one could argue that the extreme weakness in the Dollar is what has helped drive a lot of their earnings and revenue growth over the past two to three years but the facts remain that by a number of metrics, McDonald’s is not only executing well they are improving their position within the global Quick Serve Restaurant (QSR) market.

Same store comps in every market except Emerging Markets/Emerging Asia rose more than 3.5% in what was deemed a very difficult quarter. 3.7% sales growth in Europe, along with market share gains in places like Italy and Spain where they are in a severe depression show a very good underlying business as well as a flexible business model to adapt to rapidly changing economic conditions.  Income in the U.S. and the Europe was only up 2% but part of that was the extreme weakness in the Euro and other European currencies, like the Russian Ruble.

Speaking of Russia, buried in the earnings call was a note that Russia has returned double-digit comp growth for the 7^th consecutive quarter.  While everyone wants to discuss China and dissect their plans there, quietly Russia is becoming a major market for the Golden Arches.  Commodity and labor inflation in China for McDonald’s is a leading indicator of the difficulty that will be seen there over the next couple of quarters.  Also, a 2% devaluation of the Yuan did not help the COGS there as well. 

Japan’s struggles with the rebuild after Fukishima and other issues have plagued sales there and the effects of the Yen have been effectively neutral quarter to quarter.  The CurrencyShares Japanese Yen ETF (NYSEMKT:FXY) averaged $124.02 during the first quarter and $123.10 in the 2^nd, though the yen was more than three times more volatile in the first quarter. 

So, the story at this point for McDonald’s has to be one of cross-currents.  They are masters of the supply chain and cost controls at the corporate and franchise level but a slowing global economy and rising food and energy prices are putting them in a pincer move where margins will likely be squeezed over the next few quarters while China attempts to get control over its real estate and production over-capacity, liberalize the Yuan and disconnect itself as much as possible from the U.S. and Europe.

Hot Enough to Fry an Egg

The drought in the U.S., the global shortage of soybeans which have pushed up more than 60% since the beginning of 2012, and the secondary effects it will have on the global food supply from domestic beef and chicken prices to the price of hay all over the U.S. and Canada, absent further quantitative easing from the Federal Reserve the input costs up and down the food supply chain will likely rise to a near breaking point for the U.S. consumer. 

The rise in corn and soybeans can be seen by the performance of iPath Dow Jones UBS Agriculture Total Return Sub-Index ETN (NYSEMKT:JJA) one of the largest agricultural commodity instruments available to investors.  Since the beginning of June JJA has returned an astounding 31%.  The effects of the drought are already being felt in the market as local feed prices in the U.S. have jumped as much as 25% in the past month.  This will put huge upward pressure on McDonald’s breakfast value menu as the cost of eggs will rise proportionately. 

This will have a similar effect on all QSR’s, especially McDonald’s chief competitor in China, YUM! Brands (NYSE: YUM) KFC.  Corn and Soy are the primary ingredients in layer and grower feed.  If the harvest is as bad as is being priced in right now there will be sincere substitution effects into other grains like oats and rice, but they are much lower in protein content.  No doubt the chicken industry will adjust, but costs will rise.

The ripple effects should have investors demanding exemplary earnings growth.  If you are a current McDonald’s shareholder the company will continue to take care of you, the company is a cash generating machine.  But as a growth play it is hard to recommend it until Europe and the U.S. come out of their shells and the full effects on the global commodity markets are felt.

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