Why This Food Company Will Find it Tough in 2013

Lee is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Equity markets have been in positive mood over the last month or so, but it’s been an unusual type of rally. Blue chip defensives in the S&P have outperformed many technology stocks, which rather suggests to me that this is about money managers putting money to work rather than a concerted bullish opinion on the global economy. As a disciplined (some would say deluded) GARP investor (on the long side), I do not follow the crowd into stocks and stick to my own analysis. All of which leads me to ask, what is going on with McDonald’s (NYSE: MCD)

McDonald’s Diet Quarter

Frankly I wasn’t as impressed as the market was with McDonald’s last quarter or its outlook for this year. From a geographical perspective US margins have declined as McDonald's expands its value offerings in order to drive sales growth. Europe is looking weak with little pricing power outside the UK.  Meanwhile APMEA is also disappointing with weak conditions in Japan now being joined by negative comparable sales growth in China.

The slowdown in APMEA is worrying, particularly in China. There is a school of thought that thinks that MCD can take advantage of Yum! Brands' (NYSE: YUM) difficulties in China over probes into alleged high amounts of antibiotics in KFC chicken products. However, as I pointed out in an earlier article, fast food sales in China have been weak across the industry, and competition is fierce. Yum has been disappointing for a while there. Moreover, Yum keeps going with its expansion plans in China and Burger King (NYSE: BKW) has plans to open up 1,000 stores in China within the next seven years. Indeed, this plan was a significant part of the rationale behind its IPO. Burger King is obviously more of a direct competitor to MCD, and its resurgence may also be causing pricing issues for MCD globally.

Europe is obviously difficult even though the UK remains the standout performer. In a sense MCD finds itself in a similar position to H.J. Heinz (NYSE: HNZ), which always seems to report good numbers in the UK. Heinz is somewhat of an iconic brand in terms of its baked beans and sauces range and the UK and US have similar levels of income disparity. I suspect this means their mass markets have a similar predilection in their eating habits. There is less variability in food consumption in countries with more evenly distributed income. However, neither Heinz nor McDonald's can rely solely on the UK for European growth!

McDonalds Spending Plans for 2013

Capital Expenditures were ramped up in 2012 and ended the year between $3 -$3.1 billion, which is somewhat higher than the expected $2.9 billion. And there is no let up in 2013 with $3.2 billion planned, half of which is going towards opening new restaurants. Is aggressively opening new stores the right way to deal with slowing comparable sales growth?

McDonald's opened 256 restaurants in China last year and plans to open 300 this year in order to have 2,000 in place by the end of 2013. All in all 850 are planned for APMEA, 20 in Europe and 220 in the US, with 1,600 restaurants intended to be reimaged globally. In addition, reimaging activities will remain strong in 2013.

Facing Headwinds

Moving into 2013 McDonald's faces some headwinds:

  • Global Informal Eating Out (IEO) visits are forecast to be flat to negative.
  • US growth seems to be being achieved at the expense of margins thanks to initiatives like revamping the Dollar Menu.
  • Commodity costs for MCD are forecast to rise 15-2.5% in the US and 3-4% in Europe alone.
  • MCD forecast G&A costs to rise 2-3%.
  • Europe remains challenged and APMEA is slowing.

Putting all these things together, I’m wondering out loud whether MCD is going to hit its targeted 6-7% operating income growth rate. Many of the assumptions around this idea seem to be relying on easier comparisons in the second half, menu refreshes, successful restaurant openings, general execution in the face of rising costs, constrained consumers and tough ‘growth’ markets.

It's a tough proposition.

Where Next for McDonalds?

I’m not a buyer here. The stock has had a strong run in line with the markets but it trades on nearly 18x earnings, and free cash flow growth is going to be held back thanks to the new restaurant openings and reimaging activities. I’m not against investment, on the contrary we should support companies that do, but it does create risk. And with everyone else keen on carrying on with expansion plans with informal dining in China, I can’t help but think that on a risk/reward basis MCD is not great value.


SaintGermain has no position in any stocks mentioned. The Motley Fool recommends Burger King Worldwide, H.J. Heinz Company, and McDonald's. The Motley Fool owns shares of McDonald's. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!

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