The Bad News Isn't Over for McDonald's

Shares of McDonald's (NYSE: MCD  ) were sinking Monday, down 2.5% because of, in part, a stronger dollar weighing on earnings. The fast-food king reported a decline in earnings per share of $0.03 to $1.32, though in constant dollars it would have made $1.39/share. Other line items were similarly affected as revenue was essentially unchanged despite a 5% increase at last year's exchange rates. Over the last 12 months, the value of a euro has dropped from $1.43 to $1.21, and with Europe being McDonald's most valuable region, bringing in 40% of its revenues last year, the Golden Arches are particularly susceptible to increased currency risk out of the eurozone.

The bad news for investors is that the situation is only getting worse this quarter. With worries over Spain and Greece again spooking investors, the shared currency has fallen to a new two-year low, and is unlikely to recover anytime soon. Assuming exchange rates don't improve, McDonald's will face a significantly greater shortfall in Q3 than Q2 as the chart below indicates.

Euro to US Dollar Exchange Rate Chart

Euro to US Dollar Exchange Rate data by YCharts

While euro rates held steady from Q2 2011 until September, current rates are already significantly lower than just a few months ago.

McDonald's isn't only the restaurant cooling off after earnings. Rival Yum! Brands (NYSE: YUM  ) missed earnings estimates by $0.03 as sales in China were particularly disappointing with a 4% drop in operating income. Meanwhile, fast-casual pioneer Chipotle (NYSE: CMG  ) was the big loser in the sector, losing 20% after the company showed slower sales growth than expected.

Feeling the heat
The recession in Europe is just one problem multinational restaurant chains like McDonald's are facing these days. Much of the U.S. heartland has found itself in the midst of the nation's worst drought in 50 years as corn and soybean prices reach record highs, which will lead to higher dairy, beef, pork, and poultry prices that could last into next year. And those increases aren't just limited to the U.S. as they will put a drain on wheat-importing countries in the Africa and the Middle East.

While McDonald's may escape some of the additional costs since it franchises 80% of its restaurants, as opposed to Chipotle which owns all of its restaurants, Mickey D's still takes in about two thirds of its revenue from company-owned stores. With lower prices and narrower restaurant-level margins than Chipotle, McDonald's may feel the sting of the added commodity costs even more so than its burrito-slinging competitor.

Furthermore, considering the drought began in June, McDonald's and other restaurant chains won't begin feeling the brunt of it until this quarter.

On another front, the golden arches is experiencing revamped competition from an unlikely foe north of the border. Tim Hortons, (NYSE: THI  ) the Canadian coffee chain and national symbol, recently launched a new lunch campaign, adding Panini sandwiches to its menu, and CEO Paul House believes the chain can overtake McDonald's, currently No. 1 in lunchtime market share, within five years. While Canada may constitute just one small corner of McDonald's kingdom, Tim Hortons' move is a reminder that just as Mickey D's is rolling out new items such as its McCafe line and snack wraps, its competitors are taking aim at the fast-food champion from all sides.

What's next
McDonald's is one of the best-known brands in the world, as visible a success story in business as any, but its shares have struggled this year. The stock is down about 10% after beating all other Dow components last year, indicating that perhaps it was due for a pullback. It's hard to doubt its franchising model long-term, which provides healthy margins due to its global rent roll, and for the buy-and-hold investor, the issues above don't constitute a reason to run from the stock. But through the next several months, shares should continue to feel the pressure from eurozone headaches and rising commodity costs. For the prospective buyer, a better price likely awaits.

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Fool contributor Jeremy Bowman owns shares of Chipotle Mexican Grill. The Motley Fool owns shares of Chipotle Mexican Grill and McDonald's. Motley Fool newsletter services have recommended buying shares of Chipotle Mexican Grill and McDonald's. Motley Fool newsletter services have recommended creating a bear put spread position in Chipotle Mexican Grill. The Motley Fool has a disclosure policy.

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  • Report this Comment On July 24, 2012, at 1:58 PM, midnightmoney wrote:

    Commodity costs and exchange rates aside, we're talking about a company that sells a fat-bomb hamburger that's not really a hamburger, but a zesty, sugar-laden little piece of chemistry made to look like a hamburger. If it were nike, they'd be selling a shoe that's not really a shoe, if hillenbrand, caskets that aren't really caskets, just this kind of flimsy appropriation. With a bun, of course. That's the centerpiece of the company, a hamburger that's not a hamburger. Thank you, but I'd sooner eat the shoe or the casket with a bun. As for the company succeeding, I wouldn't bank on it.

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