Sluggish Bottom-Line Growth Knocks the Edge off the Value Case for McDonald’s

McDonald's future growth prospects have diminished considerably in the face of novel sales strategies from its competition.

Jan 14, 2014 at 2:01PM

McDonald's (NYSE:MCD) has for many years distinguished itself as a marquee fast-food stock whose returns put to shame those of its competitors. This time around, the giant fast-food chain has earned itself a new and unflattering reputation as the biggest laggard among its peers. Even relatively new upstarts such as Yum! Brands (NYSE:YUM) now command more respect than this behemoth of the space. 

The low expectations for growth for McDonald's has resulted in the shares being among the cheapest in the sector. The stock's low forward P/E ratio of 17.55 is a true testimony to this.

This is not to say that McDonald's has not rightfully earned this new tag. The firm has been recording poor revenue growth and declining operating margins -- very worrying trends for a large, mature company. McDonald's could only manage to chalk up a measly 0.7% growth in same-store sales during the third quarter of 2013, while competitor Wendy's managed a respectable 3% growth.

It's not exactly like Yum! Brands has been wowing its investors either -- far from it. Yum! Brands recorded far worse results for the third quarter of 2013 as its profit tumbled by 68%. In contrast, McDonald's managed a modest 4.1% growth in its bottom line. So you might wonder, why are investors using double-standards and doling out this kind of treatment to McDonald's, while they seem unperturbed by Yum! Brands' far worse record?

Well, it's quite simple, really. Investors are far more optimistic about the growth prospects of Yum! Brands' Pizza Hut, KFC, and Taco Bell restaurants than they are about McDonald's franchises. McDonald's is, in the eyes of many investors, a built-out franchise with relatively limited potential for growth. McDonald's has not been helping its bull case either, as it recently announced that weak consumer growth in its Asian market would keep sales depressed in the near future.

New breed of competitors
McDonald's has been performing relatively worse than many of its U.S. counterparts. The company seems to be lacking a focused and aggressive marketing strategy, even as the space gets more crowded.

The emergence of the 'fast-casual' food segment has given rise to a new breed of McDonald's competitors. Several players in the fast-casual segment have been busily chipping away at McDonald's customer base by using subtle positioning -- combining high-end food with a quick-service experience. This strategy is intended to cater to both regular eaters who frequent fast food joints and diners who prefer fancier restaurants.

One of these ''new age'' players is Chipotle Mexican Grill (NYSE:CMG), which gives customers a chance to trade-up on the quality of their fast food at a premium price. This novel strategy seems to be working -- Chipotle's same-store sales grew 6.2% in the last quarter, and 5.5% in the preceding one.

Wendy's has of late been focusing on a new ''Image Activation'' plan which emphasizes a trendy, more-modern look for its restaurants. In the same vein, Dunkin' Donuts has been trying to boost its afternoon segment by introducing new menu items as well as enhancing the overall decor of its restaurants.

Low-hanging fruit
Meanwhile, McDonald's has been aiming for low-hanging fruit by trying out new eatery themes that run the risk of alienating its traditional customers. The firm has been experiencing little success so far with its 'Dollar Menu.' It's also been tweaking the menu to come up with things like the 'Dollar Menu and More' and 'Mighty Wings.' There is little evidence that these strategies are working for McDonald's: same-store sales grew by a puny 0.2% in October, and they improved by 0.8% in November for a marginal gain.

The overly complicated menu has bred other, unforeseen problems. Wait times at the firm's drive-thru spots have soared to 15-year highs, and customer complaints about slow service have been growing. This does not augur well for a company that has built a reputation on fast service at affordable prices.

The fast food chain has also decided to follow in the footsteps of Starbucks (NASDAQ:SBUX), and it plans to introduce a packaged coffee under its McCafe brand. The firm plans to partner with Kraft Foods Group, which will distribute and market the packaged coffee. Perhaps McDonald's is doing this to capitalize on the success it has recorded in its coffee sales, which have improved 70% since 2009 when it introduced the McCafe brand.

McDonald's urge to try to mimic Starbucks is perfectly understandable. Starbucks has been wildly successful with its specialty coffee offerings, with its customers willing to fork out $4 or more for popular flavors. McDonald's has been introducing specialty coffees such as Chocolate Chip Frappe and Pumpkin Spice Latte that are mainly targeted at more fanciful coffee consumers. However, the firm could be straying too far from its core business, and this elevates the risk of alienating its traditional customers.

Menu simplification
Reports note that McDonald's has been trying to simplify its menu, which is currently too big. A longer menu results in longer waits before customers can choose their fare, and this is partly to blame for the long queues at the firm's drive-thrus.

The company's decision to start selling packaged coffee is not entirely without merit though. Arabica coffee prices are at four-year lows after a bumper harvest in Brazil, the world's leading producer of Arabica coffee. This might improve matters a bit for the company.

The bottom line
If past records of companies that failed to stick close to the knitting and made changes that were too jarring for their customers are anything to go by, then McDonald's might be on the wrong footing. J.C. Penney instituted new product lines intended for high-end customers under CEO Ron Johnson, and saw its sales plummet a shocking 25% as a result. Maybe McDonald's should concentrate more on its core business and only make these novel changes a little at a time.

Trading at less than 17 times expected 2014 earnings, McDonald's might be the cheapest among its peers. Its decent 3.4% yield also offers some degree of downside protection. However, its expected EPS growth of just 9% in 2014 to $6.11 is the lowest in its sector. These factors, coupled with the uncertain sales growth prospects for the company, make it less attractive as a long-term investment.

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Fool contributor Joseph Gacinga has no position in any stocks mentioned. The Motley Fool recommends Chipotle Mexican Grill, McDonald's, and Starbucks. The Motley Fool owns shares of Chipotle Mexican Grill, McDonald's, and Starbucks. 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.

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