Why McDonald's Should Take Its Competition Much More Seriously

McDonald's is still one of the most universally recognized brands in the world, but smaller competitors Chipotle and Panera are eating its lunch.

Feb 11, 2014 at 4:00PM

For many years, fast-food giant McDonald's (NYSE:MCD) could do no wrong. The company was the unquestioned leader in the fast-food industry. It grew into a corporate empire, serving billions of customers around the globe. This vaulted the golden arches to become one of the most valuable and easily recognized brands in the world.

Currently, McDonald's faces a much less certain future. Americans are paying much closer attention to their eating habits, and as they learn more about what they're eating, they're increasingly turning away from McDonald's. While McDonald's still has a lot to offer investors in terms of worldwide growth potential and compelling cash returns, it's nevertheless time to start taking its competitors seriously.

New menu items couldn't stem the tide
Consumer preferences are changing in the United States, and it's clear that McDonald's is flailing in its attempts to reverse course. As Americans have become much more conscious of what they're eating, McDonald's is often seen as a stale corporate giant that simply doesn't care about public health. In response, McDonald's has revolutionized its menu, offering healthier options to try to woo health-conscious consumers. Unfortunately, this hasn't had the positive results McDonald's was hoping for; guest traffic declined last year.

The response by consumers has simply been to eat elsewhere, and the results are now becoming obvious. Last year, McDonald's reported 2% revenue growth and 4% growth in diluted earnings per share. Global comparable-store sales, which include sales only at locations that were open for at least one year, inched up 0.2% during the year.

Consumers who prefer healthier alternatives have flocked to Chipotle Mexican Grill (NYSE:CMG) and Panera Bread (NASDAQ:PNRA). Chipotle registered impressive 5.6% comparable-restaurant sales in 2013 as well as 18% total revenue growth last year. Management specifically cited increased traffic as the primary reason for its strong results in the fourth quarter and for the full year, and it seems that customers who used to go to places like McDonald's are now going to Chipotle instead.

While Chipotle may not seem like a direct competitor to McDonald's due to its reputation as a "fast-casual" restaurant, it's nevertheless a different place for wary McDonald's customers to go if they want healthier options. Customers appear to be entirely willing to pay higher prices at Chipotle and Panera in exchange for better-sourced food with fewer calories.

For its part, Panera's diluted earnings per share jumped 17% through the first three quarters of the fiscal year on the strength of an increase in the average customer check amount. And Panera expects the trend to continue, since management expectations call for as much as 3% same-restaurant sales growth in the fourth quarter.

McDonald's still has a lot to offer
As an investment, McDonald's can definitely still satisfy investors' hunger for returns. First, since it's such an established company, it doesn't need to retain all of its cash flow to reinvest in growing the business. Instead, McDonald's distributes lots of cash back to shareholders in the form of share repurchases and dividends. This year, management expects to return approximately $5 billion to shareholders.

In addition, McDonald's has a great opportunity ahead in the emerging markets. McDonald's has still by no means fully penetrated emerging economies. This is why McDonald's plans to spend as much as $3 billion next year to open at least 1,500 new restaurants, with most of this being allocated to the emerging markets.

Time to get serious
McDonald's tried to respond to changing consumer attitudes by offering healthier alternatives such as wraps and salads. These options haven't really moved the needle, though, which is evident in McDonald's lackluster sales and earnings growth last year. The hard truth McDonald's is now realizing is that no company is immune to shifting consumer tastes. McDonald's can no longer stand by while smaller competitors steal its business.

McDonald's will still pump out hefty cash flow and pay a solid 3.4% dividend, but growth is slowing. Its underlying results disappointed last year, its stock performance badly lagged the market, and its 5% dividend increase was widely viewed as a disappointment. As a result, it's time for McDonald's to take its competition more seriously.

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Bob Ciura owns shares of McDonald's. The Motley Fool recommends and owns shares of Chipotle Mexican Grill, McDonald's, and Panera Bread. 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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