It isn't a great time to be a McDonald's Corp. (NYSE:MCD) investor. Shares of the fast-food giant are up just 3% over the past two years, while the S&P 500 Index has soared 40% in that time. McDonald's is being hit by a number of headwinds. Some of these are external, such as the strengthening U.S. dollar, which has taken a bite out of McDonald's international sales. But to be sure, plenty of the damage that McDonald's has incurred in recent years was self-inflicted. Many consumers are taking a harsher view of food ingredients, and also demanding a more personal, customizable experience, and McDonald's adapted too slowly.
But while nearly everyone is piling on McDonald's for all it's doing wrong, it's worth noting that there are plans in place to engineer a turnaround. Here's why investors may be underestimating McDonald's turnaround prospects in 2015.
Perhaps things aren't as bad as they seem
It's certainly true that McDonald's is deteriorating in a very important metric, comparable sales, which measures the sales at restaurants open at least one year. Indeed, comparable sales fell 3% last quarter. However, on a separate yet equally important measure, profits, the situation is far from dire. McDonald's earnings per share fell 28% last quarter, which seems like an outright disaster. But it's worth mentioning that earnings were significantly affected by external factors.
For instance, a higher tax rate resulting from an increase in tax reserves in certain foreign markets shaved a whopping $0.26 per share off McDonald's earnings in the quarter. Separately, a food supply issue in China skimmed off another $0.15 per share, according to the company. In all, excluding the impact of these special items, McDonald's EPS would have been flat year over year. This is disappointing, but far from a disaster. And, it underscores the true earnings power of McDonald's business, thanks largely to its unparalleled scale, even under the pressure of falling comparable sales.
McDonald's has a plan to aggressively open new restaurants across the globe. With satisfactory returns on investment, this strategy should continue adding to profitability, even if comparables disappoint.
McDonald's has more than 35,000 locations. Through September, McDonald's had opened about 750 new restaurants globally, and had plans to open about 1,400 in all of 2014. The reason McDonald's has continued its aggressive push to open locations is because, despite all of its challenges, McDonald's still generates industry-leading margins. In the past three quarters, McDonald's operating profit margin clocked in at 29%. This compares very favorably to McDonald's biggest peers. For example, Yum! Brands, which operates the Taco Bell, Pizza Hut, and KFC chains, produced a 17% operating profit margin in the same period.
Doing this allows McDonald's to generate a lot of cash, despite disappointing same-restaurant sales figures. Despite deteriorating comps, McDonald's still brought in more than $6 billion in operating profit in the past three quarters combined. In turn, it funneled more than $4 billion of cash to investors through dividends and share repurchases, with plenty of cash flow left available to continue opening new stores around the world. This should keep the snowball effect of McDonald's strong business intact.
"The Experience of the Future"
McDonald's refers to its transformation as the "Experience of the Future," which looks at topics including the menu and customer experience. A cornerstone of this is a digital strategy. McDonald's hasn't done much to improve the customer experience in recent years. Customer wait times increased, and McDonald's overly bloated menu did little to offset this. As Chief Executive Officer Don Thompson stated during the third-quarter earnings call, "In some of our markets, the reality is that we haven't been changing at the same rate as our customers' eating-out expectations."
But McDonald's is rolling out a number of new initiatives designed to reignite excitement in its customers' experiences. First is a slimmed down menu. While specific details are yet to be released, it plans to reduce the number of Extra Value Meals from 16 to 11.
In addition, McDonald's announced a collaboration with Apple that will allow its 14,000 U.S. restaurants to utilize Apple Pay digital payments. There's even more in store. Utilizing mobile technology, McDonald's will offer advanced ordering capabilities. For example, the company is developing the Create Your Taste concept, in which customers can use digital ordering at kiosks to simplify the selection process, but also enhance the experience to make it far more intuitive and responsive to different tastes. Customers will be able to select from a list of toppings and ingredients to create a truly customized meal. In addition, McDonald's will also allow for pickup.
McDonald's believes these steps will allow for more customer engagement with its brand. To be sure, McDonald's turnaround won't happen overnight. But there are real, identifiable measures in place to help make 2015 a better year than 2014.