A mere nine-tenths of 1%. That's the margin that enabled shares of McDonald's Corporation (NYSE:MCD) to soar roughly 8% during trading after it released third-quarter 2015 earnings on Thursday. After two years of decline, McDonald's posted a U.S. comparable sales increase of 0.9% and, perhaps unsurprisingly, investors bid up McDonald's stock in force. Let's briefly look at highlights from Thursday's report, and then examine why the U.S. "comps" number is so vital to the company's prospects going forward.
Revenue dwindled, but reflected underlying strength
McDonald's posted revenue of $6.6 billion, a 5% decrease versus the comparable prior-year quarter. Stripping away the effects of foreign currency translation, revenue would have increased 7%, implying a 12% drag due to U.S. dollar strength versus local currencies within McDonald's international markets.
While shareholders receive their earnings in dollars, and thus should rightly be concerned over the 5% revenue shrinkage, it's helpful to understand that even a slight dollar retraction next year could provide a top-line boost.
Efficient operations smoothed out the effect of lower sales
Earnings certainly pleased investors, as net income rose 23% to $1.3 billion, which translated into diluted earnings per share of $1.40, an expansion of 28% over the prior period.
Part of the gain in profits can be traced to operational leverage: The burger giant was able to reduce total operating costs by 7% versus the prior year, which meant that operating income and income before taxes both only declined 2% from Q3 2014.
Given the above, what's responsible for the large gains in net income and earnings per share this quarter? In a word, taxes. McDonald's booked a much lower provision for income taxes of $569 million in the current period, in contrast to an expense of $853 million a year ago. So, the company did well to land extremely close to last year's operating income given its 5% revenue decrease, but final profits aren't as robust as earnings per share in isolation might suggest.
Global comparable sales jumped, but with a caveat
A 4% rise in global comparable sales made for a great bullet point in today's earnings press release, but as the company pointed out, the comparison benefited from a weak number last year, when McDonald's was struggling with supplier issues in China and Japan. In Q3 2014, global comps decreased 3.3% so, in reality, the company is simply pulling even with comparable sales levels from 2013.
Why the "MCD" ticker turned on its jets after the earnings release
Since annual revenue peaked in 2013, McDonald's has sought to stem its declining top-line growth. Despite another quarter of decreased revenue, investors celebrated that U.S. comparable sales gain of 0.9% I mentioned at the outset, for four very good reasons.
First, U.S. comps provide investors their best view into the window of consumer sentiment as regards this once-invincible franchise. Rising U.S. comps, however small, will signal that the company's customers are willing to give McDonald's a second chance and increase their visits as the chain revamps its offerings under CEO Steve Easterbrook.
Secondly, domestic comps that stabilize and grow create a consistent earnings base, which balances out the vagaries of the global business. In May of this year, Easterbrook realigned McDonald's operating segments into just four buckets: the U.S.; "international lead markets," which include Australia, Canada, the U.K., Germany, and France; "high-growth markets," concentrating on China, Spain, Russia, Italy, Poland, Korea, Switzerland, and the Netherlands; and "foundational markets and corporate," which captures the rest of the world plus corporate activities.
Out of these segments, the U.S. market is the one part of McDonald's business that's homogeneous and in turn perhaps more predictable than its peer divisions. International lead markets, well represented by developed countries though it may be, is still comprised of quite disparate economic units. Just because two territories are both European countries in proximity to each other doesn't mean that they'll operate similarly and provide consistently correlated results. For example, as former CEO Donald Thompson was fond of pointing out, Germany is an idiosyncratic market that requires quite different discount strategies than other eurozone nations to attract customers.
Third, U.S. comps point to the direction of McDonald's largest profit driver. In May, when management realigned business segments, it essentially presented the U.S. and International Lead Markets as equals, by pointing out that each was separately responsible for 40% of McDonald's total 2014 operating income. But in the first nine months of this year, due to the heady power of the greenback, the U.S. has leaped ahead, accounting for nearly 50% of total operating income.
Finally, growth in comparable sales in the U.S. will appease and engage what is at the moment one of the most important stakeholder groups in the company's universe -- its U.S. franchisees. This group, by operating 80% of U.S. stores, is thus responsible for 80% of the 50% of global operating income the U.S. provides. Needless to say, franchisees have been waiting to see positive comps in their locations, a precursor to returning to the increasing cash flow that used to be a given for McDonald's restaurant partners.
Shareholders, stop celebrating and look ahead
As I wrote recently, Easterbrook has preferred to ignore the myriad voices calling for sweeping change at this venerable global brand, and instead sees merit in focusing on the little things. Incremental changes such as toasting hamburger buns a few seconds longer, introducing a limited all-day breakfast menu (the success of which we'll be able to judge on next quarter's earnings), and experimenting with order customization, all appear to have at least stabilized the all important U.S. sales base for the present. But it takes at least two data points to make a trend. Now, despite the stock rally, investors must begin the wait for another improvement in U.S. comps in the fourth quarter, in the form of a presumably larger increment than 0.9%.