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McDonald's Dusts Off Forgotten Strengths

By Asit Sharma - Jan 27, 2016 at 7:15PM

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The quick-service giant is capitalizing on advantages conventional wisdom may have written off years ago.

These appealing sliders were recently rolled out in Canada. Will we see them in the U.S. soon? Image source: McDonald's Canada.

With a fourth-quarter 2015 global comparable sales increase of 5% and a 5.7% lift in U.S. comps, McDonald's Corporation (MCD 0.20%) provided emphatic evidence in earnings released this week that it's indeed turning its revenue woes around.

Though the company received some assistance from unseasonably warm weather in the U.S., it received its greatest top-line boost from the introduction of all-day breakfast at the beginning of the quarter. Resurgent traffic from all-day breakfast translates into solid revenue momentum at the outset of fiscal 2016. It would be premature to call McDonald's turnaround effort complete today, but it's not too early for perceptive investors to question conventional wisdom of the past few years, which holds that McDonald's may be too large and lumbering to ever experience significant growth again.

Such wisdom ignores at least two of the company's intangible advantages which have been dormant for a while: the franchise's ubiquity, and its unique menu innovation system.

The advantage of being everywhere
McDonald's vast global enterprise handles a staggering amount of sales. The company recorded $6.3 billion in revenue in the fourth quarter, but systemwide sales, which count franchisee revenue, reached $17.0 billion. 

The McDonald's system can boast of such massive revenue generation because, of course, its restaurants are truly everywhere. Yet this scale, until recently, seemed to characterize a company that could no longer operate nimbly enough to keep pace with customers' rapidly changing tastes.

Now it looks as if perceptions are in flux, and customers are returning in numbers. In this instance, ubiquity can very quickly transform into a competitive weapon. And McDonald's is so embedded in urban and semi-urban areas that when it introduces an innovation, even mighty Starbucks Corporation (SBUX -1.17%) must pay attention.

To be specific, if McDonald's all-day breakfast continues to drive customer traffic higher this year, it will present a slight yet direct challenge to Starbucks' U.S. stores' sales growth. All-day breakfast is a "proof of concept" of McDonald's ability to attract more traffic during dayparts outside of its lucrative breakfast time-frame. But these revenue windows are the very ones Starbucks has pinned its long-term U.S. sales growth potential on.

From lunch to snack hours, to the end-of-day tea break it has promoted through the purchase and expansion of high-end tea retailer Teavana, Starbucks sees its greatest comps expansion potential outside of its own successful breakfast daypart.

Pressure on Starbucks' U.S. sales gains isn't a reality yet, but if McDonald's strings together another two to three quarters of 5% U.S. comps increases, the company will certainly climb the priority list when Starbucks management addresses competitive threats. Potential effects are exacerbated simply because so many McDonald's restaurants are proximal to Starbucks locations as customers make non-peak hour refreshment decisions on a daily basis.

CEO Steve Easterbrook implicitly validated the company's wide market presence when he described the opportunity for McDonald's (and the opportunity cost to competitors) of all day breakfast this week during the company's Q4 2015 earnings call (emphasis mine): 

All Day Breakfast built on this momentum in the fourth quarter, exceeding internal expectations during the launch phase. It's driving incremental business. Many customers who otherwise would have gone elsewhere are coming to McDonald's to enjoy some of their favorite breakfast items, like our Egg McMuffin and Hash Browns at lunch and throughout the rest of the day.

The advantage of innovating everywhere
Effective July 1st of last year, McDonald's operations were simplified into four basic reporting segments: the U.S., International Lead Markets, High Growth Markets, and Foundational Markets. 

At the time, McDonald's rationalized that under the new structure, decision-making would be more streamlined and successful menu innovations could be propagated much more quickly across national borders. 

This second point capitalizes on geographical diversity, which investors may have forgotten about, but on which management seems to be extremely focused. With menus that can vary greatly from country to country, linked loosely by variations of core burgers and french fries, McDonald's essentially owns a set of test kitchens spread around the globe.

The company's U.S. product experimentation, headed up at McDonald's headquarters by executive chef Dan Coudreaut, is still vital to domestic menu evolution. But there's a visibly faster and freer menu interchange between regions and countries that is supplementing typical product research and development.

For example, during this week's earnings call, Easterbrook noted that Australia, which enjoys a current reputation as perhaps the most innovative McDonald's market, actually grabbed a successful idea from the U.S. during the past quarter. After testing all-day breakfast in 300 units, McDonald's Australia will extend the concept nationwide this quarter.

Another illustrative example is McDonald's Canada's introduction of a stand-alone McCafe in Toronto last month. This smaller footprint store is focused on coffee, croissants, salads, cafe-style sandwiches (no burgers on the menu!), and desserts. Upon its launch, the Canadian McCafe tacked on an idea gleaned from the U.S. by adding a sliver of all-day breakfast, in the form of an always-available Egg McMuffin, to its lineup.

Intriguingly, the inclusion of an all-day Egg McMuffin will lure core customers into trying a coffee shop, which appears designed from the ground up to compete with Starbucks. Again, the Canadian McCafe is but one experiment in McDonald's global laboratory, but a trial nonetheless that executives in Oak Brook, Ill.,  will take quite an interest in as the year progresses.

As for that Canadian market, keep an eye on it, as we may soon see some innovations head south. "McTasters," the slider-style mini-sandwiches pictured at the top of this article, may have great potential in the U.S. market. At the current U.S. dollar to Canadian dollar exchange rate, a single McTaster would sell for approximately $2.12 stateside. That price point is low enough to land credibly on a value menu, but the sliders' diminutive size means they're not likely to cannibalize sales of core burgers and sandwiches.

The amount of menu differentiation in the 100+ countries in which McDonald's operates will provide fertile ground for the future identification and cross-border promotion of its most successful products. Having said this, it's ironic to me that McDonald's, which has often been maligned for the sameness of its U.S. offerings over the decades, likely boasts the most varied aggregate menu of any international food retailer. Similar to the advantage of seeming to exist everywhere, McDonald's unique menu innovation strategy is a strength management has only just started to dust off and leverage.

Asit Sharma has no position in any stocks mentioned. The Motley Fool owns shares of and recommends 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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