McDonald’s set for tough Q4

McDonald’s is heading for what is likely to be a tough set of earnings on Friday, thanks to competition in its home market and FX weakness in Europe, while trading in Asian markets has been choppy at best.

A McDonald's sign
Source: Bloomberg

Fourth-quarter earnings from the iconic American fast food firm are likely to be fairly disappointing. Expectations are for adjusted earnings of $1.23, down 12.5% year-on-year, while sales are forecast to be $6.68 billion, around 5.8% lower compared to a year ago. Comparatives for October and November were poor, with sales declining 0.5% and 2% respectively, and the pattern is expected to be repeated in December as year-end promotions by competitors take a chunk out of sales for that month as well.

In Asia we are likely to see a distinct impact thanks to the Husi scandal that caused firms like McDonald’s and Yum! Brands to cut ties to a meat factory that was supplying out of date meat. In addition, a shortage of potatoes in the Japan division meant that this part of the business was forced to ration the allocation of fries to customers, a remarkable turn of events. Overall Asia is expected to have endured a poor quarter as Chinese customers shun McDonald’s in favour of domestic franchises.

Europe’s situation is likely to be affected by currency implications due to the strengthening of the US dollar during Q4, while in the US competitors like Five Guys are taking market share. The shift to a more personalised menu will arrest this to some degree but will take time to become fully implemented.

There are, however, reasons to be optimistic. McDonald’s is capitalising on its strong margins to open new locations around the globe. The overall plan for 2014 was to open 1400 new stores, so we can expect to see some comment on the achievement of this goal. When operating profit margins stand at 29% versus 17% for a competitor like Yum!, the company must be doing something right. It gives McDonald’s the financial firepower to combat competitors, even as it continues to pay out cash to investors via dividends and share repurchase plans.

Against competitors, McDonald’s comes out ahead on an earnings valuation, trading at 18 times current earnings versus 22.68 for Yum!, 36.37 for Burger King and a remarkable 50.25 for Chipotle, and well below the sector average of 28.76. On a price-to-sales basis Yum! might be cheaper than McDonald’s, but with a larger global footprint McDonald’s would seem to justify the higher valuation.

McDonald’s shares reached an all-time high during 2014 but have since been on a steady downward trajectory. For the moment they have succeeded in holding generally above the $90 level, although a weak set of earnings could see this support zone come under serious pressure. The loss of the 200-day moving average earlier in the year signalled further weakness to come, with a firm close below $90 meaning that downside targets in the direction of $86 and then $84 become likely. 

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