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Is McDonald's (MCD) Growth Sustainable?

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McDonald’s (MCD - Free Report) last-reported results were encouraging with the company bettering our expectations on both top and bottom lines. Shares are also trending up as seen in the chart below:

But to understand whether this was just a one-time thing or part of a broader recovery, let’s look for a moment at what was bothering the company in the first place.

The way I see it, there were two main problems that led to the decline in its share of the market from 17.5% five years ago to 15.1% last year, according to Euromonitor. The first was an inability to capture an equal share of millennial traffic as it had of earlier generations. The second is related to the persistent weakness in Asian markets, particularly China.

Of course, strategic refranchising makes headline numbers erratic and comparisons difficult because closing down company-owned stores is a big hit to revenues that can’t be offset by the 6% commission on sales from franchised stores. But at the end of the day, it makes sense, because both capital and operational expenses are thus taken out, with a resultant positive impact on profitability.

In this respect, other fast food chains have already moved to a model where around 95% of the stores are franchised; so McDonald’s, being slightly late to react, will continue to enjoy some near-term positive impact that may not be seen in the others.

Targeting Millennials

Millennials are generally more concerned about health, convenience, responsible sourcing and freshness of ingredients. And these are areas the company is doubling down on.

In what is a complete reversal of earlier policy, management announced the intention to use fresh beef instead of frozen patties. Being somewhat more difficult to handle, this increases the risk of microbe buildup and food borne disease, but the strategy has given Chipotle Mexican Grill (CMG - Free Report) an advantage so it’s worth trying out. McDonald’s isn’t taking this to all products at once, which sounds like a good idea.  

Other menu changes include a reduction in the use of artificial preservatives, colors and flavors, HFCS-free buns and antibiotics-free chicken, in addition to the Premium Salads refresh, the margarine replacement with butter in Egg McMuffins, milk products from growth hormone-free cows and localized menu options that were announced earlier. In the pipeline is 100% cage-free eggs by 2025 in the U.S. and Canada.

On the convenience side, the company is working on putting up digital sign boards, facilitating mobile ordering, tables with serving staff as in fast casual restaurants in some places, curbside service and delivery options both by its own staff and through partnerships with companies like GrubHub (GRUB - Free Report) . It will also have 2,500 Experience of the Future (EOTF) stores by year-end, meaning that that’s the number of stores that will have Samsung tablets on the table or in kiosks that customers can use to order or communicate with staff.

Stealing from the Competition

McDonald’s figures that not everyone is that health conscious however, so it seeks to lure in the diet cheaters as well. Not to mention those that would otherwise have gone to a Starbucks (SBUX - Free Report) or a Dunkin’ (DNKN - Free Report) outlet instead. In the 2-5 PM timeframe that has always been quiet for quick service restaurants, McDonald’s is laying out croissants, muffin tops and a new sundae-topping station for ice cream lovers. It also has special offers on drinks that can be purchased for as low as $1-2.

Plus there are seasonal-themed coffees and environmentally friendly coffee beans (a page out of Starbucks). For this purpose, McDonald’s is getting 12,000 new espresso machines, store redesigns and stepping up marketing efforts. The goal is clear: McDonald’s may be looking out for the health conscious, but it isn’t about to dump those wanting to indulge.

Looking for Growth in China

China is part of McDonald's “fast growing” segment, but it hasn’t been growing too fast of late. Changing customer perceptions following the stale meat scandal had a notable impact on not only McDonald’s but also on Yum Brands (YUM - Free Report) . Chinese fast food chains in the meantime have gained some ground. Families in particular have moved on from Brand America to other things like food quality, so they are frequenting the fast casual segment these days. But office goers are reportedly coming back.

McDonald’s isn’t taking chances. Just as it has done in other Asian markets like Japan (3,000 outlets), South Korea (600) and Taiwan (400), the company is transferring an 80% interest in 2,000 Chinese outlets to CITIC Limited, CITIC Capital Partners and The Carlyle Group for 10 years. In return, it’s getting a cool $2.08 billion from the largest franchisee outside the U.S.

There are ambitious plans afoot, with the group targeting double-digit growth in each of the next five years by increasing the number of restaurants from 2,500 to 4,500. By 2022, it also intends to bring delivery hub coverage to over 75% of restaurants. This therefore looks like a very good deal by which McDonald’s is refranchising the business, acquiring local talent and catering to local preferences in a highly profitable way.  

Last Words

To ensure that all goes smoothly, McDonald’s has brought in Morgan Flatley (formerly CMO of Global Nutrition at Pepsico, responsible for getting Gatorade back to sustained growth), as U.S. Chief Marketing Officer; Farhan Siddiqi, as Head of U.S. Digital (formerly worked at Bank of America, Target and GE); and Linda Van Gosen (formerly VP at Startbucks, responsible for Starbucks Evenings, VP of Brand Strategy, Insights and Menu Innovation at TGI Friday’s and VP of Product Innovation at Chili’s Grill & Bar) as new Head of U.S. Menu.

Given the above and the possibility of President Trump’s tax reforms kicking in, Mc Donald’s is set for a rebound. So if results are beginning to look up at McDonald’s it’s very likely an indication of more to come.

McDonald’s shares carry a Zacks Rank #3 (Hold). But you can see the complete list of today’s Zacks #1 Rank (Strong Buy) stocks here.)

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