The fast food stalwart that levels up when recession strikes

David Thornton

Livewire Markets

Consumer-facing companies generally suffer as growth slows and people reign in their spending. But for some companies in the consumer space, this is a good thing. Sometimes referred to as the "lipstick affect", expensive options get substituted for cheaper alternatives. 

McDonald's (NASDAQ: MCD) is one such beneficiary. Despite inflation soaring and growth slowing, the fast food giant was able to increase its same-store sales in the third quarter by 9.5%, beating StreetAccount estimates of 5.8% growth.

"Consumers are sensitive to price, but what happens for McDonald's is they become a net beneficiary because consumers see prices rise everywhere and they end up trading down to somewhere like a McDonald's," says Emma Henderson from Magellan. 

"So the fact McDonald's could raise prices to help cover those costs and still post a 1% increase in traffic demonstrates the resilience of their demand."

In this wire, Henderson discusses why a winning combination of pricing power, brand positioning and execution by management make McDonald's such a strong defensive play in the current environment.  

Emma Henderson, Magellan
Managed Fund
Magellan Global Fund
Global Shares

McDonald's (NYSE: MCD) FY22 Q3 key results

Please note the 'expected' numbers below are consensus forecasts

  • US same-store sales increased 6.1% versus 3.66% expected
  • International same-store sales increased 8.5% versus 5.60% expected
  • Revenue of US$5.87 billion versus US$5.70 billion expected
  • Adjusted earnings per share (EPS) of US$2.68 versus $2.57 expected

Note: This interview took place on Friday 28 October. 

Edited transcript

What was the key takeaway from this result?

The key takeaway is how important your brand positioning, business model and management execution are heading into a challenging macroeconomic environment. McDonald's is the leader brand on value and affordability in the restaurant space. It runs a highly profitable franchise model and it’s management team has been executing superbly on digital and marketing initiatives in its markets. And all of those elements were showcased in last night’s results.

What was the market’s reaction to this result? In your view, was it an overreaction, an under reaction or appropriate?

McDonald's stock traded up over 3% over night, compared to the S&P500 off half a per cent. This response was warranted, in my view. It was similar to the 4% earnings beat on market expectations. However, what was particularly notable in the result was how broad-based the outperformance was, and the consistency of execution we’ve been seeing. The key performance metric that the market monitors for McDonald's is same store sales growth, and that was up a strong 9.5% ahead of what the market was expecting of around 5.8%. And importantly, every geographic segment posted a strong beat.

McDonald's is a classic defensive holding for investors during times of volatility, and this result showcased the durability of its demand and the earnings stability it offers.

Were there any major surprises in this result that you think investors should be aware of?

There were no material negative surprises, which is what we’d hope to see from a resilient consumer business like McDonald's. The key positive surprise was just how strong revenue trends were in the US and Western Europe. McDonald's US business contributes around 40% of its earnings, and it posted a very strong 6% same store sales growth number compared to market expectations of 4%. Like other restaurant companies, McDonald's has been pushing through significant price increases to help its franchisees offset rising costs in food, labour and utilities. But what was particularly positive this quarter, alongside these price increases McDonald's was able to deliver positive customer traffic. 

Consumers are sensitive to price, but what happens for McDonald's is they become a net beneficiary because consumers see prices rise everywhere and they end up trading down to somewhere like a McDonald's.

So the fact McDonald's could raise prices to help cover those costs and still post a 1% increase in traffic demonstrates the resilience of their demand.

Part of this reflects McDonald's strong value positioning, but it’s also benefiting from strong brand and marketing initiatives in the US. The most recent example has been their Cactus Plant Flea Market x McDonald's Adult Happy Meal, which has been remarkably successful and so into next quarter we’ve now seen October same store sales in the US rise to the low double digit range, which is really reflecting some strong execution.

The strength of McDonald’s Western Europe business also positively surprised the market, particularly given a bit of caution around the external situation in Europe leading into the result. Every European market for McDonald's posted positive same store sales numbers, and both France and Germany were called out as particularly strong. Like the US, McDonald's has strong value positioning in Europe, and it’s outperforming the competition and taking share.

The one comment from management that was a little bit more cautious than what these strong top line numbers would suggest is that McDonald's is preparing for a scenario where they may need to provide some temporary financial relief to their European franchisees.

McDonalds corporate runs a very profitable franchise business model in Europe, but the cashflows of its franchisee partners are facing some pretty significant headwinds from food and wage inflation as well as rising energy costs, which are up 2 or 3 times year on year. This comment from McDonald's doesn’t come as a surprise to us given the very challenging operating environment we are expecting in Europe next year, and it’s a risk we’re trying to make sure we’re appropriately positioned for.

But while we consider McDonald's to be well positioned, we are cognisant that other businesses are going to be facing financial pain and we’re supportive of management taking a longer-term view here. It’s similar to what they did early days of the COVID pandemic – providing financial support to franchisees, making sure that over the longer-term the financial health and brand of those businesses remains intact.

Would you buy, hold or sell McDonald's on the back of these results?

McDonald's is a top ten position in the Magellan Global Fund, and it’s a stock that I’m very comfortable continuing to HOLD in today’s environment. We own McDonald's because of the resilience and the dependability of its earnings and cashflows. Last night’s results showcased their inherent defensive characteristics, and there was no new information to challenge our conviction in the company’s brand positioning and the execution from management. So we’re a hold.

What’s your outlook on McDonald's and its sector over FY23? Are there any risks to this company and its sector that investors should be aware of?

Like FY22, we are expecting FY23 to be another year of material uncertainty on the consumer front. Overnight, McDonald's management provided their base case scenario for next year – a mild to moderate recession in the US and one that will be a little deeper and longer in Europe, which is consistent with our outlook. What we really like about McDonald's is that it’s earnings should prove resilient against a range of backdrops. Using the 2008-2009 example, McDonald's is what we call a recession beneficiary. It was one of the very few US businesses that saw its revenue trends accelerate rather than decline as consumers who might not normally eat at a McDonald's trade down from more expensive options.

However, relative to the 2008-2009 example, there are two differences in today’s environment. The first is that given the significant spike in inflation, nominal dollars are very important to investors at the moment. 

McDonald's franchise model is well positioned in this environment given it earns its income by taking a royalty fee on their franchisees revenues, which are in nominal terms. You can think of it as being similar to a business model like VISA or Mastercard that clip the ticket on the total dollars that consumers are spending.

The second comparison I’d draw to 2008-2009 is that while McDonalds has always had a strong value and affordability perception, what they have this time around is a very large digital business and loyalty program, which means that as consumers face financial pressure, they have a more targeted way of reaching out to consumers and communicating the affordability and value they can offer.

In terms of risks for the broader restaurant sector, there are a couple I’d highlight. Firstly, we are more cautious on restaurant chains that are overexposed to China given the ongoing zero-COVID and rolling lockdown measures, and the limited visibility we have as to when those conditions will normalise. McDonald's did refer to China weakness in their result, but fortunately for them it’s a very small part of earnings.

The second risk in the restaurant industry relates to whether you’re running your business as a franchise model, like McDonald's, or directly, and are therefore going to be exposed to rising costs in food, wages and utilities. For company operated models investors need to think about how they’re exposed to risks around further inflation and pressure on operating margins. It’s our view that ultimately as inflation subsides, these businesses will have some nice margin tailwinds, but in the meantime making sure you’re invested in businesses with pricing power is going to be important.

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David Thornton
Content Editor
Livewire Markets

David is a content editor at Livewire Markets. He currently hosts The Rules of Investing, a half hour podcast where he sits down with leading experts across equities, fixed income and macro.

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