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Analysts Are Skeptical of McDonald's Strategy

Restaurants: Dollar menu could lower customer checks, and money for make-over may be better spent elsewhere, many say.

September 12, 2002|From Reuters

Will the dollar menu lift sales at McDonald's?

That question is on many Wall Street analysts' minds as they await McDonald's Corp.'s mid-quarter update Tuesday.

Worried by several straight quarters of sluggish sales in the United States, McDonald's has gone on the defensive with an ambitious plan to drive sales in its biggest market through a nationwide dollar menu and an overhaul of its older restaurants.

The Oak Brook, Ill., company said Friday that it would provide more details of its strategy in its interim update.

But instead of being reassured by the company's new resolve, many analysts expressed skepticism that McDonald's aggressive strategy would be enough to increase sales in its core U.S. market, and said it could even eat into future earnings.

That would further fuel investor dissatisfaction with the world's No. 1 restaurant chain, which has disappointed Wall Street with its lackluster results and under-performing stock price over the last two years.

Though McDonald's has billed the launch of the dollar menu--which offers eight items such as its signature French fries for $1--as an initiative to drive traffic, many analysts expressed doubt that discounting food would be enough to attract customers.

About half of its 13,223 restaurants in the United States now offer a dollar menu. Other chains such as Burger King have long relied on discounting prices to attract customers.

"The everyday low-price menu is not that novel of an idea. The initiative may lower the average check, which may offset traffic gains, and margins," Lehman Bros. analyst Mitch Speiser said.

This year, McDonald's shelved an everyday value menu in Los Angeles because it led to sharply lower average customer checks and sales in outlets open for at least a year, a key measure of restaurant performance, Speiser said.

J.P. Morgan analyst John Ivankoe agreed and advised clients not to buy McDonald's stock before Tuesday's update.

"We do not believe the promotion will be a significant traffic or profit driver in the near term," Ivankoe said.

Shares of McDonald's closed Wednesday up 4 cents at $21.34 on the New York Stock Exchange. They have dropped about 19% this year, compared with a nearly 8% decline in the Standard & Poor's restaurant index.

McDonald's also is expected to provide earnings guidance for the third quarter.

The average estimate of 16 analysts polled by market research firm Thomson First Call is 42 cents a share. A year earlier, McDonald's posted net income of $545.5 million, or 42 cents a share.

Besides the dollar menu, McDonald's is expected to give more details next week on its proposal to remodel or rebuild many of its older outlets.

McDonald's said it did not know how much the physical improvements would cost because financing would be decided on a case-by-case basis.

But analysts worry that financing a sweeping overhaul of restaurants would cost hundreds of millions of dollars, requiring several years to complete.

That would divert cash from share buybacks--which is how McDonald's has managed to eke out earnings growth amid tepid sales in the last several years--and lead many analysts to cut their forecasts for earnings growth.

In the first six months this year, McDonald's said it spent $466 million to buy back shares.

"They've been buying back stock like there's no tomorrow," said CIBC analyst John Glass, who noted that McDonald's increased its earnings last year by about 3% largely through stock buybacks.

Although refurbishing older restaurants is a positive step, buying back stock does not improve McDonald's underlying business and will not sustain long-term earnings growth, Glass said.

"They will have to make some hard choices about where to spend their capital: building new stores, remodeling existing ones or buying back stock. It's unlikely that they can do all at once," he said.

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