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Changes Ahead for McDonald's Dollar Menu

By Mike Hughlett
Chicago Tribune
Thursday, July 24, 2008

http://www.chicagotribune.com/business/chi-thu-mcdonalds-earnings-jul24,...

McDonald's Corp. blew past Wall Street's profit expectations and posted a strong second quarter Wednesday, despite weak consumer confidence and soaring commodity costs.

But with ingredient costs expected to remain high -- the hamburger giant forecast a significant jump in its beef costs -- Oak Brook-based McDonald's may raise prices on its popular dollar menu.

McDonald's executives said in May that consumers would be spared the brunt of its food cost increases, and that the company has no plans to veer from its "everyday affordability" concept.

But Wednesday, Ralph Alvarez, McDonald's chief operating officer, acknowledged growing cost pressures on the dollar menu, which makes up about 14 percent of McDonald's U.S. sales.

"The cost implications of having that value menu have changed when you see what's going on in beef and chicken," Alvarez said in a conference call with stock analysts. "The way the dollar menu looks today won't be the way it looks next year," he said, adding that "in this current environment, we've got to make sure we're pricing smart, not just pricing low."

Alvarez didn't elaborate on how the dollar menu might change, but said tests have been under way in some markets. Bill Whitman, a spokesman for the firm, said one test has been to raise the price of the double cheeseburger, the anchor of the dollar menu and McDonald's best-selling U.S. sandwich.

Investors seemed to focus Wednesday less on McDonald's sterling second quarter than on fears that the elevated cost of beef and other ingredients will crimp future profits: The company's stock fell 46 cents, or just under 1 percent, to $59.66.

McDonald's posted net income of $1.19 billion, or $1.04 per share, a sharp contrast to the year-ago quarter when a big divestiture-related charge handed the company a net loss of $711.7 million, or 60 cents per share.

The latest results include a one-time gain of 10 cents per share from the sale of its stake in an investment. Excluding that gain, however, McDonald's per share earnings of 94 cents still topped by 8 cents the consensus estimate of analysts polled by Thomson Financial.

The firm's revenues of $6.08 billion were also a bit higher than the $6.06 billion expected by analysts, and they were 4 percent higher than a year earlier. Same-store sales in Europe jumped a healthy 7.4 percent over the same time last year, while they climbed 8.8 percent in Asia, the Mideast and Africa.

McDonald's U.S. operations posted 3.4 percent comparable growth over 2007's second quarter, which analysts called a respectable showing considering the tough U.S. economic backdrop.

"Considering the very challenging consumer environment and commodity cost pressures, the fact that they could drive a solid increase is really good," said John Owens, an analyst at Morningstar Inc. "It was just a great quarter. Practically everything went right for McDonald's—with the exception of commodity costs."

In the past nine months or so, food prices have been escalating at a rate not seen since the early 1990s, pressuring not only consumers but food manufacturers and restaurant operators.

McDonald's expects the price it pays for cheese to rise 21 percent this year in the U.S., while chicken costs may climb 5 percent to 6 percent. Escalating beef prices had not been a big issue until recently, as ranchers have cut back cattle herds.

The company said Wednesday it expects its 2008 U.S. beef costs to be up 8 percent to 9 percent, well above its prior estimates of flat prices, Larry Miller, a stock analyst at RBC Capital Markets, said in a research note. Beef makes up about 15 percent of McDonald's commodity costs.

In response to rising costs, Morningstar's Owens said, the company could also drop or add items from the dollar menu, or reformulate current items so they cost less to produce. But raising prices makes sense, Owens said, and that goes for the myriad other restaurant companies featuring value menus. "With commodity costs rising so much, it's not rational to keep prices on these value menus standing still," he said.

Jack Russo, a stock analyst at Edward Jones, agreed and said McDonald's franchisees, who operate 85 percent of the company's U.S. restaurants, have likely been pushing for such a change. Franchisees bear the rising costs of commodities, yet the dollar menu limits revenues.

"This is impacting franchisee profitability," Russo said. McDonald's "has heard this from franchisees: 'Look, please help us.'"

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