Understanding McDonald's: Comprehensive company primer and profitability analysis hellcat intake on 5.7(Part 20 of 21)

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Continued from Part 19

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McDonald’s profitability is tied to the execution of its strategic plan, the Plan to Win, which is subject to execution risk. The most important aspects of the plan relates to whether the company can stay relevant and remain a brand that customers trust. There are many components that will drive this.

Ability to differentiate experience that balances consumer value with margins

Impact pricing, marketing, and promotional plans on sales and margins

Ability to drive restaurant improvements that achieve optimal capacity, particularly during peak mealtime hours

Ability to motivate employees to achieve high service levels in order to improve customer perceptions

Ability to complete restaurant reimaging and rebuilding plans

Success of new menu initiatives

Lower same-store sales

The company’s business model is built around growing comparable sales to realize margin leverage, and it expects unfavorable economic conditions in many markets to continue to pressure its financial performance, with continued flat or contracting IEO segments in many markets, broad-based consumer caution and price sensitivity, reduced pricing power, and intensifying competitive activity. Given these conditions and persistent cost pressures, management expects McDonald’s results in the near term to remain challenged, especially in 4Q13.

Falling European sales and margins due to austerity

Austerity is a threat to continued growth in European sales, especially in the periphery. Since labor and raw materials costs are higher in Europe, margins are more sensitive to average selling price (ASP) declines.

Currency headwinds in emerging markets

Since more than half of the company’s sales are abroad, managing currency risk is pivotal to the business. Luckily, for most of the company’s store locations, costs are denominated in the same currency as local sales. Where practical, the company’s restaurants purchase goods and services in local currencies, resulting in natural hedges.

The company’s net asset exposure is diversified among a broad basket of currencies. Its largest net asset exposures (defined as foreign currency assets less foreign currency liabilities) at year end were as follows.

The company prepared sensitivity analyses of its financial instruments to determine the impact of hypothetical changes in interest rates and foreign currency exchange rates on the company’s results of operations, cash flows, and the fair value of its financial instruments. The interest rate analysis assumed a 1 percentage point adverse change in interest rates on all financial instruments but did not consider the effects of the reduced level of economic activity that could exist in such an environment. The foreign currency rate analysis assumed that each foreign currency rate would change by 10% in the same direction relative to the U.S. dollar on all financial instruments. However, the analysis did not include the potential impact on revenues and local currency prices or the effect of fluctuating currencies on the company’s anticipated foreign currency royalties and other payments received in the U.S.

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Based on the results of these analyses of the company’s financial instruments, neither a 1 percentage point adverse change in interest rates from 2012 levels nor a 10% adverse change in foreign currency rates from 2012 levels would materially affect the company’s results of operations, its cash flows, or the fair value of its financial instruments.

Rising labor costs

A rise of minimum wages would adversely impact the business, since more than 24% of its costs relate to labor. The impact of events such as boycotts or protests, labor strikes, and supply chain interruptions (including due to lack of supply or price increases) could also adversely affect both the company and its franchisees.

Financing and market risk

The company generally borrows on a long-term basis and is exposed to the impact of interest rate changes and foreign currency fluctuations. Debt obligations at December 31, 2012, totaled $13.6 billion, compared to $12.5 billion at December 31, 2011. The net increase in 2012 was primarily due to net issuances of $1.2 billion.

Fitch, Standard & Poor’s, and Moody’s currently rate, with a stable outlook, the company’s commercial paper F1, A-1, and P-1, respectively, and its long-term debt A, A, and A2, respectively. As a result, the company doesn’t have a material risk of being downgraded to below investment grade in the immediate future.

Debt maturing in 2013 is approximately $690 million of long-term corporate debt. In 2013, the company expects to issue commercial paper and long-term debt to refinance this maturing debt. As of December 31, 2012, the company also had $581 million of foreign currency borrowings outstanding, primarily under uncommitted line of credit agreements. Neither of these amounts is very material.

In managing the impact of interest rate changes and foreign currency fluctuations, the company uses interest rate swaps and finances in the currencies in which assets are denominated. The company uses foreign currency debt and derivatives to hedge the foreign currency risk associated with certain royalties, intercompany financings, and long-term investments in foreign subsidiaries and affiliates. This reduces the impact of fluctuating foreign currencies on cash flows and shareholders’ equity. Total foreign currency–denominated debt was $4.9 billion and $5.0 billion for the years ended December 31, 2012 and 2011, respectively.

Overall, none of these risks—other than austerity in Europe, rising labor costs, and rising commodity costs—seem pressing at the moment.

Continue to Part 21

Browse this series on Market Realist:

Part 1 - McDonald’s global business model, the “three-legged stool”

Part 2 - What is a franchise and how do McDonald’s franchise agreements work?

Part 3 - How important are franchise revenues to McDonald’s?

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