60 million customers every day

The new menu items continue to help McDonald’s to increase operating earnings in a tough environment. European sales looked a little sluggish as did US company-owned restaurants, but once again, tight control of expenses lifted operating income by 9.7% over the prior comparable quarter.

Chief executive Jim Skinner said the momentum of the second quarter is carrying through to the third quarter with global comparable sales trending in-line with the prior quarter. Considering the subdued state of consumer spending overall, especially in the US, that suggests McDonald’s is performing strongly in this market.

In the second quarter, global comparable sales grew 4.8% with the US up 3.7%, Europe up 5.2% and Asia/Pacific, Middle East and Africa up 4.6%. If this series is a guide, it appears that comparable sales bottomed in the fourth quarter of 2009 at 2.3% and is now steadily climbing back towards acceptable territory in each region.

Including new stores, total sales grew 5.3% for the second quarter to $5.9 billion. Sales by company operated stores grew 4.2% to $4.0 billion with the balance of $1.9 billion coming from franchised restaurants which grew by 7.5%.

Total operating costs were just 3.4% up on the prior quarter leading to an operating profit margin expansion to 31.0% from 29.8%. Lower food costs have been helping with food costs down about 5.5% in the US and about 4.5% in Europe. This effect is moderating but should reamin in the company’s favour for at least this year.

Net income of $1.2 billion represented earnings per share of $1.13, a 14.7% increase on the prior period. During the quarter, McDonald’s returned $1.6 billion to shareholders through dividends ($600 million) and share repurchases.

McDonald’s said its Dollar menus and new frappe drinks initiative had both seen significant positive contributions to earnings in the period. At a time when each ‘guest’, as McDonald’s describes its customers, is spending a little less, these menu alternatives are encouraging more guests through the door. That translates into sales growth and, according to the company, market share growth as well. McDonald’s set each outlet a target of adding $125,000 in extra sales due to the new drinks. In particular, the fruit smoothies have exceeded the company’s expectations.

As McDonald’s constantly looks for new products and menu items, it is inevitably stepping into territory that overlaps with its neighbours in the convenience food industry. One such competitor is Starbucks, the world’s largest coffee chain which has specialised in frappe drinks and espresso coffee, both of which McDonald’s is aggressively pursuing. Starbucks is unlikely to start selling burgers and fries anytime soon, but it will respond to the intrusion into its core drinks franchise.

One factor where McDonald’s has a big head start over its competitors is in international sales. The company has 57% of its 32,466 global systemwide restaurants outside the USA in 117 countries. During the quarter, international sales accounted for approximately 64% of group sales. The growth rates of sales from each region is generally faster than the more mature US market, with the current exception of Europe.

McDonald’s is still expecting to spend approximately $2.4 billion in capital expenditure in the 2010 financial year. About half this amount will be used to refurbish existing stores with most of the rest used to build new outlets. The company is expecting to open a net 325 restaurants during the year.

Cash flow is still is big plus for the company. It will enable further share buybacks and dividends throughout the next few years, providing an added attraction for investors.

While conditions are somewhat anaemic within the economy, businesses like McDonald’s become a bit of a safe haven in terms of reliability of earnings. The rent and royalty feature of the franchised store system is a strong feature of this model and probably delivers better returns than the company-owned outlets.

Further international expansion is clearly another source of growth that can sustain earnings growth while the US and European economies mark time. The quality of the brand and the consistency of the offer probably offset the risks associated with such an expansion. Foreign exchange gains in McDonald’s four main currency exposures – Canada, Australia, Euro and British pound – won’t help earnings in the short term but could ultimately work in the company’s favour without any speculative positioning.

Even though we have highlighted some of the company’s defensive characteristics during a time of low consumer spending, McDonald’s is clearly not ex-growth. When conditions improve, the business model should gain some operational leverage from its good cost control.

Taking a look at the weekly chart of McDonalds we see little sign of the Global Financial Crisis as this share price has maintained a solid uptrend over the past five years. The $67 level had provided resistance for several years but this level has now been broken and looks to be providing support to the share price. Of slight concern is the negative weekly MACD sell signal but so long as the $65/$67 horizontal support level holds we are not concerned by the MACD signal.

Looking at the daily chart of MCD we can see how the recent pullback found support at the confluence of the $65 horizontal support and the uptrend support levels. The price has driven toward the 52 week high of $71.84, putting in a high of $71.54 on the 22nd of July, but has so far failed to break above this level. The 50 day moving average looks to be providing short term support and the daily RSI has just put in a higher high but is still a long way from overbought. We would expect to see a break through the $72 level which would then give us an upside target of $80 based on an upward projection of the height of the current trading range.