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McDonald's Keeps Rolling, Starbucks Back in the Game

Jeremy Glaser

Jeremy Glaser: For Morningstar.com, I'm Jeremy Glaser. Both Starbucks and McDonald's posted outstanding quarters today. I'm here with analyst R.J. Hottovy to discuss what is driving the results and what the future could hold. R.J., thanks for talking with me today.

R.J. Hottovy: Thanks for having me, Jeremy.

Glaser: So, starting with McDonald's, which reported this morning. They had another great quarter. What was driving their growth?

Hottovy: It was a number of factors, and really I think that the key takeaways here are two-fold. First, that March sales in the U.S. took off. We had seen flattish sales in January and February, and saw a nice rebound in March.

To me, that shows that a lot of things they have done on the menu are gaining traction. Whether or not that's the introduction of frappes and the soon-to-be-launched smoothie products, some of the more premium products such as Angus burgers, and some of the simpler things they've done in terms of snack and portable products, in terms of the Big Mac wrap--all these things are having a meaningful impact on driving traffic.

Another thing that they have done very well, is the introduction of the everyday breakfast value menu, which certainly played a role in driving traffic. We've seen a little bit of sacrifice at the average ticket level, but certainly this has been a key driver of sales. I think that that's going to help drive operating margins going forward.

The second factor really is just the operating margin line. To continue to put up 200 basis points of operating margin improvement really was the key highlight for us. A lot of that has to do with favorable commodity costs. That will lap in the back half of the year--we won't see that favorability.

I expect the company to post still some pretty impressive margin gains for the year, just based on basic blocking and tackling at the G&A level. I think the company is well-positioned for the rest of this year.

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Glaser: One of the concerns about McDonald's has been that with unemployment so high people aren't eating out as much, they're staying at home. Is that something that you saw in the quarter? Or does it seem that people are back in the restaurants.

Hottovy: It's certainly a factor, and quick-service restaurant sales are so tied to unemployment rates, and we did see some of that impact in the quarter. Traffic was back in March but still not great. I think the company will acknowledge that things won't be great until unemployment rates continue to fall.

But that said, I think that they are offsetting that again with some of the value-orientated promotions that they have, with breakfasts and a number of other things on the menu. So that's their way of combating those numbers.

Glaser: Getting back to--you were saying earlier that the launch of frappes and smoothies could be a big boon for them. That seems to be elbowing into Starbucks territory more and more. How is Starbucks dealing with that competitive threat? Or are they really going after different customer sets?

Hottovy: Yes, it's amazing. We've really seen a convergence of McDonald's and Starbucks over the past couple of years. McDonald's got into specialty coffee and Starbucks fired back by introducing breakfast pairings. So really we've seen a convergence of that and that's how Starbucks is competing with that. Breakfast pairings is one thing where they have coffee and a pastry for under $2.99.

Whether it be other lunch food products that they have at Starbucks, a number of ways to combat that. Even just something as simple as maybe lowering the prices on their most popular lattes and products where maybe raising the price on their most advanced or complex drinks, that's how they're competing with that.

But ultimately, at the end of the day, we feel like the coffee space is large enough, it's growing, it's going to support both these players, and probably a few more.

Glaser: So we look at Starbucks' quarter. They also had some pretty good numbers, that seems to be playing out there as well.

Hottovy: Yes. I think what we are seeing here is that consumer spending in March and into April, it's been pretty broad-based. We still see strength in McDonald's, so that says the lower-income consumer is starting to spend more. But again, it echoes what we've seen in retail, where the more affluent customer, who would typically go to Starbucks is also more willing to spend.

The big question is whether or not these trends are sustainable. We probably will see some deceleration in the back half of the year. But at the same time, things look pretty good, especially with the cost-cuttings that a lot of these companies have put in place. It bodes well for margins in the back half of the year.

Glaser: Starbucks is now returning some capital to shareholders through a dividend. Is that an admission that their explosive growth is over? Would you expect to see more modest store openings over the...?

Hottovy: Yes, I think that the period of double-digit growth is over probably in the U.S. I think they've got a pretty good runway of growth, especially in the international side of the business. The consumer products side of the business, I think, is especially intriguing.

The instant coffee launch, the Via product that the company has put on the market, has blown away expectations. It's done a lot better than I ever expected it to do. It's a compelling product, and again, as people associate that with the popular Starbucks brand, I think that could be a potentially large revenue stream and potentially something that drives margins down the road as well.

Glaser: From a valuation perspective, are either of these stocks attractive right now?

Hottovy: I think we're starting to see a little bit of over-value in this space. Our fair value estimate on McDonald's is still $66. Stock is currently trading at about $71, so we think that's modestly ahead of our fair value estimate and would probably wait for other pullbacks before really looking at that attractive name.

Starbucks' stock is currently at $25. Our fair value estimate is $20. Again, we start to think valuations here are starting to get ahead of themselves. Admittedly, things look great right now, we've had a great couple of months, and probably that will continue into the second quarter.

But longer-term, again, keeping in mind where margins can go, it's important to keep that long-term perspective and maybe recognize that things have gotten ahead of themselves a little bit.

Glaser: So there could be some opportunities in the back half the year?

Hottovy: I think so.

Glaser: R.J., thanks so much.

Hottovy: Thank you.

Glaser: For Morningstar.com, I'm Jeremy Glaser.