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McDonald's new menu is about inflation more than value

March 13, 2012: 12:12 PM ET

Inflation has made the Dollar Menu an unprofitable but necessary evil. The latest tweaks to McDonald's value menu won't change that.

By Howard Penney and Rory Green, Hedgeye

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Some incremental changes are coming to a McDonald's menu near you – what are the implications?

Later this month, McDonald's will change some of its Dollar Menu items and it will begin offering an expanded value menu, including 20-piece chicken McNuggets, double cheeseburgers, chicken snack wraps, and Angus snack wraps, according to Reuters.

As we learned in a conversation with the company, McDonald's is focusing its menu on four tiers (not including combo meals):

  1. Premium: $4.50-$5.50+
  2. Core: $3.50-$4.50
  3. Extra Value Menu (new): $1.20 to $3.50+
  4. Dollar menu

In trying to understand the implications of what McDonald's is doing, a restaurant industry consultant and associate of ours had this to say: "I get a kick out of these corporate guys at Wendy's (WEN) and McDonald's pretending they have some magical formula for value pricing. It's 100% driven by food costs and customer behavior."

Given that McDonald's (MCD) is seeing increasing inflation in 2012, we believe the company is trying to manage its margins by forcing consumers to trade up to the "extra value menu" from the "dollar menu." This makes more sense when we consider that one of the biggest changes is to remove small drinks and small fries from the dollar menu and replace those items with fresh baked cookies and ice cream cones.

We see this as a big risk for McDonald's. If customer preference is to have the drink and fries as part of the dollar menu then there is a risk that this change negatively impacts customer satisfaction. The company told us that a "mini-combo meal" offering may bundle the fries, burger, and drink but a decision has not been made on that yet. Still, ordering the $1 items individually is being taken off the table.

The new "Extra Value Menu" will be advertised on March 26th. According to Reuters, "the new menu will include 20-piece chicken McNuggets, double cheeseburgers, chicken snack wraps, Angus snack wraps, medium iced coffees and snack-sized McFlurries, plus up to four regional options, that were previously listed elsewhere on its menu." The idea for McDonald's is to streamline and change what is highlighted on the menu. The company likes to phrase this differently, saying that it is "making it easier for customers to find ['Extra Value Menu' items]."

From our perspective, the big problem is that the "Dollar Menu" has been around for a very long time. Inflation has made it an unprofitable but necessary evil. Customers, also pressed by inflation, have been migrating from the combo meals on the core menu, which can cost $6-$7, over to the Dollar Menu where customers get almost double the value from a price perspective. We view this latest change as an attempt by the company to stem this flow of business from the core menu to the dollar menu. This adds an extra emphasis on the importance of April sales; investors will be watching closely for an indication of whether or not the new menu strategy is working.

Going after Dunkin'

Separately, McDonald's launched a new breakfast initiative in New England on Monday. We see this as a move to steal share from Dunkin' Donuts (DNKN) that could make life difficult for Dunkin longer-term.

According to the Boston Globe, McDonald's new "menu items include cheese Danish, two kinds of muffins, banana bread, and vanilla scones. Unlike the traditional McDonald's breakfast menu, which features offerings such as oatmeal, pancakes, and variations of the long-popular Egg McMuffin, the baked goods will be available all day."

The initiative was organized for McDonald's Boston region and will be sold in Albany, N.Y. Massachusetts, Rhode Island, Connecticut as well as a few other states in the Northeast.

The New England region worked with the menu management team in Oak Brook "to create a line of breakfast pastry products that they believe will resonate well with the local customer base" according to McDonald's. The products are prepared daily in the existing breakfast ovens that are used to cook McDonald's biscuits and pies.

We are hearing that the prices are very competitive and are consistent with the "extra value meal" section of the new menu initiative being launched at the end of March. A Cheese Danish goes for $1.79 or $2.79 with coffee, muffins for $1.59 each, three mini scones for $1.89 and Banana Bread for $1.59 per slice.

We have seen several times how ruthless a competitor McDonald's is and we do not see this foray into Dunkin's turf as being insignificant. The baked goods are a natural extension of the McCafé initiative launched in 2009. The baked goods are going to be sold throughout the day and, while it's difficult to know for sure how they will do, Dunkin is clearly in McDonald's crosshairs.

Follow Howard Penney on Twitter @hedgeyeHWP

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Hedgeye, a real-time investment research firm founded in 2008 by former Carlyle-Blue Wave portfolio manager Keith McCullough, operates as a virtual hedge fund. Staffed by research analysts from across Wall Street, Hedgeye offers fundamental, macro and sector analysis, present picks in a transparent way to its clients. It has built a stable of subscribers, which includes hedge funds and mutual funds, and recently launched a retail investor product.

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