McDonald’s misfires in blaming consumers for slowing profits

July 26, 2012, 6:53 PM UTC

English: Sign outside McDonald's Plaza, one of...

FORTUNE – For nearly a decade, McDonald’s has been wildly successful. Even in the years following the financial crisis when tough economic times weighed on U.S. consumers, the Oak Brook, Il-based fast food hamburger chain rarely let investors down. In 2011, it generated revenue topping $27 billion, higher than the $24 billion it posted the previous year. And as Fortune featured last summer, McDonald’s is well positioned, since consumers tend to eat there in good and bad times.

But the chain’s golden arches have unexpectedly dimmed. Net income fell 4.5% to $1.35 billion or $1.32 a share during its most recent quarter, from $1.41 billion or $1.35 a year earlier, McDonald’s reported Monday. Wall Street analysts had expected earnings of $1.37 per share.

Various factors led to the profit miss: A sharply strong dollar that cut profits; high food prices gnawed on margins; high labor costs abroad. In particular, the chain broadly blamed consumers: “We’re seeing more markets that are having consumer confidence issues,” CEO Don Thompson said in a conference call with analysts. “It’s a little more than a European cold, if you would.”

No doubt Europe’s worsening debt crisis combined with a sluggish U.S. economy have dampened consumer confidence. And expectations of a slower growing China and India, among other economies, don’t help ease investor worries.

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But as much as executives focus on general economic weaknesses across the globe, business moves within McDonald’s (MCD) headquarters deserve a closer look. The chain has struggled to keep up with competitors, Bank of America analysts have noted. As McDonald’s sees softer earnings, other fast-food rivals, including Burger King (BKW) and Taco Bell (YUM) have, enjoyed a rebound in sales. Regional chains, such as Sonic (SONC) and Jack in the Box (JACK), have also enjoyed stronger sales in recent quarters.

McDonald’s has done an impressive job turning itself around since 2002, but the latest earnings reflect symptoms of a chain that in recent years has moved further away from its core burgers and fries business – essentially, what’s kept customers returning all these years.

Take McDonald’s Dollar Menu, says Howard Penney, restaurant industry analyst with the investment research firm Hedgeye and a Fortune contributor. In March, amid higher food costs, executives announced it was removing small drinks and small French fries from its Dollar Menu, replacing those items with fresh baked cookies and ice cream cones. The chain also launched its extra-value menu, which included, among other items, 20-piece chicken McNuggets, double cheeseburgers, chicken snack wraps, Angus snack wraps, medium iced coffees and snack-sized McFlurries. (See McDonald’s new menu is about inflation more than value)

Looking back, the move probably wasn’t the wisest. The Dollar Menu had been around for years. And it seemed counterintuitive (arguably, perhaps even a little unjust) to take one of the most popular items off its recession-friendly menu.

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“You’re basically telling a set of customers you don’t want them anymore,” Penney says.

The latest quarter suggests McDonald’s has struggled to upsell the new menu to budget-conscious Americans. Sales at stores open at least 13 months in the U.S., a key measure of business performance, rose 3.6% during the quarter that ended June 30, the slowest growth in five quarters.

McDonald’s has also expanded too much into beverages, Penney warned in January 2011. While the chain’s focus in specialty coffees (sold at relatively higher prices) has given it considerable success, the returns are uncertain because the operations are more complex. “It takes more to make a latte than to pour a Coke,” he said.

A McDonald’s spokeswoman says the chain’s classic core favorites, as well as new additions to the McCafe beverages in the U.S. have added to the company’s performance. And as far as its extra value menu, the company says it “builds on the Dollar Menu favorites by offering affordable meal options.”

Andy Barish, senior equities analyst at Jefferies & Company, says much of the downward pressures that McDonald’s faces are beyond its control. “They’re still running the business really well but things are normalizing,” says Barish, pointing out that rivals have followed McDonald’s playbook to plant the seeds of their own successes.

He wonders, however, if it might be time for McDonald’s to do something markedly different. “It has been doing the same old thing; they haven’t done much. Maybe customers are getting a little tired of the same old thing?”