The restaurant chain beats first-quarter earnings estimates as price-conscious diners shop for values

It’s not a big surprise that McDonald’s (MCD) first-quarter earnings beat Street estimates on Apr. 22. The fast-food chain is expected to thrive in a recessionary economy where diners are looking to cut costs. But surprisingly, the gains aren’t necessarily coming from the cheapest items on its menu—the $1 specials. More important, says CEO James A. Skinner, McDonald’s is doing a good job stealing business from higher-priced competitors such as Starbucks (SBUX) and selling those customers higher-margin items, such as espresso-based coffees and Snack Wraps, that are seen as comparative bargains.

“We are not the winners in the current environment because everybody has decided to trade down,” Skinner said in a recent interview with BusinessWeek. “That is not the case.”

For the quarter ended Mar. 31, McDonald’s reported income of $979.5 million, or 87¢ a share, compared with $946.1 million, or 81¢ a year earlier. Analysts had estimated earnings at 82¢ a share. Revenues declined 4% year over year, to $5 billion. The results included a 4¢-per-share gain in the sale of the company’s minority interest in the Redbox DVD rental machine business and an 8¢-a-share negative impact of foreign currency translation. Worldwide sales at restaurants open at least 13 months were up 4.3%. In the U.S., same-store sales rose 4.7%

Sales were slightly weaker in China than expected. But McDonald’s sees China as one of its brightest prospects, along with Germany, Japan, Russia, and the U.S.

Hearty Breakfast Sales

McDonald’s has been on a tear since spring 2003. Same-store sales have gone up every month since then, with only two lapses. One key driver: The Oak Brook (Ill.) chain is doing much better at breakfast, a “day part” when burger competitors Wendy’s (WEN) and Burger King (BKC) are nonentities, and Starbucks is tumbling because it’s perceived as a too-expensive luxury. To grab even more of the morning market from Starbucks, McDonald’s is adding McCafé coffee bars to all 13,900 U.S. locations; the rollout should be complete by midyear.

McDonald’s is also gaining because while people worldwide are trading down, they’re not necessarily eating away from home so much less. According to market trackers NPD, on average Americans will eat out 204 times in 2009, only three fewer meals than last year, based on current trends. “This recession has not caused us to want to cook more,” says NPD’s Harry Balzer. But people are moving toward cheaper meals, and McDonald’s long-standing reputation for value helps a lot here. Indeed, the $1 menu brings in lots of traffic, and always has, even during good times.

But Skinner points out that the $1 menu isn’t the only reason McDonald’s is succeeding. The CEO notes that the $1 menu has steadily accounted for 13% to 15% of sales since 2003’s turnaround. Surprisingly, given the recession, its share has dropped to about 10%. The reason, Skinner says, is that McDonald’s has lots of other items that don’t cost much more—that are seen as bargains. Its Snack Wraps, at $1.29 to $1.49, are selling strongly, as are breakfast sandwiches.

Another example is in its basic burger. McDonald’s recently dropped the Double Cheeseburger from the $1 menu. Cheese prices had climbed so much in 2008 that the sandwich had turned into a money loser at many outlets. McDonald’s replaced it with the McDouble, which has two patties of burger, but only one slice of cheese. The Double Cheeseburger now sells for $1.19 to $1.39 depending on location, but even with that price hike, it’s outselling the $1 alternative by a 60-40 ratio.

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