McDonald's Corporation (MCD) Q2 2013 Earnings Conference Call July 22, 2013 11:00 AM ET

Executives

Don Thompson - President and CEO

Tim Fenton - COO

Peter J. Bensen - EVP and CFO

Kathy Martin - VP, IR

Analysts

Joseph Buckley - Bank of America Merrill Lynch

Jason West - Deutsche Bank Securities, Inc.

John Glass - Morgan Stanley & Co.

Keith Siegner - Credit Suisse Securities LLC

Brian Bittner - Oppenheimer Securities

Matt DiFrisco - Lazard Capital Markets LLC

Jeff Bernstein - Barclays Capital, Inc.

David Tarantino - Robert W. Baird & Co., Inc.

Mitch Speiser - Buckingham Research Group, Inc.

Michael Kelter - Goldman Sachs & Co.

Jeff Farmer - Wells Fargo Advisors

Andy Barish - Jefferies

Bryan Elliot - Raymond James

John Ivankoe - JPMorgan Securities LLC

R.J. Hottovy - Morningstar Research

Peter Saleh - Telsey Advisory Group LLC

Nicole Miller Regan - Piper Jaffray & Co.

Paul Westra - Stifel, Nicolaus & Company Inc.

Operator

Hello and welcome to McDonald’s July 22, 2013 Investor Conference Call. At the request of McDonald’s Corporation, this conference is being recorded. Following today’s presentation, there will be a question-and-answer session for investors. (Operator Instructions)

I’d now like to turn the call over to Ms. Kathy Martin, Vice President of Investor Relations for McDonald’s Corporation. Ms. Martin, you may begin.

Kathy Martin

Good morning everyone, and thanks for joining us. With me on the call are President and Chief Executive Officer, Don Thompson; and Chief Financial Officer, Pete Bensen. In addition, Chief Operating Officer, Tim Fenton is here Q&A. Today’s conference call is being webcast live and recorded for replay via the phone, webcast and podcast.

And before I turn it over to Don, I want to remind everyone that, as always, the forward-looking statements in our earnings release and 8-K filing also apply to our comments. Both documents are available at our website www.investor.mcdonalds.com, as a reconciliations of any non-GAAP financial measures mentioned on today’s call with their corresponding GAAP measures.

And now, I'd like to turn it over to Don.

Don Thompson

Thank you, Kathy, and good morning everyone. I’d like to begin by briefly framing our performance using three lenses. The past, the present, and the future.

First the past, because it provides perspective and guides our present and future. Throughout McDonald’s history, we respectively grown both the top and the bottom lines to varying degrees across a variety of economic and competitive cycles. We have an iconic brand an outstanding system of owner-operators, suppliers and employees and superb real estate locations in nearly every market around the world. This provides a solid foundation from which we operate.

Second, the present. In second quarter we grew revenues, operating income and earnings per share, despite the ongoing impact of the challenging environment. This is truly a testament to the fortitude and resilience of our system, our sustainable competitive advantages, and the collective focus on execution at our restaurants.

And third the future. We expect the dynamics of this cycle should persist in the near-term, namely flat to declining informal eating out markets, increasingly less ability to take price, cost pressures throughout our P&L and heightened competitive activity.

Our second quarter results tells story consistent with these lenses. Global comparable sales were up 1%, operating income was up 3% and constant currencies and earnings per share was $1.38, a 6% increase in constant currencies. And as we begin the third quarter, global comparable sales are expected to be relatively flat in July. Based on our recent sales trends, our results for the rest of the year are expected to remain challenged.

We remain committed to the plan to winning our three global growth priorities to optimize our menu, modernize the customer experience, and to broaden accessibility to brand McDonald’s around the world. This customer centric plan enables us to deliver an appealing experience by offering great tasting, affordable food and beverages, and clean and modern restaurants.

At the same time, we are diligently implementing thoughtful adjustments to our proven strategies and solutions when and where needed. This flexibility has enabled us to maintain or grow market share in most of our major markets around the world.

Let's review ours results in every geographic business units, starting with the United States, where comparable sales for the quarter were up 1% and operating income was flat. We continue to appeal to our customers with an increased emphasis on new news across our menu, and an ongoing focus on everyday affordable value.

The Dollar Menu remains a foundational component of our strategy to consistently deliver value across the menu, rather than implementing aggressive short-term discounting tactics. At the same time, our focus on enhancing core classics and offering additional premium products, continues to provide customers with even more variety and choices across day parts and price points.

This quarter we introduce new items across all four key growth categories, chicken, beef, breakfast and beverages. Premium McWraps launched in April, the Blueberry Pomegranate Smoothie and Egg White Delight debuted in May and last month we added fresh new taste to our Quarter Pounder Burgers with three new flavorful recipes, Bacon Habanero Ranch, Lettuce Tomato Deluxe and Bacon & Cheese.

From a comparable sales standpoint, these new menu additions individually met or exceeded targeted performance levels. However, softer IEO environment and comparisons against prior-year promotion with chicken and beverage activity offset the sales driven by the new menu news. And while June comparable sales were slightly negative in the U.S., we continued to outpace the competitive set.

In June, I met with our leadership franchisees while they were in Oak Brook for one of their regularly scheduled meetings. While the challenges of operating a small business today are many, it is clear that we’re aligned and focused on what's most important and that's the customer. It’s that commitment to remaining customer centric, along with the assertive plans and vision we have in place, that enables all three legs of the McDonald’s system to grow sales and profitability for the long-term.

Let's shift to Europe where comparable sales were down 10 basis points for the quarter and operating income was up 5% in constant currencies. The U.K. and Russia continued to deliver positive results, while weak performance in Germany and France persist. The U.K.’s business remains solid. Second-quarter results and continued market share growth were driven by a balanced focus across value core new products and promotional offers.

The U.K. launch blended ice beverages in June, just in time to satisfy customers craving for something cool and refreshing during the summer months. The lineup includes two delicious fruit smoothies, strawberry and banana and mango and pineapple, and a line of frappes including Carmel and Iced Mocha.

Inspired by the U.S., these new products expand the overall beverage lineup and further validate blended ice as a proven system solution that can be deployed across markets worldwide. Russia also delivered positive performance for the quarter on top of last year's strong results. In addition to a focus on the Big Mac, two seasonal premium offerings, The Royal Cheeseburger and The Big Tasty with Bacon, contributed to Russia's performance and demonstrated the strong ongoing appeal of our brand in this growth market. We expect the lower inflationary environment in Russia to continue dampening our pricing power, pressuring near-term sales momentum compared to last year.

Moving over to France, comparable sales and guest count performance remained negative as the recession continues to pressure the informal eating out industry. However, we’re growing market share by balancing value and premium products across the menu. For example, France recently added two new recipes to the popular Casse-Croute entrée and drink combo. They contributed to market share growth during the lunch day part. This value offer was complemented by a strong focus on two premium beef burgers, Le M and Le 280.

In Germany, negative comparable sales and traffic trends persist. Our traffic has declined at a faster rate than the IEO industry, which also continues to contract. It’s critical that our initiatives resonate with consumers in this environment and in this marketplace. So to re-establish our momentum, we are leveraging recent consumer insights and continuing to adjust our plans.

Let’s shift to Asia Pacific, Middle East, and Africa or APMEA. Comparable sales were down 30 basis points for the quarter and operating income increased 3% in constant currencies. Although market share improved in China, Australia, and Japan, comparable sales were negative for our big three markets. Positive performance in other markets like South Africa, Singapore, and South Korea partially mitigated the overall segment’s decline.

Markets across APMEA are taking a holistic approach to stimulating demand. Across day parts, they are offering limited time and innovative products alongside established price value platforms. In Australia, we continued to grow market share by balancing our focus on the core with new product introductions and promotional activities. Strong performance in 2012 including the launch of our Loose Change menu along with external pressures in 2013 from lower levels of consumer spending and heightened competitive activity have contributed to weaker performance.

In Japan, consumers remain extremely price sensitive. Comparable sales have been positive the last two months, and we continue to grow share by leveraging limited time offerings like the Chicken Teritama and sharing options such as the Mega Potato to keep customers coming back to our restaurants and to build our average check.

In China, comparable sales were down 6.1% for the second quarter reflecting the negative impact from avian influenza, which continues to dissipate. We remain focused on leveraging promotional activities to showcase the diversity of our menu beyond chicken and strengthening our connection with customers through our ongoing brand trust campaign that focuses on the quality and the safety of our food.

We remain confident in our ability to drive future performance in China. Going forward, comprehensive plans for our key growth areas, particularly beverages, the family business, and the late night day part remain our top priorities.

Around the world and across our system, we are focused on ensuring our strategies and tactics resonate with customers. That's the key, the key to our performance today and for the long term. As I mentioned earlier, our market teams continue to strategically and thoughtfully adjust their plans in response to local consumer dynamics and growth opportunities.

At the same time, we remain committed to prudently investing our capital and resources in those initiatives that will further differentiate us from the competition for the long term. We're broadening accessibility by adding new restaurants, we're modernizing our existing restaurants with reimages and remodels, and we continue to deploy technology and convenience initiatives.

As our predominantly franchised business model continues to generate significant levels of cash, our priorities regarding the use of cash have not changed. After investing in our business, we're committed to returning all free cash flow to shareholders over the long term, first through dividends and then through share repurchases. For the second quarter, we returned $1.2 billion to shareholders through a combination of dividends and share repurchases.

In closing I want to reiterate my confidence in our business and in the growth opportunities that exist. We are diligently focused on executing the proven strategies within our plan to win. We have a resilient business model, an aligned and talented system, and an experienced management team.

We're leveraging these strengths and making deliberate, continued progress toward winning this battle for market share and fortifying our position as our customers' favorite place and way to eat and drink.

With that, I'll turn it over to Pete.

Peter J. Bensen

Thanks Don, and hello everyone. McDonald's continued to grow revenues and net income in second quarter within the challenging global environment. The system remains focused on executing our strategies to become even more relevant to the 69 million customers we serve every day.

We continue to adjust our tactics where prudent and are committed to optimizing those factors within our control. Our financial results for the second quarter reflect these efforts to strengthen near-term performance while continuing to build our business for the long term.

For the six months ended June, system-wide sales increased 3% in constant currencies due to expansion. Combined operating margin declined 30 basis points to 30.3% over that same period, primarily due to lower restaurant margin percentages.

We are primarily a franchisor with 81% of our global restaurants operated by local businessmen and women. Consolidated franchise margins contribute approximately 70% of our restaurant profits. This stable, predictable income stream benefits from comparable sales growth and is more insulated from inflationary and other cost pressures.

For the quarter, each area of the world contributed to franchise margin dollars growing 4% in constant currencies to more than $1.9 billion. The margin percent declined 40 basis points to 82.8% as positive comparable sales were more than offset by higher occupancy expenses.

Global company-operated margin dollars declined 1% in constant currencies to $842 million for the quarter. The margin percent decreased 50 basis points to 17.7% as higher labor, commodity, and other costs more than offset slightly positive comparable sales. The margin pressures for the quarter were most acute in the U.S. and APMEA while Europe grew its McOpCo margin.

In the U.S., second quarter company-operated margins declined 110 basis points to 18.7% due to higher labor occupancy and other operating costs. The McDonald's system is effectively managing commodity expenses with cost up about 1% in second quarter. The full year outlook for the increase in our U.S. grocery basket remains at 1.5% to 2.5%.

The U.S. has been deliberate regarding pricing seeking to remain below the food-away-from-home inflation index of 2.2%. Another relevant data point is Food At Home index which is up only 0.9%, somewhat limiting our pricing power. At the end of June, our U.S. price increase was 1.5% which is about 120 basis points less than one year ago.

As we move through the second half of the year, we will consider future price increases balancing our desire to grow traffic and market share amidst the reality of higher input costs. In addition to pricing, we're employing more suggestive selling strategies at the order point to encourage trials, new products and add-on purchases. As Don mentioned, it's a market share battle so we're employing a variety of strategies and tactics to grow traffic and increase relevance to our consumers.

Turning now to Europe, company-operated margins were probably the biggest positive of the quarter as they increased 10 basis points to 19.4%. Europe's McOpCo margins benefited from the significant contribution from the UK and Russia, our two strongest performing markets in the region who contribute nearly half of the segments company-operated margin dollars.

In addition, France and other markets realized labor productivity gains as part of their overall efforts to control costs and enhance efficiencies within the restaurants. Commodities increased about 2% for the quarter and for the full year, Europe's projected increase is now slightly lower at 2% to 3%.

Europe is a collection of 39 markets, so our price increases vary by market with Russia at the higher end due to its inflation albeit a little less than a year ago and all other markets averaging about 1.5% year-over-year. Similar to the U.S. we have less pricing power in 2013 versus a year ago.

In addition, given the economic environment in nearly all of our markets we're balancing a stronger emphasis on value with compelling premium products to effectively manage average check and margins. We have a strong underlying business in Europe and we believe we are making the right strategic decisions and value investments to protect and grow the band over the long term.

In Asia-Pacific, Middle East and Africa, company-operated margins for the quarter decreased 100 basis points to 14.3% due to new restaurant openings mainly in China along with higher labor costs throughout the segment. To a lesser extent, avian influenza impacted our sales and margins in second quarter, but our team work hard to manage expenses and other controllables to mitigate some of the negative impact.

G&A discipline remains an area of focus. We seek to grow sales and revenues faster than our G&A spend. Year-to-date, G&A as a percent of revenues was 8.8% versus 9% a year ago, which included our biennial Worldwide Convention. For the full-year, as part of our ongoing efforts we have reduced our G&A spend and now expect it to be relatively flat versus the prior-year due in part to lower incentive compensation and efficiencies we have identified.

The growth in revenues and operating income within our franchise business model translates into significant generation of cash. As Don reiterated, our first priority for this cash remains reinvesting in our business to drive future growth and returns. In light of the current environment we have trimmed our 2013 capital expenditure forecast by $100 million to about $3.1 billion. Although we will open about 50 fewer sites, we believe this is prudent given the short-term pressures. More importantly it will not undermine our long-term growth potential and the quality and returns of our new restaurants remain very solid.

The remainder of our capital is being invested in existing restaurants, in part through reimaging more than 1,600 location’s, we’re making steady progress in our efforts to modernize our brand with about 50% of our exteriors and about 60% of our interiors on a global basis reflecting the current contemporary look. In the U.S. this year we will touch about 10% of our traditional brief standing portfolio through a combination of reimaging, rebuild and new restaurants, this will put us close to the 50% mark. Within the next year a U.S. customer more often than us will experience our brand in a more modern and relevant manner than before. We’re excited about the potential that this brings to our largest market.

Lastly, let me touch on foreign currency translation which negatively impacted second quarter results by $0.02 more than originally forecasted as several currencies weakened against the U.S. dollar during the quarter. At current exchange rates we expect a negative impact of $0.01 to $0.02 on third quarter EPS with a full-year negative impact of $0.07 to $0.09. As usual though, please take this as directional guidance only because rates will continue to change as we progress throughout the second half of the year.

Despite flat to declining and formal eating out markets around the world McDonald’s grew revenue operating income and earnings per share in second quarter. Our results underscore the solid performance, the solid platform from which we are operating. A unique franchise business model that harnesses the entrepreneurial spirit of local businessmen and women will operate approximately 28,000 of our nearly 35,000 restaurants around the world. The powerful alignment of our system around the strategies and key growth priorities that have allowed us to maintain or grow our industry leading market share in most of our major markets and a strong financial foundation that allows us to invest for the future while making prudent decisions to deliver near term performance. We remain confident in our brand and the competitive advantages of our system which we believe will continue to drive positive results over the long-term. Thanks.

Now, I’ll turn it over to Kathy to begin our Q&A.

Earnings Call Part 2:

• Q&A with McDonald's Corporation CEO