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Executives

Don Thompson - President and CEO

Peter Bensen - EVP and CFO

Kathy Martin - VP, IR

Analysts

Joseph Buckley - Bank of America Merrill Lynch

John Glass - Morgan Stanley

Jeffrey Bernstein - Barclays Capital

David Tarantino - Robert W. Baird

Will Slabaugh - Stephens

Matt DiFrisco - Lazard Capital Markets

Brian Bittner - Oppenheimer

Sara Senatore - Sanford Bernstein

Nicole Miller - Piper Jaffray

Jeff Farmer - Wells Fargo

R.J. Hottovy - Morningstar

Andy Barish - Jefferies

Mitch Speiser - Buckingham Research

McDonald’s Corporation (MCD) Q3 2013 Earnings Conference Call October 21, 2013 11:00 AM ET

Hello and welcome to McDonald’s October 21, 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 would 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

Thank you, and hello, everybody. With me on the call are President and Chief Executive Officer Don Thompson and Chief Financial Officer Pete Bensen. 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 the forward-looking statements in our earnings release and 8-K filing also apply to our comments. Both of these documents are available at our website www.investor.mcdonalds.com, as are 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

Good morning everyone, and thank you, Kathy. In July, we talked about three lenses through which we’re framing our performance. We talked about the past, the present, and the future. Today, I want to talk about the present and the future.

We’re focused on the actions that we are taking to drive current performance in an environment that is pressuring growth, and we’ll discuss how those actions will position us to deliver results in the near and the longer terms.

Today, our business continues to grow, as demonstrated by third quarter performance. While global comparable sales of 0.9% were not as high as we’d like, operating income grew 6% in constant currencies and earnings per share was $1.52, a 7% increase in constant currencies.

Even though our comp sales lap eases in the fourth quarter, macroeconomic and competitive conditions are not expected to change dramatically. As a result, we expect October sales to be relatively flat.

Around the world, we are accelerating those initiatives that we believe will have the greatest impact on our customers within our three global growth priorities to optimize our menu, modernize the customer experience, and broaden consumers’ access to our brand. We’re also thoughtfully adapting local market plans to remain relevant and appealing at a time when consumers are uncertain and the industry is stagnant.

We continue to intensify our focus on the most critical tenets of the customer experience: the strength in our performance, menu quality and choice, customer service, affordability, and consumer engagement. I’d like to briefly discuss each one of these.

Regarding menu quality and choice, we must ensure that the true quality of our ingredients and food recipes are better known to all consumers, and that customers have choices across our menu to meet their taste desires and/or nutritional expectations. This includes featuring relevant and appealing new food and beverage news.

Next, customer service. Simply stated, we must exceed our customers’ expectations for fast, accurate, and friendly service at each and every one of our nearly 35,000 restaurants around the world. And furthermore, those restaurants must be clean, well-maintained, and contemporary.

The third point is affordability. We need to offer compelling value options across all price tiers of our menu. And lastly, deepening [unintelligible]. This means creating stronger awareness and excitement around our menu and around our restaurants while further revealing the ways in which we’re a good neighbor in communities around the world.

We know that meeting customers’ expectations in all of these areas is critically important to a great experience at McDonald’s. We’ll talk more about these tenets, including specific examples of actions we’re taking around the world to elevate the McDonald’s experience at next month’s investor meeting on November 14.

So let’s take a look at the business across the globe, starting with the U.S. U.S. comparable sales were up 0.7% for the quarter, and operating income increased 5%. Our current sales performance was driven by a focus on bringing new and familiar taste to customers, exciting promotions, and an ongoing emphasis on affordability across our menu.

We accelerated the timing of our Monopoly promotion in an effort to further increase awareness and encourage trial of recent new product introductions like Quarter Pounder line sandwiches and the new McWraps. Monopoly also reminds customers about our core menu classics. It drives traffic and builds average check while also engaging customers in a fun and familiar game experience that’s only available at McDonald’s.

We also introduced Mighty Wings in the third quarter as a limited time offer. This [bold] (ph) new flavor addition to our U.S. menu originated in China and Hong Kong and has encouraged trade up to increase average check. While overall performance of Monopoly and Mighty Wings met our internal targets, it was not strong enough to offset current guest count trends.

Our promotions and new products are complemented by our consistent value approach to offer affordable variety and choice across the menu. The Dollar Menu remains core to our high-low strategy, with products like the Grilled Onion Cheddar Burger and the popular McChicken continuing to generate strong demand at the $1 price point.

As we celebrate the 10-year anniversary of the Dollar Menu, we’re leveraging the equity we’ve built to ensure we continue to satisfy our customers’ expectations for affordability. The new Dollar Menu and More platform is designed to provide every day predictable value beyond the $1 price point and will be supported with the weight of our national advertising. The sandwich lineup, which ranges from $1 to $2 adds new flavors and tastes to complement our existing favorites and provides additional pricing flexibility for the McDouble.

In addition to the launch of Dollar Menu and More, we’re balancing proven favorites with new tastes that add further excitement and variety to our menu. The return of the popular McRib sandwich and the Southwest Premium McWrap are examples of this flavorful balance that will be seen in restaurants within the United States.

Now let’s turn to Europe, where comparable sales were up 20 basis points for the quarter and operating income grew 8% in constant currencies. These results reflect strong performance in the U.K. and Russia and solid performance in France. Negative trends in Germany continue amidst the highly competitive environment.

The U.K.’s business momentum remained strong, and we continued to grow market share. This growth has been supported by our expanded beverage lineup and an ongoing breakfast focus. This month, we’re launching Mocha in the U.K. and using this opportunity to introduce the McCafe brand across our entire range of espresso-based coffees. Following the successful launch of McCafe iced smoothies and frappes over the summer, this represents a significant step in our journey to become a beverage destination in the U.K.

Russia delivered positive performance in the third quarter despite the lower inflationary environment that continues to limit our ability to take price. Successful food offers such as Tastes of the Season and the Ciabatta Beef Burger helped boost results for the quarter.

France also delivered positive results for the quarter, marking its first positive quarter of comparable sales since the third quarter of 2012. The market continues to grow share in a contracting and [unintelligible] industry. A core menu focus, supported by strong marketing execution and an ongoing emphasis on affordability helped to drive our performance.

The Big Tasty re-hit in September generated strong demand and the Classic Return campaign, which launched in August, proved to be successful drivers of France’s performance during the quarter. Additionally, Petit Plaisirs and Casse Croute continue to do well by providing attractive offers at affordable price points. While we’re pleased with these results, we’re cautious about recent performance, especially given the volatility in France’s economy.

Germany’s performance remains weak, as negative comparable sales and traffic trends continued through the third quarter. Competitive activity remains aggressive, and the decline in IEO category persists as the industry grapples with price-sensitive consumers. Today, affordability and specifically price value is key in Germany. We continue to evolve the balance between our base value and premium offers across the menu to address the near term needs of the marketplace.

Now let’s move over to Asia Pacific, Middle East, and Africa, or APMEA. Comparable sales were down 1.4% for the quarter, and operating income decreased 4% in constant currencies. Performance across our big three markets remains challenging. This reflects tough macroeconomic conditions along with the performance of recent new products and promotions that were unable to overcome our current negative guest count momentum.

Across APMEA, we remain focused on driving performance through consistent price value offers, accelerating growth at key day parts, particularly breakfast and overnight, and by leveraging brand extensions to enhance the service and convenience of the McDonald’s experience.

Australia continues to balance new product news and strong promotional activity to appeal to customers in a highly competitive environment. Looking ahead, Australia is targeting opportunities in chicken and the family business to broaden customer appeal.

Japan’s negative comparable sales and traffic trends persist. We’re committed to making improvements to our value platform in the near term in an effort to appeal to consumers who remain extremely price sensitive in this deflationary environment. At the same time, we’re introducing new products and promotions to create excitement and attract customers into our restaurants.

In China, comparable sales were down 3.2% for the quarter. As a key emerging market, China has significant long term opportunities across all three of our growth priorities. We’re also evolving our value platform to give it a greater reach across day parts and meal occasions. At the same time, we’re using limited time offers and promotions to create energy around new menu news, and we’re leveraging brand extensions like kiosks and McCafes to reach our customers when, where, and how they want the McDonald’s experience the most.

Around the world, we remain focused on our customers. It’s our top priority to deliver an experience that meets their evolving tastes and lifestyles. We recognize the opportunities that exist to profitably grow our business for the immediate and the longer term.

We remain committed to making disciplined investments to fuel future growth and further differentiate Brand McDonald’s. Our efforts to broaden accessibility through new restaurants and to modernize the customer experience by reinvesting in existing restaurants, including reimaging, technology, and convenience initiatives, remains a top priority.

Consistent with our longstanding priorities regarding the use of cash, 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 share repurchases. In fact, we recently announced a 5% increase in our quarterly cash dividend to $0.81 per share, bringing the annual dividend to $3.24.

Combined with our share repurchases, we expect our total cash return to shareholders for 2013 to be between $4.5 billion and $5 billion. In times like these, our ability to stay focused on those factors within our control is absolutely critical. As important is our ability to look within, to understand what’s working, what needs to change, and why and we must execute.

Our decentralized local markets have the ability to test their plans and quickly course correct based on customer reactions. This is even more important in this environment because it allows us to identify the right tactics that resonate with consumers and that will drive our performance in the near and longer terms.

Our culture is built on the premise of always putting the customer first, making them feel good about visiting McDonald’s today and into the future. Our ability to deliver on that promise through our actions will enable us to deliver long term value for our system and for our shareholders.

Thanks again, everyone. I’ll now turn it over to Pete.

Peter Bensen

Thanks, Don, and hello, everyone. Our performance in third quarter speaks to the resiliency of our business model and our ongoing commitment to invest strategically and grow our business over the long term through a balanced approach of adding new units and increasing sales at existing restaurants.

Despite modest comparable sales growth, McDonald’s was able to achieve solid growth in revenues and income. While the growth has not been as high as recent years, we are confident in our ability to deliver significant shareholder value over time.

Through the first nine months, revenues increased 2% and our combined operating margin increased 10 basis points to 31.2%, primarily due to higher franchise margin dollars and lower G&A expenses.

With 81% of our nearly 35,000 restaurants franchised, our profitability is primarily driven by franchise margins. In the third quarter, franchise margins reached about $2 billion, an increase of 4%, or nearly $70 million in constant currencies, with each area of the world contributing to this growth. The franchise margin percentage for the quarter declined 40 basis points to 83% as positive comparable sales were more than offset by higher occupancy costs.

Global company operated margins totaled $919 million for the quarter, and were relatively flat in constant currencies. The margin percent decreased 40 basis points to 18.7% as weaker performance in the U.S. and APMEA offset gains in Europe.

In the U.S., third quarter company operated margins declined 140 basis points to 18.4% due to higher operating and commodity costs. Commodity costs increased about 2.5% in the third quarter, with similar pressure expected in the fourth quarter. We have tightened our full year estimates and now project 2013 commodity costs in the U.S. to be up 1.5% to 2%.

We have taken three price increases year to date, with the most recent increase in September totaling about 1%. This brings our total increase to about 2.6%, which is relatively consistent with a year ago. We are at the midpoint of the projected 2% to 3% full year increase for food away from home inflation. Food at home inflation has been running at about a point lower, so we are keeping a close eye on this measure as well as we consider future price moves.

In Europe, third quarter company operated margins increased 70 basis points to 21.1%, primarily due to the strength of our two largest McOpCo markets, Russia and the U.K. These two markets contribute nearly half of Europe’s company operated margin dollars.

In addition, France, the third-largest market in terms of McOpCo margin dollars, contributed through positive comparable sales and certain labor efficiencies, most of which we don’t expect to realize in the fourth quarter.

Commodities increased about 1% for the quarter. Europe has also lowered its full year projected increase to 1.5% to 2%. Our price increases varied across the 39 European markets. Excluding Russia, most European markets are averaging year over year price increases around 1.5%.

As we consider future price increases, we remain mindful of the economic uncertainty, cautious consumer sentiment, increased taxation, and lower disposable income. Our global strategy and approach to pricing remains unchanged. We continue to balance our goal of driving traffic and market share gains while effectively managing the impact of rising costs and evolving consumer trends.

Turning to Asia Pacific, the Middle East, and Africa, company operated margins for the quarter decreased 160 basis points to 15.3%, primarily due to higher labor costs across the segment as well as new restaurant openings, mainly in China. For a perspective, China represents approximately 30% of APMEA’s company operated margin dollars.

Our G&A expense in the quarter declined 11% or more than $66 million versus a year ago. This was primarily due to lower incentive-based compensation and lapping the sponsorship of the London Olympic and Paralympic Games last summer. For the full year, we now expect G&A to be down 2% to 3% in constant currencies.

Solid, consistent financial performance from our unique business model generates meaningful amounts of cash flow. We strategically reinvest a significant amount of this cash back into our business to drive future growth and returns. Our restaurant development teams are making good progress against their plans for building new restaurants and reimaging existing locations, taking advantage of improved tools and capabilities.

We have trimmed our 2013 capital expenditure estimate to $3 billion. This is a conscious decision to delay a limited number of new openings into 2014 based on current conditions. We feel this is prudent given the short term pressures and our desire to maximize the quality of our new openings.

We continue to generate strong returns at new restaurants in mature markets with emerging markets like China historically achieving our benchmarks within three to four years. In 2013, we expect to open about 1,500 new restaurants, ending the year at over 35,000. New openings by are of the world include over 225 in the U.S., about 300 in Europe, and more than 750 in APMEA. Approximately one-third of our global openings are in development of license or affiliated markets where we do not invest our capital.

We also continue to modernize our existing restaurant base through reimaging more than 1,600 restaurants this year. Globally, about two-thirds of our interiors and over half of our exteriors reflect the current contemporary look.

Let’s now turn to foreign currency translation, which negatively impacted third quarter results by $0.01. At current exchange rates, including the euro at the $1.35/$1.36 level, we expect full year EPS to be negatively impacted by about $0.05 to $0.06, which implies a fourth quarter negative impact of $0.01 to $0.02. Please take this as directional only, given the volatility in exchange rates.

Lastly, I’d like to comment on our expectations for the remainder of this year. On the first quarter call in April, I said that we expected company operated margins to be pressured throughout 2013, though the margin decline should be less pronounced than in the first quarter, as sales comparisons ease in upcoming quarters.

Let me give you an update. Though sales comparisons have eased and will continue to do so, our current sales trends are a stronger predictor of future performance than prior year comparisons. As a result, based on what we know today, we expect fourth quarter global comparable sales performance to be in line with recent quarterly trends and restaurant margin percentage declines, both McOpCo and franchised, to be at a level relatively similar to first quarter declines.

We’re wrapping up our planning cycle over the next few weeks, and we look forward to sharing some of our 2014 outlook with you at our November investor meeting next month.

The McDonald’s system remains focused on building our business to generate enduring, profitable growth for our shareholders, franchisees, and suppliers. Our third quarter results speak to the benefit of our geographic diversification and the many levers we have to generate top and bottom line growth.

We are confident in our ability to successfully navigate this environment while preserving our competitive advantages and positioning the brand to participate fully when consumer spending improves.

Thank you. Now I’ll turn it over to Kathy to begin the Q&A.

Question-and-Answer Session

Kathy Martin

Thanks, Keith, I’ll now open the call for analyst and investor questions. [Operator instructions] Our first question is from Joe Buckley with Bank of America.

Joseph Buckley - Bank of America Merrill Lynch

I’m going to ask a very near-term question. Looking at the year ago October performance, this comparison looks pretty easy and obviously you’re guiding to a relatively flat number. So I’m curious if things have worsened yet, if perhaps the government shutdown and debt ceiling discussions may have impacted U.S. business or sort of what drove that?

And then kind of a related question, the margins held up fairly well, very, very well. They were actually up in Europe this quarter. So why the greater margin deterioration in the fourth quarter? Is there something unusual going on?

Don Thompson

I’ll take the first part, and then I’ll ask Pete to speak to your question relative to margins. Regarding October, and it’s really October in the fourth quarter, we expect the fourth quarter to remain challenged based on some of the existing top line pressures that we’re seeing. We’re seeing flat or declining IEO markets and heightened competitive activity across all the geographies.

And even though the comp sales lapped – do ease in the fourth quarter, heightened macroeconomic and competitive pressures are not expected to change dramatically as we said. In Europe, we’ve got less pricing power than we had a year ago, and consumer psyche is affected by both the economies and also some of the upcoming austerity measures, VAT pressures, etc.

In the U.S., we continue to experience a bifurcation of the consumer base. McDonald’s core customers skew towards those customers whose disposable income is not rising as much and are spending a little bit less in QSR. And so as we look at those things, as we look at the macroeconomic conditions that persist in APMEA and across APMEA, we believe that this fourth quarter is still going to be relatively challenged as we mentioned.

Regarding the government and the shutdown, you asked a question about that, actually for us at McDonald’s, the impact is limited to a few different areas. One would be communities with large federal employees and those populations where a lot of the consumers there, their purchasing power may be limited based upon the government shutdown if the government employees or impacted by it.

Another is from a supply chain perspective, in port authorities, when things like that happen from an impact perspective, the port authorities are operating at reduced level, so that changes the importation processing times for some of the products that we may have.

And lastly, it’s things like the e-Verify program, Federal e-Verify program, when it’s closed down and the impact it has relative to hiring processes, so you can see that outside of that first one, which really gets into population impact, it’s fairly minimal at this point relative to what’s taking place from a government perspective.

Peter Bensen

And regarding margins, you pointed out exactly the difference between the third quarter and our outlook for the fourth quarter and that was Europe. The two markets that really had the biggest impact on that improvement in the third quarter in Europe were Russia and France. Combined, they basically contributed to 70 basis points of growth. While the U.K. had growth, it was pretty much offset by the other markets.

And France, we had some exceptional labor efficiencies due to their higher sales levels in the quarter that we don’t expect in the fourth quarter. And in Russia, we had a true-up of some of their distribution costs that resulted in a credit that added some improvement to the margins there. Last year, that true-up happened in the fourth quarter, so their margins in the fourth quarter were a little higher last year based on that. So on a comparative basis, we don’t get that benefit.

So at the end of the day, based on the current sales trends and the lack of a couple of these unusual items, we don’t expect there to be that growth in Europe margins in the fourth quarter leading the consolidated margins to be more in line with the declines we saw first quarter.

Kathy Martin

Our next question is from John Glass with Morgan Stanley.

John Glass - Morgan Stanley

My question’s on the U.S. It sounds like you’re saying that the promotions you’ve run the last couple of months have been sort of in line with what you expected, but the underlying business is just so weak, and I just wanted to challenge that.

Can you sort of back up why you think these promotions have been effective, because they seem like they’re not driving incremental traffic to the business? Are you focusing too much on the short term for example whereas remember in prior periods you were winning from a position of strength?

And can you also just talk about the Dollar and More menu? It didn’t seem to work a couple of years ago, because the consumers still thought dollar meant dollar, not more. So why does that work this time do you think?

Don Thompson

I’ll talk a little bit about both of the areas. Relative to promotions, actually the promotions themselves have been within the range of our expectations. As an example, if I look at Mighty Wings, Mighty Wings resonated with consumers but performed at the lower end of our expectations, and your comment about overall base and base trendlines was very accurate. When you see the overall industry being a bit softer, it does impact our ability for us to drive sales to a higher level.

But when it speaks specifically to the wings, there were a couple of things that, although it performed within our targeted expectation range, again at the lower end, there’s a couple of things we can improve on, one is still affordability. $1 per wing was still not considered to be the most competitive in the current environment. The other thing we saw, and it’s a very slight modification, but the flavor profile was slightly spicy for some consumers.

But having said that, what’s interesting is we sold or expect to sell probably about 35 million pounds of wings. We can address the challenges with spice, or as we look forward, price, you will see wings again in the U.S. business. It has been successful for us. But it is at a time when the overall environment is a bit softer. They create trade-up as most of the products that we’ve introduced have done.

Remember that as we went into this year, one of the things we wanted to do was to make sure that we had an innovative food pipeline, but we did not want to forget core classics, and we have tried to do that. Monopoly helped us again with that. The other thing we wanted to do is make sure we remained affordable. And we’ve been working on this around the globe. And that part I feel we still are operating from a position of strength in most of our markets. Markets where we have challenges, we’re addressing those challenges in those markets.

And so all in all, we’re doing the things that I think we should do to position ourselves to grow this business. As the economy does come back a bit, we know that we’ll benefit from that. But we’re also not going to sit back and just wait. We are doing many things tactically to try to address the current environment, but we’re not missing out on a long-term environment as well.

The other piece I want to mention real quick is the notion of Dollar Menu and More. And we have not tried Dollar Menu and More. One of the things that was attempted a while ago was something that was called an Extra Value Menu. This is very, very different. Dollar Menu and More means that you keep the Dollar Menu price points, and it’s consistent with how we have continued to evolve the Dollar Menu, since its inception back in the early 2000.

Over time, we have changed some of the products on the Dollar Menu as we’ve needed to. We changed from a Big N’ Tasty initially to a Double Cheeseburger, from Double Cheeseburger to McDouble, so we’ve always evolved the dollar menu. That’s what we’re doing now, that continued evolution.

But what we’ve also found is the need to have a $2 price point for some products that are a slight trade up from just the dollar-based price points that also supports additional margin growth in the restaurants, and it gives customers a value ladder of sorts, so that based upon their discretionary spending, they have multiple offers at McDonald’s.

We also have a $5 price point, which really speaks to things like 20-piece nuggets. And so there’s varying levels of affordability, and we still continue to have our Extra Value Meals and premium-based products that we’ll talk to.

So we’ve definitely not forgotten our core, and the core classics of Big Mac and Quarter Pounders and Fish Filet, and those things you’ll continue to see. We haven’t forgotten the innovative food pipeline, McWraps, Mighty Wings, etc. And for us, we most definitely haven’t forgotten our affordability platform with the Dollar Menu. So all of those things will play well together as we continue to come up with the most compelling menu offerings and compelling calendar for customers moving forward.

Kathy Martin

Next question’s from Jeffrey Bernstein with Barclays.

Jeffrey Bernstein - Barclays

Question on the longer term business model. I’ll preface it by saying beyond 2014, because I do know you have an analyst day coming up, where we’ll get some color on that. But could you just maybe offer us some insight longer term? You mentioned the franchise business, 81% worldwide. Just wondering whether there’s still an opportunity to push that? Obviously you still have huge skin in the game, but with 35,000 units, I’m wondering whether over time the idea might not be to push that to 85% or 90%.

And as a related question, the capex, I know you mentioned you tweaked it down in terms of dollars and modestly in terms of the unit openings, I’m wondering whether that’s at all a sign of future - I know you talk about maybe accelerating the pace of openings and whether this tweak might not be to signal that maybe things are slowing a little bit, or maybe you want to shift to more remodels and less new units. So, how you think about that.

Peter Bensen

I’ll talk about the capex, and Don will probably have a perspective on the franchising percentages. Really, the change in our capex this year has really been a short term thing. It speaks nothing about our view of the future. As we look at the environment, most of the unit cuts have come from China and some of the emerging markets in APMEA. So virtually all of the dollar variance from our original budget to our revised outlook is coming from APMEA.

Europe will be on their opening budget, U.S. and the other areas of the world will hit. So it’s really in China and some of these emerging markets where we’re looking at where the projects were. In a lot of these countries, we rely in other retail development and housing development and some of the other development activity in the marketplace to create the traffic generators. And if they’re delayed or behind schedule, there’s been years where we would go ahead and open the restaurants anyway, knowing that that demand would be coming.

And this year we’re just taking a little more prudent look at those kind of projects in light of the sales environment, to say, you know what, we’ll hold off and wait for those traffic generators to open or those projects to continue before we’ll open the restaurant. So it’s really just some fine tuning and not an indication of going forward we’re looking to change our capex mix more toward reimaging and backing off of openings. We still think there’s plenty of opportunity to grow to the market potential in several of these countries by opening new units.

Don Thompson

And relative to franchising, as we move forward, your point is appropriate, we continue to look at opportunities. So today we’re 81% franchised globally, 19% company operated. We continue, particularly across areas we’re growing in such as APMEA, we’ll be continuing to leverage our DLs, to look for new DLs as we’re doing across China. We’re continuing to move forward conventional franchisees and conventional licensing. And so we continue to do that. APMEA will continue to see more franchising across the market.

In addition to that, we’re also looking at the mature markets and existing markets, where there are opportunities for us to effectively franchise as we continue to grow the business. And so yes, we will continue to definitely look at franchising, franchise opportunities. And you’ll see it more particularly across APMEA.

Kathy Martin

Our next question is from Michael Kelter with Goldman Sachs.

Unidentified Analyst

Thank you, it’s [Ivan Holman] sitting in for Michael. I was just wondering, the Dollar Menu itself has represented, historically, 13% to 14% of sales. Can you please give us a little bit of guidance on how you see that evolving in the near term, as well as from a longer term perspective in terms of how you see the business model over the next couple of years? And within that context, how do you think franchisees might be receptive to a change of that percentage, either up or down?

Don Thompson

Just relative to the Dollar Menu, I think that we will continue to look first at customers, and customer behaviors, and affordability. And what we’ve always done is leverage that data and then as we had discussions with the franchisee body, to look at what’s going to be the most compelling offering for McDonald’s. And again, the Dollar Menu’s only a part of that.

We continue to see and believe that it will continue to represent somewhere in that same percentile, 13% to 15%. As we stretch out the Dollar Menu a little bit more with Dollar Menu or More and provide some additional offers that will be even more appealing to customers, we believe that it will continue to be a compelling offer, and still best-in-class when we look at the overall marketplace.

And so that part will remain the same. Franchisees have been a part of the discussions. They always are as we look at making decisions like this one.

Kathy Martin

The next question is from David Tarantino with Baird.

David Tarantino - Robert W. Baird

Don, I think you mentioned in your initial remarks that you’re focusing or have been focusing on what’s working well around the globe, and what needs to change. So I was particularly interested in maybe the last part of that. What do you think needs to change going forward? And perhaps if you could give us some examples of some maybe bigger picture or more meaningful changes as you look out to next year, or even the following year, just as you’re planning your business.

Don Thompson

I’ll start at the back end of that and then go into what needs to change. I think as we look at next year, clearly the areas of, we call it the three global opportunities that we have, those things will remain the same. And so we’re still focused on making sure that we have the best menu across the board for customers. We’ll continue to balance that between the core classics and favorites with new products, and we’ll continue to enhance that relative to the nutritional offerings that we have. So that’s been a focal point, and that has been working around the world.

The modernizing customer experience is something we’ve been focused on and that really deals with our reimaging and making sure the restaurants are contemporary. That part has been received well by customers. We continue to do that. The strong portion of that, and Pete mentioned it, is that when you look across Europe, Europe is much further ahead there. So we won’t have to do as many globally, but we’ll leverage what we do need to do to make sure we are a compelling offer to customers around the world.

Technology is going to be a big part of our future, particularly digital engagement with consumers. And so you’ll hear us and see us talk much more about digital engagement with consumers. The other thing that you’ll see change a bit is we are being much stronger relative to communicating about our brand, communicating about our food. Customers want to hear more about transparency. They want to hear about provenance and where the food is from. So those things we’re very proud of at McDonald’s, and we’ll continue.

At the November 14 NIM meeting, we’ll discuss more about some of these opportunities. When it comes to changes, we’ll chat a little bit about that in November as well, but frankly we’ve got a few markets where we have opportunities and we’ve been, again, very transparent about those.

In Japan, we’ve got to get consistent value, and it’s a deflationary environment and a tough market, so we’re focused on that. We’ve had some leadership changes in Japan and we continue to look at the opportunities we have in that marketplace.

Germany is a market that we are also focused on solidifying the balance between premium and the value based offerings. We fluctuated a bit there, possibly too much, and we need to shore that up.

Australia we’re focused in a very competitive environment, on making sure we have that same balance. And in the U.S. we’ve got a great food pipeline now. We’re focused well on the operational base of what’s taking place in the marketplace. And those things, again, you’ll get to hear a little bit more about at the NIM meeting in November, but those are some of the areas and some of the markets that we’re focused more intently on.

Kathy Martin

Our next question is from Will Slabaugh from Stephens.

Will Slabaugh - Stephens

I wanted to ask you a little bit more about the value menu domestically. Do you feel like you’re winning that value game here in the U.S.? And then is that a segment that can actually drive sales and profits higher? Or do you think more or less that the dollar menu as it is is maybe something that helps you hold those guest counts in place in a tough environment and it takes more the success on those higher end of those more premium items to really return to stronger same-store sales and profit growth?

Don Thompson

Great question, and the answer is yes. The dollar menu definitely, particularly in times like these, where you see consumers stressed a little more from a discretionary spending perspective, and you see a bit of bifurcation relative to the economic strata in the U.S., it’s very important to have that affordability platform and the dollar menu that we have. So it does keep a base of customers. Keep this in mind, while it only represents 13% of 15% of sales historically, you’ve got about a third of the customers that will leverage that dollar menu in some form or fashion. And so it is a strength part of the base.

Having said that, we also have to have core news, and the core has to be affordable at a value menu price point, and premium based news whether that be McWraps or Might Wings. Those are promotional, those are limited time offers. But those things help not only with margin, but they help with the excitement for customers, so there’s something new and exciting at McDonald’s.

And so we have to be able to balance both of those two ends of the barbell, if you will. And also, I would say we have to fill in what’s in between. That’s the reason for Dollar Menu and More. We’ve talked about $2 price points with sandwiches that have a few additional things to offer than our base value dollar menu offerings do.

Kathy Martin

Next question is from Matt DiFrisco from Lazard.

Matt DiFrisco - Lazard Capital Markets

Just looking at the franchise margins in the guidance, I appreciate the guidance you give given the volatility we’re seeing in the comps and everything for the current quarter that we’re in now. Can you just sort of give us some sort of what you expect in trends for ’14, especially with the franchise side of the margins? Is there anything structural that you’re doing as far as relief plans or anything that might continue into ’14 that you can give us an outlook on now? Or is it just simply comps coming back and the franchise margins improving in step with the comps?

Peter Bensen

We will get into 2014 in a little more detail in November, but essentially there’s nothing structural that’s changing. As you’ve pointed out, and we continue to mention, it is really a top line game, and our franchise margins are even more sensitive to comp, because a great proportion of the costs in that line are fixed. So when we generate higher comps, we get the significant leverage.

The only thing structural that’s been going on the last couple of years has been our contribution toward reimaging with franchisees, so as we coinvest with them, we continue to get greater amounts of depreciation, but again, with comp sales increases, that should not be a barrier to the margin growth. But as you point out, in this current environment, we’re not getting that top line, so we don’t expect the franchise margin to grow in the fourth quarter.

Kathy Martin

The next question is from Brian Bittner with Oppenheimer.

Mike [Tamis] - Oppenheimer

This is Mike [Tamis] on for Brian. Is there anything in G&A that can be cut if sales trends continue to underperform? And then if there are any quick comments you can give on the China business of why that continues to struggle.

Peter Bensen

I’ll talk about G&A and Don maybe can give a perspective on China. When we look at our total G&A mix, what we’re doing in this current environment is really looking at what are the discretionary items that we can kind of pull as levers to moderate short term performance. So, travel, meetings, open head count, things like that are things that we look at in environments like this. But at the end of the day, we’re about growing this business for the long term.

And so we’re going to continue to make investments in things like technology, especially digital that Don mentioned. We’re going to continue to make investments in our restaurant development teams and in the tools and processes to continue to grow restaurants. So as we look forward, there’s no dramatic restructuring or anything like that that’s going to happen, and we’re going to continue to invest our G&A in the areas that we think are good for the long term growth of the business.

Don Thompson

Relative to China, I’ll give a bit of an overall perspective as to what we’re seeing at least and then just a little insight as to McDonald’s business as well. There is and has been, as you all know, a slowing of the economy. The GDP is at its slowest growth level in 23 years, and that’s causing a little bit of a credit crunch across China. Slight decline in consumer confidence that goes along with that as consumer sentiment is very cautious, is the way I would describe it.

GDP is expected to be in the mid-sevens for the rest of the year. Typically anything below an 8% is a bit concerning, but nonetheless we do see, across China, some bright spots and for the long term, definitely see a bright opportunity in China.

Today, IEO is flat to declining. That makes it a little bit more difficult for growth. And the Chinese typically, in tougher economic times, they typically revert to what we would call CQSR, Chinese QSR, noodle shops, etc., than they do Western QSR-based companies.

So these are things and phases we’ve seen before. We’re solidifying our affordability and opportunities to reach the customers with some of the products that we have. Breakfast has performed positively for us in the marketplace. We’ve got a broader strategy around how we engage Millennials and own the night, as we call it, because that’s a big opportunity for us. And again, we continue to look at our menu mix across the board.

One last point, and that is Pete mentioned G&A, and we get asked about it quite a bit. One other thing I would add is I would keep in mind that our compensation - so when we talk about a savings in G&A based upon performance based incentives or performance based compensation, if we are not hitting the expectations we have in sales and operating income, then that compensation is at risk.

And that is a good balance. It’s a good hedge within our overall formulas and the way we operate as McDonald’s. And so we constantly look at our G&A to make sure we’re making prudent investments for the future, and those investments yielding appropriate returns for our shareholders.

Kathy Martin

Next question is John Ivankoe with JPMorgan.

Unidentified Analyst

Thanks, it’s [Ahmod Gallan] filling in. Can you address some specifics or concerns on how your speed of service and operations scores in the U.S. have trended over the past year given some of the changes in menu? You’ve had the new POS in place for I think almost a couple of years now, and other aspects like scaling up dual drive throughs, but are there any specific opportunities that you’ve identified for further improvement in 2014?

Don Thompson

There are quite a few things that we continue to look at. Clearly service for us, as I mentioned in my opening comments, is a critical performance factor and an experience factor for customers. When we add something like a dual-lane drive through, on a per-car basis, if you looked at flowthrough speed, we typically will see a couple second increase in a flowthrough kind of a measure, because you now have two lanes and they split off. For an individual customer, they get attended to quicker and the absolute times that we see tend to be overall shorter for the experience. And so the dual lane drive through has helped, and it has helped us with capacity.

When we implement new products, there’s always a softer period upon the launch of the new products, and then there’s a recovery. The more ingredients in a product, yes that will impact service times, but our operating platform of made for you basically enables us to be able to implement those types of products.

So I would tell you at this point the operational focus is strong. There are different measures that come through each and every year relative to customer satisfaction. What we’re focused on is our internal measures of whether or not we’re satisfying the needs of customers from a fast perspective, an accuracy perspective, and then I will tell you the quality of that service and the friendliness of that interaction.

Kathy Martin

Next question is Sara Senatore with Sanford Bernstein.

Sara Senatore - Sanford Bernstein

I wanted to step back if I could and just ask you about the demand environment and your results. And I guess if I think back to the recession, ’08 to ’09, your comps were better and certainly a lot better than your competitors vis-à-vis where they are today. And I think it would be hard for us to say that the demand environment was a whole lot better back then than is the case now.

So I was just hoping you could help me just diagnose is the issue your competitors are a lot better? Is the issue that you don’t have quite as much of a sales layer opportunity? Just maybe if you can help me compare and contrast. And then a related question is how are your franchisees doing in this environment? Obviously there’s always some talk in the media about McDonald’s relationships, and I just wanted to get your take on that.

Don Thompson

Just having been the president in the U.S. when we went through this back in 2008 to 2009, I would tell you things that were similar and some that were different. Clearly there was a, from a consumer discretionary spending perspective, it was a very timid if not restricted environment.

Having said that, though, the competition at that point was not as strong from a pure price perspective. We had just evolved our dollar menu, just as we’re talking about doing now with Dollar Menu and More. We had just completed that evolution. As you all may recall, we went from a Double Cheeseburger to a McDouble, and we talked about snack wraps a little more strongly.

So we were talking about affordability in the same way that we’re doing now, and plan to do even more so in the U.S. business. We had just begun really focusing on the coffee opportunity. I think you’ll hear more about the coffee opportunity, as it still does exist, and you’ll hear more about that at the NIM meeting.

And so those things are fairly consistent in terms of how we approach it. Again, definitely more competition in the marketplace. We’re getting back to that focus on the value, the coffee, and those interim pieces. I would tell you we had a pretty decent product innovation at that point, and I think that what you’ve seen this past year is getting us back on track with that in the U.S. as well.

Relative to the franchisees, I was just recently at our national leadership council meeting as they meet with the U.S. leadership team. And I’ve not seen as strong an alignment in quite a few years. I think everyone understands the environment that we’re facing. They also understand the legislative environment that we’re facing. Those things cause us at McDonald’s to really consolidate our different needs and desires and really focus on the customer.

And so that’s what they were doing, and I left there feeling pretty good about what I was seeing and sensing from the operator leadership group and from our U.S. leadership team, and them all being on the same page. So notwithstanding different reports that will come out, it’s wonderful to live in this world and get a chance to see and visit with the franchisees, not only in the U.S. but around the world.

Kathy Martin

Next question is from Nicole Miller with Piper Jaffray.

Nicole Miller - Piper Jaffray

I was hoping you could help us close the gap, or get more color around, your pricing. I understand the comment about limiting pricing power, but you do have a very sophisticated process. So maybe compare and contrast what that process has told you to do historically versus what it’s telling you to do today. And maybe, if it makes sense, could you tell us how it impacted taking the dollar menu to a dollar more?

And then sorry for this part, but if you have it could we get the gap in September of U.S. comp versus QSR?

Peter Bensen

I’ll talk a little bit about the pricing. So, traditionally, we strive to keep our price increases in line with food away from home. And for the year, food away from home is projected to be up 2% to 3%. And where we sit today, we’re at about a 2.6% increase. So we’re kind of in line with that measure as we look at it.

The other dynamic that we have to keep in mind is what’s going on with food prices at the grocery store. And so the food at home price increases are actually growing about 100 basis points less. So through August, I think was the last data I saw, food at home was only up 1%. So that does create a value perception with the consumer that we do have to keep an eye on.

So those are the two biggest factors that we look at as we’re looking at our pricing, as well as using our model that actually goes back in time and looks at a history of all of the price increases by individual item, by restaurant, and look at what happened to demand at those various price changes to make sure we’re optimizing the menu price changes that we do choose to make.

So that’s how we continue to look at that. And for the month of September, which is really the four weeks ended the 29th, our gap was actually positive 10 basis points to the QSR sandwich. On a year to date basis, that gap is 0.7.

Don Thompson

Relative to dollar menu products, I want to make sure everyone understands, the dollar menu, there will still be a dollar menu. What we’ve changed is “and more” which means we’re adding products that are $2 level and there will be some $5 level products, and there may be some other fill ins. So I want to make sure no one thinks that we’re abandoning the dollar menu. That is not something that will be part of our affordability strategy, particularly not at a time like this.

And so this is one of the ways that we can maintain the dollar menu in the face of rising commodities and labor pressures, but also get a little bit more margin basis on some of the products at $2 and some of the products at higher price points from there, and the franchisees support this.

I think when you listen to Pete, and he talked about the comp sales gaps in the QSR sandwich industry, clearly we at McDonald’s are still in a very viable and strong position. The challenge for us is still there is softness in the QSR industry. And we have the right things in place, I believe, for the long term to continue to drive shareholder value.

Kathy Martin

Okay, we have four more folks that we’re going to try to get to, because we’re running out of time. Jeff Farmer with Wells Fargo?

Jeff Farmer - Wells Fargo

Just did some quick math there on Nicole’s question. It looks like 70 basis points of sequential improvement in share, September versus August. So I guess the question is, what do you attribute that improved share from month to month to?

Peter Bensen

To clarify, our gap between us and the QSR sandwich competition year to date September is 70 basis points. For the month of September, it was only 10 basis points.

Don Thompson

And those are our sales gaps. And what we attribute it to is the fact that we did have successful promotions relative to what we’ve done with Mighty Wings. We’ve had some good products with wraps. Those things we have. The challenge, again, that we have is in an industry and an IEO industry that’s been contracting a bit, and also as spending has kind of split, we call it a bifurcation of spending, what we’ve seen is we’ve seen those customers that, to the moderate, middle to low ends, are a little bit more stressed from a discretionary spending perspective. And so that part’s a bit of a wait. At the same time, as you can see from those comp sales gaps, we still have offers that are appealing to consumers.

Kathy Martin

Next question is R.J. Hottovy with Morningstar.

R.J. Hottovy - Morningstar

Appreciate the color on the fourth quarter margins, and your expectations that restaurant margin pressures will be similar to the first quarter, but I expect that the magnitude of the different line items will be different. Could you elaborate on where the different variations from the first quarter might be on the different food, labor, and occupancy line items? Any color here would be appreciated.

Peter Bensen

At this point, we’re not going to get into that level of detail on our outlook. We really were just trying, in this environment where the general expectation was that we would improve as these comparisons ease, we wanted to give some directional perspective on where we thought the numbers would settle out. Obviously in January we’ll get into a lot of the details on what drove the actual.

The one item I will mention, though, as we move throughout the year, the commodity cost pressure actually is a little bit greater in the fourth quarter relative to the first quarter, and that’s just really more a factor of specifically some of the proteins that were a little more benign earlier in the year, and us having hedges in place, which actually protect our grain costs throughout the year and really don’t allow us to participate in sharp declines when they do happen, yet over time provide us with that predictability and stability.

Kathy Martin

Next question is from Andy Barish with Jefferies.

Andy Barish - Jefferies

It looks like, even with maybe some pushback on the new unit opening front, it’s still going to be a heavy fourth quarter opening schedule versus last year. I know oftentimes it’s back end weighted, but is that factoring into some of the margin discussion as well?

Peter Bensen

No, it actually isn’t. I haven’t looked market by market, but the fourth quarter new restaurant openings aren’t dramatically different than we see traditionally year after year. And in fact the new store drag, if you will, the new store impact on margins in China and APMEA has actually sequentially gotten a little bit better. So there’s nothing in those opening numbers that is adding to the pressure in the fourth quarter.

Kathy Martin

And we’re going to take our last question from Mitch Speiser with Buckingham Research. And for those of you who we didn’t get to, please feel free to call IR.

Mitch Speiser - Buckingham Research

Just one final question on the margin outlook. And I know it’s a global margin outlook. In particular, just in the U.S. you did take some incremental pricing. You did give us some pieces of the cost outlook, but I was just wondering if the weaker margin outlook is due to maybe the chicken wing costs, or just a little bit of increased discounting versus prior quarters, if those are issues in the overall margin outlook as it relates to the U.S.

Peter Bensen

They’re not really. As I said, in the U.S. the commodities, the chicken, the beef, and actually our new bacon are the three biggest impacts on commodity costs vis-à-vis the first quarter, partially offset by some of the lower grain costs. So it’s really, as I mentioned in one of the earlier answers, the biggest changed from where we are in the third quarter is really being driven by Europe in terms of the global margin, and that was due to some of the more unusual or one-time kind of items that led to the increase in their third quarter margin.

Kathy Martin

Okay, we’re out of time, so I’m going to turn it over to Don with the final closing talk.

Don Thompson

Everyone, once again thanks for joining us this morning. As we wrap up the call today, I just want to reiterate our commitment to balancing thoughtful and strategic decisions for the long term with informed and decisive actions that we must take within our markets to continue to actively adjust the plans to strengthen our connection with customers, and also to position ourselves to grow the business profitably. We’ve balanced both of those things together.

I’m confident in our ability to deliver long term growth for the system and for our shareholders as we continue to optimize our menu, as we look for additional ways to strengthen and modernize the customer experience, and as we broaden accessibility around the world within the framework of our plan to win. Thanks again, and have a great day.

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Source: McDonald's Corporation CEO Discusses Q3 2013 Results - Earnings Call Transcript
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