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McDonald’s Corporation (NYSE:MCD)

Q3 2006 Earnings Call

October 19, 2006 11:30 am ET

Executives

James A. Skinner - Vice Chairman of the Board, Chief Executive Officer

Ralph Alvarez - President, Chief Operating Officer

Matthew Paull - Chief Financial Officer, Corporate Senior Executive Vice President

Mary Kay Shaw - Vice President, Investor Relations

Analysts

Jeff Bernstein - Lehman Brothers

David Palmer - UBS

Laurie Hahn - Deutsche Bank

John Glass - CIBC

Larry Miller - RBC

Joe Buckley - Bear Stearns

Andy Barish - Banc of America Securities

Jeff Omohundro - Wachovia

Rachael Rothman - Merrill Lynch

John Ivankoe - J.P. Morgan

Presentation

Operator

Hello, and welcome to McDonald's October 19, 2006 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 conference over to Ms. Mary Kay Shaw, Vice President of Investor Relations for McDonald's Corporation. Ms. Shaw, you may begin.

Mary Kay Shaw

Hello, everyone, and thank you for joining us today. With me on our call are Chief Executive Officer, Jim Skinner; Chief Financial Officer, Matthew Paull; and joining us from Hong Kong is Chief Operating Officer, Ralph Alvarez.

This conference call is being webcast live and recorded for replay later today via phone, webcast and podcast.

As always, the forward-looking statements that appear in our earnings release and 8-K filing also apply to our comments. Both the earnings release and our 8-K with supplemental financial information are available on investor.mcdonalds.com, as are reconciliations of any non-GAAP financial measures mentioned on today's call with their corresponding GAAP measures.

Now, I would like to go ahead and turn the call over to Jim Skinner.

James A. Skinner

Thanks, Mary Kay. Good morning, everybody, and thanks for being on the call.

I am excited to report that our momentum continues, with all of our area of the world business units contributing both to the top- and bottom-line.

In the third quarter, system-wide sales increased 8%, supported by solid guest count increases. Margins continued to grow. Operating income growth was up 12%, and earnings per share is $0.68, or 17% increase over the previous year. It is clear that we are satisfying our customers and, as a result, providing value to our shareholders.

As I see it, the trend is continuing. There is still substantial upside potential for us to grow our business around the world. It should come as no surprise that our core business strategy will remain to grow by being better, not just bigger. We will continue to execute this strategy through our Plan to Win. This approach has aligned our system and directed our resources and assets to deliver strong results for the past three-and-a-half years.

As you have heard me say many times, it is all about continuous improvement. Getting better at being better is how we will capitalize on the opportunity in the marketplace.

We are intensifying our efforts in a few key areas. Most important is evolving the McDonald's experience to achieve even greater customer relevance. Our pipeline is filled with innovative solutions to customer needs in all areas of our Plan to Win.

For example, in the areas of food, work is underway to address our customers' desire for additional choices of Happy Meal entrees and beverages that will meet appropriate nutritional guidelines.

In service, we have a new POS system in 5,000 restaurants. In tests, it has improved order accuracy by 33% and allowed us to serve up to 13 additional cars per hour in the drive-thru.

In convenience, we are exploring various ways to increase capacity at the drive-thru, and making it easy for our customers to experience brand McDonald's.

There are many more examples but the point is, we have the right focus and resources in place to grow our market share by providing our customers with the most relevant solutions to meet and exceed their needs.

We are also evolving our marketing to further strengthen our connection with customers and build greater trust. McDonald's is one of the most recognized and respected brands in the world. The value of this trust is evident in the larger share of customer visits and higher average annual sales that McDonald's restaurants achieved versus our competitors.

But we can -- and we will -- do more. We believe the opportunity to build greater trust in our brand and the benefit of doing so is significant. We are focused on two key priorities to build this greater brand loyalty -- creating engaging break-through communications and enhancing McDonald's brand as it relates to the wellbeing of children.

Today, it is easy for people to opt-out and ignore marketing communications, so we will accelerate our efforts around creating advertising that breaks through the clutter and is engaging. We have broadened our marketing focus beyond television to include print, billboards, mobile communications, such as the U.K.’s text message to win World Cup tickets and, of course, the Internet. The Internet is an important and effective medium for engaging customers.

For example, our global casting call last spring was entirely Internet-based, and it was a promotion where customers submitted photos and stories with a chance to be featured on our packaging. On a shoestring budget with no media support, this promotion drove 13 million hits to our website and received 70 million media impressions.

We have also created advertising targeted toward young adults, just for the Internet. One ad, that debates the proper pronunciation of Filet-O-Fish, has proved popular on YouTube, Yahoo! and Google Video. AdAge and AdCritic recently named this ad the “Pick of the Week”.

Our second priority is to further build brand trust by being a recognized leader in the area of children's wellbeing. We intend to be an ally of families by offering greater Happy Meal choices, which I talked about earlier, and educating parents about these choices and the relative nutritional value of our food.

As part of this effort, the U.S. now features Chicken McNuggets, Apple Dippers and milk in most every Happy Meal ad. In addition, we are recommitting 20% of our children's marketing budget toward communications that inspire kids to be more active, both physically and mentally.

We will pursue these priorities in an effort to build trust, which in turn enables us to grow guest counts, sales and profitability.

In addition to operations and marketing initiatives, we are also focused on ownership structures that provide the best returns for our system and shareholders. This includes our efforts around franchising more of our restaurants in the U.K. to converting more markets to a developmental license structure. Of course, Matt is going to talk about this in a few minutes.

Of course, we are always looking at ways to leverage efficiencies and improve effectiveness in those areas we consider competitive advantages, such as supply chain and market. By focusing on these areas, we will provide even greater value and returns for our shareholders.

Last month’s dividend and share repurchase announcement is a direct result of our current success and our confidence in our ability to continue to deliver strong results. As you may recall, we will increase our dividend this year by nearly 50%. That means since 2002, our shareholders have seen a 325% increase in their dividend -- one of the highest increases in the S&P 500. In addition, we committed to return at least $10 billion to shareholders through dividends and share repurchases this year through 2008.

Earlier this month, we completed our divestiture of Chipotle. This transaction was the right thing to do for both Chipotle and McDonald's. Chipotle will benefit from increased flexibility to pursue its own strategic objectives, and McDonald's customers and shareholders will benefit from our singular focus on brand McDonald's.

Needless to say, I am excited about our future. We have tremendous momentum and we are poised to maximize the opportunities in the marketplace. By intensifying our focus and improving execution of our Plan to Win, I have no doubt that we will continue to generate strong results.

Helping me lead this charge is our newly-appointed President and Chief Operating Officer, Ralph Alvarez, who is in Hong Kong today. Ralph is a strong, results-oriented leader who has driven success in our business, both inside and outside the U.S. His passion for restaurant operations, deep understanding of the competitive landscape, focus on profitability, and proven track record make him the perfect person to help take McDonald's revitalization and accelerate our momentum to the next level.

With that, I will turn the call over to my partner, Ralph Alvarez.

Ralph Alvarez

Thank you, Jim, and good morning. Before I begin, I want to emphasize how proud I am to be partnered with Jim to lead brand McDonald's.

Our Plan to Win is working. We have business momentum. It remains our systems road map, and it will continue to drive results to the top- and bottom-line.

McDonald's third quarter consolidated results were strong, with comparable sales increase of 5.8%. That is 41 consecutive months of positive global comp sales growth.

Franchise margins of 81.2%, up 60 basis points.

Company-operated margins at 17.3%, an increase of 150 basis points versus the same quarter last year. We continued to add margin expansion, as a result of healthy sales growth with a good balance of increases in traffic and average check.

I want to share with you some of what I have been doing recently.

Since assuming my new position, I have been spending time in the field and restaurants in our major markets, reviewing our 2007 to 2009 plans, and addressing opportunities for growth. I am focused on the incorporation of best practices across the globe and ensuring strong alignment around important, brand-defining elements.

Our brand is in different stages of development, but the right combination of convenience and branded affordability, coupled with locally relevant product news, has been and is a winning formula.

Now, let me also share with you how Jim and I are looking at the business and what guides our thinking and decision making.

First, replication and consistency are key to our growth. Our ability to take an idea, scale it, and consistently deliver is a point of differentiation. We are rigorously reviewing processes and systems that allow our restaurants to handle changes in menu and operations faster and better than ever before.

Simple execution and fast replication are what customers want today from our brand, is the key to our success, and it is McDonald's strongest core competency.

Second, we are setting up migration paths that enable us to handle these changes, both financially and operationally, from [corporate] leadership all the way down to each restaurant. Examples of this are restaurant re-imaging, operating system, and point of sale changes.

Third, everything we do is filtered through individual restaurant level economics, to ensure we balance restaurant enhancements and profitability.

Now, I would like to highlight what is driving the business around the world.

In the U.S., momentum continues with third quarter comp sales up 4.1%. Company-operated margins continue to be strong at 19% for the quarter, an increase of 30 basis points, despite higher average hourly rates, utility increases, and depreciation as a result of our re-imaging investments.

We are seeing specific success from breakfast, branded affordability, and chicken. Consumers love the new Chicken Snack Wrap. With a suggested price of $1.29, it is a great value and has exceeded our projections by 20%. Our profitable breakfast business had increases of 7% for the quarter, led by the leverage of this year's launch of premium roast coffee.

In addition to the significant growth from our existing restaurants, we will open about 200 new units in the U.S. this year.

I am confident in the strength of the U.S. business and the leadership of Don Thompson and Jan Fields. We have an experienced management team, strong owner-operators, and a momentum of growing guest counts.

Now, moving on to Europe, we continue to be pleased with our progress. We delivered strong third quarter comp sales of 7.6% up.

September was the eighth month of consecutive positive comp sales for Europe. This resulted in company-operated margins increasing 220 basis points to 18.3%, the highest quarter in five years. The improvement occurred in all big three markets -- U.K., Germany, and France, and was partially offset by labor pressures.

The momentum in Europe is building, due to a focus on three key plan-to-win strategies -- improving our customer experience, building brand transparency, and increasing consumer relevance.

In Germany, we are seeing success through the right balance of branded affordability, [menu] and recurring seasonal events like Asian and Mexican-themed promotions.

In France, we continue to see outstanding results. We are growing in a shrinking and formulating-out market. The French team is focused on brand relevance and building a strong connection with their customers. They, along with other European markets, saw excellent results from this summer's promotion that focused on our Extra Value Meals and featured special Coca Cola glasses.

In the U.K., we are starting to gain traction. We have now posted positive comps for the last six months, and the improvements are benefiting Europe's margins. The U.K. contributed almost 100 basis points to Europe's third quarter '06 company-operated margin improvement.

Now, the big three are not the only countries contributing to Europe's results. We continued to deliver strong, consistent performance in other parts of Europe, including Russia, Spain and Italy.

Now, let's turn to Asia-Pacific, Middle East and Africa. Their third quarter comp sales growth was plus 6.1%, led by Japan. We also generated a 150 basis-point increase in company-operated margins, primarily driven by China.

Our team in China is focused on executing the basics of the business and growing our brand equity. We are laying a strong foundation for the continued growth of our convenient strategy there. This means a movement to almost 50% of our new restaurant is being built with drive-thru’s.

While building a drive-thru restaurant in China is costing us about $200,000 more U.S., we are achieving opening volumes that are tracking at least 250,000 higher than before -- clearly a good investment.

We are confident in the leadership of our China team and the opportunities that we will capture in this market.

Bottom line, our plan is working. All major geographies are growing sales and returns.

As I mentioned earlier, I have spent the last few weeks with our global teams, as they finalize their 2007 through 2009 plans. I can tell you that it will be more of what is already working well.

It is a combination of a strong pipeline of innovative new menu items combined with everyday branded affordability and increased consumer conveniences, like extended and 24-hours, delivery, cashless and gift cards.

We continue to invest in our facilities, our operating systems and our people, so we truly can be better at being better. Our teams are motivated to continue to build on the foundations of the Plan to Win.

Now, I would like to turn it over to our CFO, Matt Paull.

Matthew Paull

Thank you, Ralph, and good morning, everyone.

At the risk of sounding a bit like a broken record, our strategic focus on being better, not just bigger, continues to deliver strong results. Jim and Ralph already discussed the quarter's performance, so I will update you on our efforts to optimize our restaurant ownership mix, explain how we will account for the Chipotle split-off, and describe our plans to reduce share count.

Last January, we outlined our intent to transfer ownership in 15 to 20 countries, with about 1500 restaurants, to developmental licensees over the next three years. As a reminder, we have successfully used the developmental license, or DL structure, for more than 15 years now, and currently have it in place in about 35 countries.

The DL structure aligns us with local entrepreneurs who know the local culture, business and legal environment. They use their capital and local expertise to build the brand. Under this arrangement, McDonald's collects a royalty, and invests no capital for new stores or for reinvestment.

In addition to the financial benefits from reduced capital intensity, improved returns, and a growing stream of royalties, this strategy enables our management team to focus most of its time and energy on the markets that can make the greatest difference.

This is an essential component of the being better, not just bigger, strategy. We are tailoring the ownership structures we use to the unique aspects and risk reward relationships in each of these markets. In fact, we now believe the DL structure is appropriate for an even larger number of countries and restaurants than originally contemplated.

In aggregate, the markets now on our DL list account for about 2300 restaurants, and in 2005, represented:

  • $2.5 billion dollars in sales -- that is just under 5% of system-wide sales;
  • $150 million in G&A;
  • About $20 million in operating income, excluding impairments of $21 million;
  • $100 million in capital expenditures; and
  • Slightly combined negative free cash flow.

These 2300, mostly McOpCo restaurants, represent about $3 billion in combined net investment. This includes some $800 million in accumulated currency translation losses reflected as negative shareholders equity on our balance sheet. We do not expect any potential licensee to compensate us for these historical currency losses. In addition, if we are able to complete these transactions, we do not anticipate that sales proceeds will allow us to recover most of the remaining $2.2 billion in net book value.

Remember, these markets generated negative free cash flow in 2005, and that is before considering the royalty we will collect from potential licensees, and any additional capital commitments we will expect from these licensees.

Though we are aggressively pursuing the DL strategy, accounting rules do not allow us to record potential losses to bring asset-carrying values down to likely value at sale, until we conclude we are likely to complete a sale within 12 months, and we have a reasonable sales price estimate. Both of these criteria must be satisfied in order to apply what we call “held-for-sale” accounting to our impairment testing.

The amount of any loss recorded if and when we cross the “held-for-sale” threshold could be significant. Until then, we will continue to test these assets for impairments, in accordance with the “held-for-use” accounting policy described in our 10-K.

Separately, in the United Kingdom, we are making progress toward our goal of reducing the company-owned store count to about 50% by the end of '07. Our ultimate goal is to get this number below 50%. Through the third quarter, we have franchised, or entered into joint venture arrangements, for 100 company-operated restaurants in the U.K. This brings company-operated restaurant ownership down to 56% from 63% at the beginning of the year.

As Jim mentioned, we completed the Chipotle split-off earlier this month. The gain from the exchange offer is about $500 million. This gain, and all Chipotle results, will be recorded as discontinued operations in the fourth quarter. All prior year Chipotle results will be presented in this manner as well.

As a result of the Chipotle exchange, we reduced shares outstanding by almost 19 million shares. This amount, plus year-to-date repurchases of 53 million shares, brings total shares acquired so far this year to nearly 72 million.

Now that the Chipotle exchange is over, we plan to resume buying back stock in the fourth quarter and, consistent with our previous guidance, we anticipate total shares outstanding at the end of '06 -- that is total, not average -- to decline by about 5% from year-end 2005.

It is important to remember that the timing of when the shares are acquired during the year and when options are exercised affects the weighted average shares outstanding calculation.

For example, the McDonald's shares acquired in the Chipotle exchange offer were still outstanding for more than nine months of calendar year 2006. Therefore, we do not expect a reduction of 5% in diluted weighted average shares for the full-year '06 or the fourth quarter. Much of the activity taking place in 2006 will affect the diluted weighted average share calculation more significantly in 2007.

We remain strongly committed to further reducing shares outstanding through share repurchase and disciplined compensation mix practices.

Last year, we implemented changes to our compensation mix that resulted in just 7 million options, and about 1 million restricted stock units being granted in both 2005 and 2006. This is substantially less than the average of 27 million options granted per year from 2000 through 2004.

As a result of reduced grant levels, and abnormally heavy option exercise activity, total options outstanding declined 18% in 2005, and are down another 16% since the beginning of 2006.

The reduced amounts of outstanding options, coupled with a significantly reduced option grant run-rate, are a big part of the reason we are confident that share repurchase activity will yield a meaningful reduction in share count in the years ahead.

Stated more simply -- we will no longer be bucking strong head-winds as we attempt to reduce share count.

In closing, we are confident that our focus on being better in all aspects of our business, from delivering great customer experiences to our financial management practices, will drive our business forward and help create even greater value for shareholders and our system.

Thank you, and now I will turn the call back over to Mary Kay.

Question-and-Answer Session

Mary Kay Shaw

Thanks, Matt, I will now open the call up for questions.

(Operator Instructions)

The first question is from Jeff Bernstein at Lehman Brothers.

Jeff Bernstein - Lehman Brothers

Thank you very much. Just a question on the company-operated margins you spoke of earlier, for both the U.S. and Europe. In the U.S., it seems we are seeing stability in the very high-teens. I am just wondering whether there is something structural that will keep them from reaching 20%-plus? As well, what comps are needed to sustain them at the current levels?

Secondly, on Europe, obviously we have seen very strong margin improvement over the past few quarters. I am just wondering if European margins can reach and maintain a level similar to the U.S.? Or are there obviously some structural differences that would limit achieving those U.S. levels? Thanks.

Ralph Alvarez

On the U.S. side, there has been a leveling at around that level. Under the type of inflationary times that we have now, we probably need something around 2% comp in the U.S. to maintain the McOpCo margins.

In Europe, that number is more like 3% because of market rents. Rents are not as fixed as they are in the U.S.

Those are the two items that are there. It is really based on our leverage off of comparable sales on our existing restaurants.

Mary Kay Shaw

Thank you. The next question is from David Palmer at UBS.

David Palmer - UBS

The question I have, if I had to limit to one, is really on the U.S. I wonder if it is fair to say that your growth initiatives, while they remain varied, are really kind of shifting in terms of the emphasis. In the past, it might have been a little bit more in the menu platform lift, menu innovation in big platforms, credit cards, extended hours.

Now it seems like it is a little bit more better advertising, better throughput and a focus on really keeping the number of menu items a little bit more flat. Could you perhaps comment on the sources of growth going forward? Thanks very much.

James A. Skinner

Ralph, did you want to respond to that, relative to the U.S. growth and the initiatives?

Ralph Alvarez

Sure, yes. Hi, David. I will tell you that what we are really focused on is that the initiatives that we have add to the base of our business versus just being promotional spikes.

So you are seeing items that do add capacity, that extend our value platform. That is what Chicken Snack Wraps does. It is an item that is a permanent menu item. It incorporates all products that we already have, that allow us to be able to execute it well and it is not a burden on the restaurant.

The convenience items that we have added, of extra hours, 24-hours, cashless and debit cards, all continue to show growth year to year, as people get more used, that we have those and we are open those hours.

Truly, those are the things that we are focused on.

We do have some very innovative menu items we are working on for the long-term, that will also play a part in the next year or two years.

Mary Kay Shaw

Thank you. The next question is from Laurie Hahn from Deutsche Bank.

Laurie Hahn - Deutsche Bank

I was wondering if you could comment on commodity costs and the outlook for 2007 across your segments, particularly U.S. and Europe?

Matthew Paull

This is Matt. I will give you a look at '06 and how we see it, and I will ask Mary Kay to jump in on '07.

First, the U.S.:

  • Beef, down in the third quarter, expected to be slightly down for the full year in the U.S.;
  • Chicken, relatively flat in the third quarter, and we expect it to be relatively flat for the full year; and
  • Cheese, down in the third quarter -- we expect it to be down for the full-year.

Europe, again for '06:

  • Beef, down in the third quarter -- we expect it to be relatively flat for the full-year. Remember that in '05, our biggest spikes that we saw in beef in Europe were in the second and third quarters;
  • Chicken for Europe in '06, the third quarter was down, and we expect chicken to be down for the full year; and
  • Cheese, relatively flat in the third quarter, and we expect it to be relatively flat for the full year.

Those are the primary commodity cost drivers, but there are other things that obviously are a factor. There is paper and orange juice and eggs -- all kinds of other commodities, but those are the big three.

I will ask Mary Kay to comment on '07.

Mary Kay Shaw

For '07, in the U.S., chicken costs are expected to be up slightly, and beef, flat to down slightly.

In Europe, beef and chicken are both expected to be up 2% to 3%.

Thank you, the next question is from John Glass at CIBC.

John Glass - CIBC

Can you talk a little bit about your unit growth plans as you think about '07 to '09? Maybe if you could comment globally on it, if there is any change to it.

Then, specifically in the U.S., where you have had outstanding results and this may be an opportunity to accelerate growth, what your thoughts are there.

James A. Skinner

John, this is Jim. We basically are staying the course on our growth profile over the next few years. We have talked very specifically about growing at that 1.2% or 1.3% or 1.5% rate. We may move more toward the 2% over the next few years, with the focus on China and Russia, Italy -- markets around the world that have demonstrated the opportunity for growth, both in terms of returns and future potential.

Relative to the United States, we may pick up a few units here and there but overall, the growth profile I think is going to stay about the same.

Mary Kay Shaw

Thank you. The next question is from Larry Miller at RBC.

Larry Miller - RBC

Thanks very much. I had a question on the franchise margin in Europe. I saw the company margins up over 220 basis points, but the franchise margin was not up quite as much. I hope you can give me a little color on that.

I am guessing you are going to talk about the mix in the U.K. being more company-owned, but my question again would be, as a follow-up, why wouldn't you see a similar kind of increase, given that you should get leverage on that increase in franchise same-store sales? Thanks.

Ralph Alvarez

In Europe, first, we always get a higher leverage on the company restaurants, because our contribution margin on every dollar of sales is higher when we are operating the restaurants than the lower percent of contribution margin that we have off of just the rent and royalties.

For Europe, our 50 basis point growth was driven primarily by Germany and France. The U.K., because we were doing some of the ownership mix changes, some of those restaurants that now become part of the mix on the franchise side may have slightly lower franchise margins, but we still had that growth of 50 basis points in Europe.

Mary Kay Shaw

Thank you. The next question is from Joe Buckley at Bear Stearns.

Joe Buckley - Bear Stearns

Thank you. A question on the U.K. I think you mentioned September was the sixth month in a row of positive comps. I was wondering if you could just talk about what is driving the business, why you think you finally gained traction from the many changes you have implemented over the past few years in the U.K.

James A. Skinner

Thanks for the question. We had a leadership change there. Steven Easterbrook now is running the marketplace, and the connection with our customers there and the results around execution in almost every aspect of the business has improved.

Of course, much of this work had been done over the last year-and-a-half or so. Peter Beresford was there. Now, Steven Easterbrook is the continuation of the initiatives that have served us well there.

It is the fundamentals. Better delivery in the restaurants, better delivery around new food news, better delivery in terms of the overall communication with our customers and the brand. All of those things added up have given us the results that we are looking at today.

Matthew Paull

Joe, you have known me awhile. I do not like to talk about anecdotes, but there is an anecdotal story that reinforces what Jim said about Steve Easterbrook and the style and the approach he has taken to running the U.K. for us, and it is about brand transparency.

As you know, there is a movie coming out that talks about our industry. In the past, our approach in the U.K. was to not dignify some of the charges that were leveled against us. But the BBC in the U.K. offered to chair a debate between the guy who authored that movie and Steve Easterbrook. Instead of backing away, when Steve was only about a month into his job, he said “Sure, I will go on network television and the BBC and talk to this gentleman about our brand”.

The very fact that we showed up, in our view, made us a winner because it showed that we had nothing to hide and we are willing to be very transparent as a company and a brand. Steve has taken that signal to the Nth degree, and I think it sends a very strong message about how proud we are of our food and our brand, and that is a big part of the reason we are beginning seeing some turn in the U.K.

Mary Kay Shaw

Thank you. Our next question is from Andy Barish, Banc of America.

Andy Barish - Banc of America Securities

A question for Matt on the update of the DLs. Previously, the developmental licensee stores you were talking about actually had operating losses of about $50 million. Now you are talking about an additional 800 stores that in total, now you are looking at operating profits that you are looking at moving aside to licensees.

I guess a little bit of background in terms of what the strategy is there. It would seem you are going to some bigger markets that are actually making money. Why has that sort of shifted a little bit here, as you have been a year into renewing the program?

Matthew Paull

I agree with your analysis. We have put some markets onto the list that are making money, but we have taken a look at each market and said, what do the risk reward relationships look like, and what is it going to take to realize our potential for the brand in each of these markets?

In many cases, we have room to grow, but we think it is not the best use of our capital, and we think we need to emphasize local relevance more than we have. When those circumstances come together, we think it is an ideal candidate for developmental licensing.

In many of these places, the returns may take a long time to harvest, and some of the competition that we are up against is using somebody else's capital, but most importantly, we want to be able to focus our management teams on the markets that have the greatest opportunity.

Jim wants to comment as well.

James A. Skinner

I just want to make a comment. I know we talked a little about this in San Francisco. Our opportunity to grow McDonald's brand presence in these markets around the world, while improving returns, is really where we are headed.

When we looked at these markets and, as Matt mentioned, the risk reward, it has been a successful structure for us. When we put the matrix of this structure to these additional markets, we were able to see where we could grow brand presence, local entrepreneurs, and deliver a better return. That is why it has met the test.

Matthew Paull

On the return side of this, the math is pretty easy. We would be removing from the denominator of the return computation, over $2 billion in assets. Then, the numerator is going to increase, and the issue is where will the royalty rate be set and how much G&A will it take for us to earn that royalty, and how fast will it grow?

But it is clearly going to help our returns by a minimum of 100 basis points once we are completed the project. Thanks.

Mary Kay Shaw

The next question is from Jeff Omohundro from Wachovia.

Jeff Omohundro - Wachovia

Yes, I wonder if you could elaborate a bit more on the higher costs associated with the drive-thru initiative in China. During the recent analysts meeting in Shanghai, this was touched on, but I was wondering if you could elaborate on the opportunities over time to reduce those costs? Thanks.

James A. Skinner

Ralph, did you want to talk a little bit about the drive-thru costs there?

Ralph Alvarez

Sure. The higher cost is obviously we are buying property that is freehold versus going in line, and we have slightly higher construction costs that also play a part there. The $200,000 additional cost is really a reasonable amount, relative to what we have there.

We will, as we start building some of these restaurants that we are doing with the deal that we signed with Sinopec, some of those costs may be different. It may be lower because we are sharing property with the gas station. Our experience with that is that we are to lower some of our fixed costs.

Matthew Paull

Also, we tend to -- when we do something for the first time, we usually do it in a bigger way. As we build more drive-thru’s, they may not all be as big as the ones that we are currently building. These are more flagship right now.

Mary Kay Shaw

Thank you. The next question is from Rachael Rothman of Merrill Lynch.

Rachael Rothman - Merrill Lynch

Could you talk about a little bit earlier in the year, when gas prices were up so much, a lot of the casual diners were talking about their consumers trading down to QSR. Now that the gas prices have come down considerably, are you guys seeing any trade-away, or trade back up to casual? Or do you feel like it was not trade-down owing to gas, it was just better execution on the part of the quick-service operators? Thanks.

James A. Skinner

I think right at the moment, it is a little too early to tell to see whether there is any trade changes regarding fuel costs.

We are all happy, of course, that the fuel costs are going down. Yet it has not indicated any change relative to our traffic in the restaurants. Earlier, of course, we were able to operate above that noise I think because of our convenience and execution, as you mentioned. We were very pleased with that but certainly, like everybody, pleased at the moment that the prices are going down.

Mary Kay Shaw

Thank you. The next question is from John Ivankoe, J.P. Morgan.

John Ivankoe - J.P. Morgan

Thank you. Jim, earlier in your prepared remarks, you talked about the point of sale system in the U.S., I think in 5,000 stores, that led to, at least in tests, 13 more cars an hour. Could you quantify that in terms of comps? Discuss when that might be system-wide, and also talk about some implications outside of the United States, in terms of driving traffic? Thanks.

James A. Skinner

Ralph might be better to talk about this, John, but the fact is, it is 5,000 around the world. It is not all in the United States. We have a number of these new POS systems in the United States, but we are not ready for prime-time there yet, relative to the execution implementation of that, and able to quantify that really in terms of comparable sales growth, except to say that we all know that serving our customers at the speed of McDonald's and improving the efficiencies in the drive-thru’s will certainly lead to top-line growth and bottom-line growth, but we have not quantified it yet.

We are in a migration path today, relative to this new POS system, and yet it will not be worldwide for probably a couple of years yet.

Ralph, did you want to talk about the U.S. migration?

Ralph Alvarez

Sure, and again, this is not hardware. This is mostly software, but the changes are significant, and so we do migrate them into the restaurants, at the same time that we may be doing some of the new food news, or some of the other items, so that the changes can be handled appropriately.

What it does is basically -- the benefit is significantly reduced key strokes, less screens to go through, and that is where the speed comes in, because the conversation with the customer, we do not interrupt the customer with questions as much as we have to under the current system.

It is a capacity enhancer. How much of that translates to sales is too early to tell. Of course, we do not always have capacity constraints, but it truly does not just improve capacity -- obviously, it improves the quality of service.

Matthew Paull

I agree with everything Ralph said. Building sales is about providing capacity and having demand as well. On the capacity side, you have heard us say for many years that saving 6 seconds off of the drive-thru experience is worth about a point of comp. This has the ability to do that, but again, there is the capacity side of this and the demand side as well.

Mary Kay Shaw

Thank you. Next question, Joe Buckley, from Bear Stearns.

Joe Buckley - Bear Stearns

Thanks. I am going to sneak two in here, because they are both follow-ups.

Matt, would you be willing to comment on the developmental licensing deals, what kind of royalty rates you are getting?

Then secondly, just a little bit more elaboration on the POS system. How many countries is it in? If you would be willing to share with us how many of the 5,000 units are in the U.S., that would be helpful.

Matthew Paull

A very small number in the U.S. out of the 5,000 -- very small, which is why we are excited about the potential.

On the issue of the DL, I will give you an order of magnitude idea. We have said that this year, we have converted four countries to DLs, and we are working on quite a few more. In general, when we have been able to DL a market, you should think of the royalty as ranging somewhere between 2% and 7%.

If you look at the 35 countries we already have out there, the low is at 2% and the high is probably somewhere 7%, or a tiny bit higher. This is going to be somewhere in the middle of that.

If you have a market that is very challenging in terms of profitability, you have to start at the low end of the range. If you have a more profitable market, you can start more towards the middle. The G&A to earn that royalty ought to be well less than half of the royalty.

Mary Kay Shaw

Thank you. We have a follow-up from David Palmer at UBS.

David Palmer - UBS

Just a quick follow-up on Europe, and in particular, the UK. Is there any sense that you can give us, any maybe even data points that can give us confidence that this turn-around there, obviously you are getting a lot of momentum now, but if that can continue on a multi-year basis, or at least through '07, anything with regard to customer perceptions or anything, particularly the U.K.? Thank you.

Matthew Paull

I will throw in a comment. We do not like to predict years ahead of time. We have trouble sometimes quarter to quarter. As you know, we do not even predict comps or earnings, but we like what we see in terms of mystery shop results and brand trust scores.

The trends are improving, and that has to happen for us to sustain what we have. We like the trends, but we are not going to make any promises or commitments.

Jim, do you have any --

James A. Skinner

I would just say that, just like our results in every other part of the world today and by individual country, the focus on our customers in our restaurants, and the diligence that we have around execution and delivering a better experience for our customers, and trying to do a better job today than yesterday, has served us so very well.

It is the same in the U.K. The discipline that team is showing regarding staying the course, delivering around the Plan to Win, showing the great results that Matthew's talked about, and it is sustainable when in fact we stay focused. It is our fly-wheel, if you will, relative to customer relevance is so important for us.

Ralph Alvarez

Just to add to that, Jim and I were there two weeks ago, and spent two days in the restaurants and looking at the U.K. plans. We are pretty familiar with what is going on.

The one thing that we looked at is, are we getting promotional spikes or are we starting to stabilize the baseline? We are stabilizing the baseline. Continued improvement in our operations and our relevance will then move the baseline, and that is really what is the health of future comps. That is why I stated the six months, because six months does not make a long-term trend, but what we see is encouraging.

Mary Kay Shaw

Thank you. It looks like we are out of questions. I will go ahead and turn it back to Jim for a couple of closing remarks.

James A. Skinner

Thanks again, everybody, for participating in the call. We appreciate your interest in McDonald's, as always.

To sum up everything you heard today, McDonald's business is strong and getting stronger every day. The future holds tremendous opportunity for growth, and under our philosophy of continuous improvement, we will seize that potential by achieving greater relevance to our customers with a robust pipeline of initiatives in each of the five Ps of our Plan to Win.

We will further strengthen our connection with customers by building brand trust. We will leverage our strongest core competency -- simple execution and fast replication, to ensure our top-line initiatives drive our bottom-line. We will optimize our restaurant ownership mix to realize further financial benefits and optimize returns.

Together, these actions will allow us to continue to build system and shareholder value. Thank you.

Mary Kay Shaw

Thanks, everyone.

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Source: McDonald’s Q3 2006 Earnings Call Transcript
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