McDonald’s Corporation (NYSE:MCD)
Q4 2013 Earnings Conference Call
January 23, 2014 11:00 ET
Kathy Martin - Vice President, Investor Relations
Don Thompson - President and Chief Executive Officer
Pete Bensen - Chief Financial Officer
Tim Fenton - Chief Operating Officer
Brian Bittner – Oppenheimer
Matt DiFrisco - Buckingham Research
John Glass - Morgan Stanley
Joe Buckley - Bank of America Merrill Lynch
David Tarantino - Baird
David Palmer - RBC Capital
Jeff Farmer - Wells Fargo
Jeff Bernstein - Barclays Capital
Howard Penney - Hedgeye
Greg Badishkanian - Citigroup
Sara Senatore - Sanford Bernstein
Alex Chan – Jefferies
Will Slabaugh – Stephens
Hello and welcome to McDonald’s January 23, 2014 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. Kathy Martin, Vice President of Investor Relations for McDonald’s Corporation. Ms. Martin, you may begin.
Hello, everyone and thank you for joining us. With me on the call today are President and Chief Executive Officer, Don Thompson; our Chief Financial Officer, Pete Bensen; and Chief Operating Officer, Tim Fenton who is joining us for Q&A. Today’s conference call is being webcast live and recorded for replay by phone, webcast, and podcast.
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 documents are available at www.investor.mcdonalds.com, as are reconciliations of any non-GAAP financial measures mentioned on today’s call with their corresponding GAAP measures.
Now, I’d like to turn it over to Don.
Thank you, Kathy and good morning everyone. As we embark on a New Year, our systems focused on leveraging our competitive advantages to deliver great tasting and high-quality food and beverages at the speed and at the convenience that only McDonald’s can provide. We have high expectations for ourselves and we have added high expectations for our brand. And we will not waver in our commitment to delivering an exceptional experience for the 70 million customers who visit us every day.
Given the challenging year that we had in 2013, I want to reiterate that we remain committed to adapting to keep pace with changing markets. We remain committed to investing to meet future demand. And we remain committed to addressing performance opportunities in the current environment. As we shared at the November Investor Meeting, our primary focus is on resetting and strengthening the relationship that we have with our customers. They are the driving force behind our mission and we continue to place them front and center in all that we do. We continue to execute against our three global growth priorities to optimize our menu, modernize the customer experience and to broaden accessibility, because these are the areas where we have the most significant opportunities to differentiate our sales.
Our near-term opportunities revolve around optimizing current initiatives for greater customer relevance, broader consumer reach and better restaurant execution. In addition, we prioritized our near-term efforts on improvements in key opportunity markets. These include Germany and Japan, which are experiencing sustained negative trends and the U.S. and Australia which are significant contributors to consolidate a performance. Specifically, the leadership teams in these markets are developing more locally relevant solutions based on stronger consumer insights and more recent market learning’s. This would help us to make the appropriate adjustments to regain momentum as we more clearly align with our customer’s needs.
Now, let’s turn to 2013 global results. In constant currencies, operating income was up 1% for the quarter and 3% for the year. Earnings per share growth increased 2% for the quarter and was up 4% for the full year in constant currencies. For the full year global systemized sales grew 3% in constant currencies and global comparable sales grew up 20 basis points. Comparable sales were down 10 basis points for the quarter. Guest tracking was down across major segments reflecting initiatives that didn’t resonate as strongly with consumers amid a sluggish IEO industry.
2013 was a difficult year and we’re keenly aware of our short term challenges. Due to economic predictions are mixed but most assumed some limited global improvement in 2014. However we don’t expect significant changes in market dynamics given modest growth projects for the IEO industry. Looking to January global comparable sales are expected to be relatively flat.
Now let’s shift to the markets, U.S. comparable sales decreased 140 basis points for the fourth quarter and 20 basis points for the entire year. Operating income was up 1% for both periods. Our U.S. 2013 results fell short of our expectations. We introduced a number of significant new products and limited time offers at a quick pace to challenge more effective restaurant and marketing execution.
Our 2014 menu and marketing strategies better balance affordability with core products, new choices and limited time offers. For example the recent evolution to Dollar Menu and More intended to drive customer visits by offering greater value and variety while improving restaurant profitability and in today results are in line with initial expectations.
We have also adjusted the sequencing of product introductions making it easier for restaurant teams to execute especially when it comes to training and staffing. So customers can truly enjoy an even better experience. Now these adjustments are complimented by a consistent focus on core equities like breakfast where a unique competitive advantage exist for McDonald’s.
We’re enhancing the breakfast experience by creating more of a coffee culture through high quality McCafe products they pair very well with delicious foods both existing and new. And additional change is underway focusing in our brand strategies as we work to better resonate with our customers. In constant with other changes that we have made in the marketing organization yesterday we announced that Deborah Wahl will be joining our U.S. business as Chief Marketing Officer.
We look forward to the fresh perspective that Deborah will bring as she leads the team as we refine our marketing strategies and our execution plans.
Now let’s move to Europe where comparable sales were up 1% for the quarter and flat for the year. In constant currencies operating income was flat for the quarter and up 4% for the year. Despite persistently low consumer confidence across the zone the UK, Russia and France generated positive comparable sales for the quarter partially offset by negative comparable sales in Germany and Southern Europe. The UK and Russia continued to grow promotions like Russia’s American Classics generated excitement and the introduction of appealing menu platforms including blended ice in the UK created additional reasons for our customers to visit McDonald’s.
The UK also remains committed to daypart expansion. Efforts centered on extended hours, breakfast and the family business are driving momentum throughout the day. In France December marked five consecutive months of positive comparable sales. Strong promotional activity and an ongoing emphasis on relevant value offers like Casse Croute help fuel our momentum.
Given uncertainty around consumer reaction to recent VAT increases and current economic indicators that do not reflect improvements in market dynamics. We remain cautiously optimistic about France.
Let’s turn to Germany where we see significant opportunities for improvement with new Company leadership in place and fresh perspectives among our franchisee leadership team. The markets goal is to stabilize this trend and begin rebuilding brand relevance. Driven by deeper insights we’re refining our plans to focus on fewer yet better tactics than more closely aligned with local customer needs. For example October’s launch of the McBaguette, a two item value bundle that mirrors the very successful cash Casse Croute in France. However with a German influence exceeded expectations because it's a high quality product at a price point where we previously had a gap to consumer expectation.
Let’s now shift to Asia-Pacific, Middle East and Africa or APMEA, where comparable sales were down 2.4% for the quarter and down 1.9% for the full year. In constant currencies, operating income was relatively flat for both the fourth quarter and the year. Japan comprises roughly a third of APMEA’s comparable sales though the market contributed less than 15% to the segment’s operating income. Amid a highly competitive environment, Japan continued to experience significant comparable sales in guest count declines. Along with new leadership in this market, Japan is taking the steps necessary to strengthen the McDonald’s brand connection with consumers. This includes repositioning its affordability strategy in concept with additional emphasis on hospitality and more relevant menu news for both the new and core foods and beverages.
In Australia, comparable sales were relatively flat for the quarter. The appeal of new McWraps and Salads did help to build average check. Looking ahead, the market plans – the market plans are anchored around being even more relevant with local consumers. We are emphasizing value across all price tiers and we are launching more premium products to create excitement across the menu.
In China, comparable sales decreased 40 basis points for the quarter, a sequential improvement over the last nine months and were down 3.6% for the full year. Our enhanced all day value platform is generating improvement and will continue to expand convenience initiatives, including dessert kiosk and delivery. And we will work to grow the family business across the market. Given the opportunities inherent in a growing more prosperous middle class, we also continue to grow through expansion in China. We opened 275 restaurants last year. Around the world, our holistic approach, which begins with the customer experience, is guiding our actions. And as our business continues to generate significant levels of cash, our first priority is making disciplined investments in the opportunities that will grow the business over the long-term.
In 2013, we opened more than 1400 new restaurants and reinvested in our base of existing restaurants, including our re-imaging efforts. After capital expenditures, we expect to return all of our free cash flow over the long-term to our shareholders through a combination of dividends and share repurchases. Last September, our Board of Directors announced a 5% increase in our quarterly cash dividend to $0.81 per share in the fourth quarter. For the full year 2013, we returned a total of $4.9 billion to shareholders through dividends and share repurchases. And in 2014, we expect to return approximately $5 billion.
In closing, I remain confident in McDonald’s future and more specifically our ability to strengthen our relationships with our customers. My confidence is grounded in the fact that we are targeting the opportunities that exist within our three global growth priorities to optimize the menu, modernizing the customer experience and broadening accessibility to brand McDonald’s. Our plans are supported by a comprehensive execution approach, which leverages all three legs of the system to satisfy customer expectations and drive improved business performance.
The alignment of franchisee, supplier partners and employees is strong and critical to our success and our strong local market structures enable us to more deeply understand and better execute those initiatives, which are most important to our customers in their local markets. These distinct competitive advantages are the reason we are well positioned to deliver enduring profitable growth today and for the long-term.
Thanks again everyone and I will now turn it over to Pete.
Thanks Don and hello everyone. Though McDonald’s grew revenues, operating income and earnings per share in 2013, our financial performance did not meet our high expectations. However, I am confident in the underlying strength of our system, our business model and competitive advantages to deliver strong performance over the long-term. We entered the year with a renewed energy around engaging more deeply with our customers. We placed the customer at the center of everything we do and we have the resources and infrastructure to meet our goal of becoming our customer’s favorite place and way to eat and drink.
So how will we do this and what will be different in 2014? We are leveraging consumer insights to better understand how we can deliver on evolving consumer needs. This includes enhancing our value based messaging and reengaging with customers in more compelling ways from our marketing and promotions to the order points that are restaurants. We have identified areas where we can improve and are prioritizing the initiatives that are most impactful to our customers and we continue to move forward with investments that will drive long term growth than returns.
Turning to 2013 performance, so revenues grew modestly at 2%, we prudently managed our expenses and maintained full year combined operating margin of 31.2%. Our operating margin continues to compare quite favorably to other large global consumer companies and restaurant businesses. Our profitability is driven by restaurant margins. Franchising remains core to our business model with 81% of our global restaurant operated by local business men and women. Franchise margins account for about 70% of total restaurant margins. In constant currencies, consolidated franchise margins increased 2% to $1.9 billion for the quarter and 3% to $7.6 billion for the full year. Our franchise business model is resilient ultimately dependent upon topline growth to maintain or expand margins over time. As a result of relatively flat comparable sales and higher occupancy cost the consolidated franchise margin percent declined 90 basis points for the quarter to 82% and declined 60 basis points for the full year to 82.4%.
Consolidated company operating margins declined 60 basis points to 17.2% for the quarter and fell 70 basis points to 17.5% for the year. Higher operating cost in both periods amid weak comparable sales contributed to the margin declines.
We’re diligently managing restaurant expenses but we expect cost increases to continue pressuring margins in 2014. Looking at segment performance in the U.S. negative comparable sales in fourth quarter combined with 2% higher commodity cost and increased labor costs resulted in a 50 basis point decline in company operated margins to 19%.
For the full year margins declined 110 basis points to 18.4% primarily due to higher labor, commodity and other expenses coupled with weak comparable sales.
From a pricing standpoint we ended the year with a 3.1% increase in the U.S. This is a result of several smaller menu board increases taken through 2013 and an effective 50 basis point increase in November due to the introduction of the Dollar Menu and More.
The food away from home inflation index ended the year up 2.1% which was at the low end of the expected 2% to 3% range. For comparison the food at home inflation index was significantly lower at 0.4% well below the expected range of 1% to 2%.
Overtime we seek to price in-line with food away from home. As we look to 2014 both food away from home and food at home inflation is currently projected to be up 2.5% to 3.5% although updated forecast are due in the coming days. We will continue to monitor these two indices closely. Balancing our desire to drive traffic to our restaurants with strategically managing margins and cash flow. On the expense side we expect 2014 U.S. commodity cost increases of 1% to 2% with more pressure in the first half of the year.
Turning to Europe, in fourth quarter this segment increased company operated margins 30 basis points to 19.4% as positive comparable sales performance offset 1% higher commodity cost and increased occupancy expenses. For the full year margins increased 10 basis points to 19.2%. Europe’s company operated margins benefited from strong performance in France as well as Russia and the UK. Combined these markets contribute over 60% of Europe’s company operated margin dollars. At year-end Europe’s price increase excluding Russia was about 1.5%. We remain very deliberate with our pricing given cautious consumer sentiment, VAT increases in markets like France and ongoing austerity measures, all of which pressure disposable income.
Europe’s 2014 commodity costs are also expected to increase about 1% to 2% with more pressure in the second half of the year. In Asia-Pacific, Middle East and Africa, our three largest markets experienced negative comparable sales in both fourth quarter and the full year with Japan having the most significant impact. Though the challenges differ across markets, we believe that emphasizing McDonald’s key advantages of value, convenience and service will be critical to long-term growth in this segment. We tailor these advantages in different ways within each local market from providing affordable entry points through dessert kiosks in China, to enhancing everyday value platforms in China and Australia, to expanding our web ordering and delivery service in Japan.
Markets across APMEA have some of our best customer service scores and we are encouraged by our continued progress. Quite simply, we want more customers to visit McDonald’s more often. We will continue to innovate and invest across the diversified portfolio of markets within this promising area of the world. Relative to profitability, APMEA’s company-operated margins declined 180 basis points for the quarter to 12.6% and declined 170 basis points to 14.2% for the full year as higher labor, occupancy and other costs pressured margins.
New store openings in China continued to negatively impact APMEA’s margins in both periods as well. Consolidated G&A was flat in fourth quarter and down about 3% for the full year in constant currencies. The full year decrease was driven primarily by lower incentive-based compensation. As discussed at the November Investor Meeting, we expect 2014 G&A to increase above $200 million or 8% in constant currencies reflecting the impact of below target 2013 incentive pay, expenses associated with our worldwide Owner Operator Convention in April and sponsorship of the upcoming Winter Olympic Games in Sochi and cost to support restaurant growth, capacity enhancements and digital initiatives.
Our full year 2014 effective tax rate guidance is 31% to 33%, although we do expect volatility between quarters given our global business. As a reminder, first quarter 2013 results reflected a one-time tax benefit of nearly $50 million related to the retroactive impact of the American Taxpayer Relief Act of 2012. This contributed $0.05 to EPS in first quarter last year, which we will be lapping this quarter. McDonald’s resilient business model continues to generate significant cash from operations. As Don mentioned, our first use of that cash is to reinvest in our business. We are the global market leader and we intend to continue leveraging this competitive advantage. We will accomplish this through a balanced measured approach to investing in new and existing restaurants to drive future growth than returns.
Looking to 2014, over half of our $2.9 billion to $3 billion of capital expenditures will be used to open between 1,500 and 1,600 new restaurants. We will grow to the opportunity in both established and emerging markets further enhancing our diversified portfolio. The breakdown for openings in our geographic segments is as follows: 250 in the U.S., 320 in Europe and 830 in APMEA, including about 300 new restaurants in China. We also continue to modernize our brand through re-imaging. We updated 1,529 locations in 2013, a little shy of our projection of over 1,600. This shortfall was spread fairly evenly across the segments. As we continued – as we make continued progress and some markets reach completion, our passive re-imaging is naturally slowing. This is reflected in 2014 plans that call for over 1,000 total re-images. This reduction is also the result of planned kitchen investments in the U.S. that are being prioritized in 2014. These new high density kitchen prep tables are designed to deliver enhanced service capabilities and menu choice to our customers. Lastly let me touch on foreign currency translation which negatively impacted fourth quarter EPS by $0.01 and the full year by $0.05.
At current exchange rates we expect first quarter EPS to be negatively impacted by $0.02 to $0.03 with a full year negative impact of $0.05 to $0.06. As always take this as directional guidance only because rates will change as we move throughout 2014.
We begin 2014 energized by our opportunities yet mindful of the challenges in front of us. We’re the global leader in a $1.2 trillion highly fragmented industry. We’re one of the strongest brands in the world with significant competitive advantages. Together with our outstanding owner/operators and suppliers whom we believe are the best in the business. We proudly serve 70 million customers every day and we aligned to drive enduring profitable growth for the McDonald system and our shareholders in the years to come.
Thanks now I will turn it over to Kathy to begin our Q&A session.
Thanks Pete. I’m going to now open the call for analyst and investor questions. (Operator Instructions). Again we will try to give as many people possible the opportunity to ask questions. So if you can try to limit yourself to one we will get back to you for a follow-up as time allows.
Our first question is from Brian Bittner from Oppenheimer.
Brian Bittner – Oppenheimer
Kind of big picture thoughts question here. I just think about over a decade you know for the last decade up until 2012 you guys really average the same store sales increase around that 5% range and you know overtime and Don you’re at the heart of this but you guys had such compelling bottoms up drivers in the business and just we’re executing against much lower sales per unit than you set at today. But as you said year-to-date seems the bottoms of drivers have just faded a bit from what they used to drive and the bottom-line I guess comps have hit this sluggish cycle and the question here is there anything that you see from a new platform perspective or new business layer perspective that you can go after to get back to those mid-single digit comps across the system or do you really sit here and look at your businesses today and think about it much more is being relied on the macro and much less about specific things that you can do to drive it.
We really believe Brian the strategic areas that we need to focus on to grow this business into the future. Those are somewhat consistent and we still have opportunities and those being around our menu and the menu being relevant really enhancing the customer experience and you guys know quite a bit about the execution focus and getting back to a stronger customer relationship this year as well as accessibility and affordability. Those areas are the right strategies; this affordability aspect is a very, very key component of our growth as we move forward. So we think we’re in the right area with those strategies. The key is going to really be to reestablished the trust of customers.
When we look across the broader range that is one of the consistent things that we see and that means basic execution at a restaurant level market engagement at a much stronger level and also to make sure that our menu is relevant. There are some other aspects of that that we have talked about being digital engagement, we have really not played in that arena in a strong way and clearly you all know based upon them and some of our conversations that our intent is to be much stronger with regard to our digital outreach and digital engagement focus.
So we’re focused really, you mentioned macro-economics. We’re focused on those things within our control to drive our performance. This is going to be a market share battle and a market share battle gain in order for us to move the business but we believe we have the right strategies and the right focus at local levels in the markets to achieve the goals that we have. One of the things we have all discussed is that we got to really get back to a much stronger focus on what we call 5P execution. When we talked about the plan of win, people, product, place, price, promotion. Those five areas we have got to make sure that we’re maxing out our execution strategies for whatever initiative that we implement in any market around the world. That’s going to help us create that relevance again with our customer.
So those focal points along with the priority focused on the key markets that we know we have challenges in and an even stronger fashion which Tim and teams are doing. I believe will get us the growth that we need not only for the current year but as we move forward Brian.
All right our next question is from Matt DiFrisco, Buckingham Research.
Matt DiFrisco - Buckingham Research
My question is with respect to margins. I think you alluded when you talked about APMEA specifically about China having a little bit of a drag obviously because it’s a company-owned mix where it’s a franchise mix, but I wonder if you could comment on China, the company-owned margins, is there de-leverage there as well, I would assume with the slower comp? And then if you could sort of tie that in also how we should think, Pete, of the direction of the comp, I am sorry, the margin in the U.S. when you rollout and we start to see the kitchen equipment being put in there? Absent a comp lift, would we be seeing also a margin benefit from that initiative of new equipment coming into the stores?
Alright, Matt, I will give it a shot. China as you mentioned, we saw both. Our comparable stores did have a decline in margin as well as the impact of the new restaurants coming online although that impact of the new restaurants was less than it was a year ago. And as I think the excess you listened or we are at our investor conference, you heard Dave Hoffmann talk about some of the initiatives they have underway with their go-to-market strategy to look at bringing cost out of that development, the new development there, which will further lessen the impact of the new openings on the margins going forward there. So that piece of it is moving in the right direction, but as you mentioned, China as well as all the markets around the world, margins are a top line game. And to the extent that we aren’t driving the comp sales that we need there, the margins will continue to be a little bit pressured.
In the U.S., specifically U.S. around the kitchen equipment, but more broadly, one of the positives, if you will, out of the fourth quarter was we saw some margin benefit from the dollar menu and more pricing aspect. So we did see a little bit of positive impact to the chef there. As we rolled this new kitchen equipment out, it’s going to have a couple of different impacts. One obviously some of what we have talked a lot is design to improve our throughput, improve our order accuracy, offer more choice and variety to the consumer. So from that standpoint, obviously that’s a – should be a positive for the business. It’s on the negative side of that so to speak. It will be additional investment. It will have additional depreciation associated with that some additional training. So in and of itself it’s not a one single piece that’s going to make or break the margins next year. We will continue to see commodity pressure. We had about 14 states raise minimum wage here effective January 1 with others making noise about doing the same thing, commodities, healthcare costs. So costs will continue to be a challenge for us in 2014 as we think about the margins.
And our next question is John Glass from Morgan Stanley.
John Glass - Morgan Stanley
Thanks very much. And more broadly Don or Pete, we are in a tough operating environment than you have been in a while, your advantage versus the peers seems to have shrunk and these are all things we have known for a while, maybe sales get better because you continue to push out these initiatives, but it may also be that we are just in a lower sales environment. So if that is a backdrop, what are the other things that you consider in looking at how to enhance the performance. So for example, many of your peers over the last several years have gone through more significant refranchising rounds. Is there an opportunity there? We have talked in the past while looking at your balance sheet, it doesn’t seem like that’s something you are inclined to do, but maybe willingness to revisit that. Looking at even corporate cost cutting, are there opportunities there to create a leaner organization given this leaner – these leaner economic times or leaner performance times. Any thoughts there will be helpful?
Yes, John thanks much for the question. Let’s go back to how we view and look at performance and some of the data and what we actually see. If we look in the U.S. particularly, one of the things that we see today is a bit of a bifurcation on a consumer base. So some of the fast casuals are performing a bit better and customers are skewing that way a little bit more as a result of a bit more discretionary income and that economic class of individuals. So we also know that those customers that tend to come to us are fairing quite as well in the current economy in the U.S. Having said that, what we have to do John in the near term is focus on the value base, focus on some of the things that we know are going to be critical in terms of the execution of our menu. I am going to ask Tim in a moment to kind of speak a little bit to the key markets, because I don’t want to just pass over that too briefly. There are a lot of opportunities we feel we have in the key markets. So Tim will give an update there. Relative to looking at things like refranchising, opportunities. We’re constantly looking at that John and yes we do have a longer term plan relative to where we refranchise and opportunities there along with optimizing the portfolio in our major markets. G&A wise we are continuously looking at that and clearly as a pay for performance culture we don’t perform as Pete mentioned the incentive based compensation in that part of G&A comes down. There are other areas that we reduce G&A and it's because we’re continuing to focus on some strategic changes to our structures and our efficiency and effectiveness.
So we’re going to continue to look at those areas but I will tell you we have to be customer relevant. The way to drive the business is going to be through the top line growth which means the execution in the restaurant it means the product focus that we have and it means the way that we’re addressing customers and engaging them. So with that Tim if you wouldn’t mind speak a little bit to some of the key markets that you see and opportunities.
Key markets that we’re looking at, obviously the U.S., Germany, Japan and relatively new leadership in the U.S., Germany and Japan as well and each team is focused on making those adjustments necessary to regain the momentum. Specifically in the U.S., energizing consumer messaging and market execution. We stumbled a little bit last year with too many new products, too fast and create a lot of complexity. As we mentioned in November reestablishing our breakfast with a lot of emphasis on beverage and coffee. We know that coffee drives the visits at our breakfast time and I guess one of the biggest things that we’re looking at and U.S. is focusing on peak hour execution. That goes hand in hand with the enhancements of our prep table. It gives us more capacity in those peak hours and of course menu choice.
In Germany, we’re going to focus on fewer but better tactics built around deeper insights behind what really addresses Germany’s needs. We are responding to the café and bakery, it really kind of impacted McDonald’s affordability and relevance by introducing such products as the McBaguette fulfill that price point gap.
And of course strengthening our value program and focus more on core and continuing to push breakfast even though it is a low base it is growing for us there. Japan taking steps that we frame what the brand represents to our customers and repositioning the markets affordability strategy. We can’t go head to head with the 45000 convenient stores on price alone we realize that. So we really have to put emphasis on our hospitality a new menu news, both new and core.
All right our next question is from Joe Buckley, Merrill Lynch.
Joe Buckley - Bank of America Merrill Lynch
I know you mentioned the Dollar Menu and More was meeting your internal expectation so far but could you talk about the extra-value menu experience in 2012 versus the early Dollar’s are more experienced in the latter part of 2013 and how are they comparing contrast? Yeah I know you had to back away from the extra-value menu and just kind of curious the reaction to Dollar Menu and More why you’re encouraged by it and what do you think that’s staying power and can it kind of move the customer traffic needle as you suggest was the goal.
First of all if you look back at 2012 we had extra-value menu, we had extra-value meals plus we had Dollar Menu. Rather confusing not only to our customers but actually kind of confusing to us. With the Dollar Menu and More it's meeting our expectations during the test. It was designed to really stretch out our products of variety and give us flexibility in pricing. It's simpler, it's easier. It's only been in stores for a couple of months and the couple of months was through the holiday period. We’re seeing slight gains in guest counts and of course as Pete mentioned earlier it's margin friendly. So far so far so good, and it was a good transition and evolution for where we had to go with our value menus and dollar menu.
Hey Joe if I might you know one thing and I have mentioned this in the comments to get back to a stronger relationship with customers. to be very honest extra-value menu while a very solid attempt was based in mining out additional profitability, the consumer part of that from a consumer benefit was not as strong as Dollar Menu and More. Dollar Menu and More is customer focused, customer based builds out to core equity and yields that value the customers in that way. Extra-value menu was really a reformulation of certain products adding some others just to build profitability. So this is what we mean by getting closer and getting back to a strong relationship with the customers.
Alright. Our next question is from David Tarantino from Baird.
David Tarantino - Baird
Hi, good morning. Don and Pete, actually I have a follow-up to maybe that last comment where you talked a lot about using consumer insights to drive the business more so than you have done in the past? And I think Pete mentioned in his remarks that you have identified some areas where you need to improve? And I know you have alluded to a lot of it so far, but maybe it would be helpful if you could give some specific examples especially in the U.S., where it looks like the relative performance has been pretty soft in the recent months? What have you learned from consumers where McDonald’s brand is currently missing the mark and maybe how does that translate to the tactics you are going to use going forward?
I will tell you what, David, what I would do is I talk to a part of this and I want Tim to talk a little bit to the operations piece of it, because that’s a big part too. So again and I know it’s going to sound like Don, you continue to mention the same thing, but I am going to go back to customer relevance. In the U.S., one of the challenges we have is we have lost some of our customer relevance and we have lost it across several parts of the day. So relative to the breakfast part which Tim just mentioned, this notion on coffee is not just about coffee, it’s about our breakfast business. Coffee too is a big part of the lead for breakfast, but we have great tasting food. If we lose relevance in coffee, then we are going to lose the transaction which yields food purchase. And so we have got to make sure that the food is relevant and that the awareness around McDonald’s as a kitchen and a restaurant that cooks and prepares fresh high-quality food is strong and pronounced in our marketing and our messaging. So we have got to get back to that on food. We have got to get back to an energy and excitement in our marketing balance in the execution of it. And that’s something that all of us have noted, Jeff Stratton and the team in the U.S. have noted. And you have seen some of the changes, which again Tim can update you on relative to even personnel changes in the U.S. So that’s one of the specifics in the U.S. that I could speak to. We talked about value, but Tim maybe on this operations front, because that’s another big one.
One of the things we did last year David, we overcomplicated the restaurants. If you remember, we introduced McWraps, we introduced Egg White Delight, we introduced Quarter Pounder Toppers and really didn’t give the restaurants an opportunity to breathe. We instituted a gatekeeper really with the intent of doing fewer products, but better execution. We mentioned a little bit earlier the capacity on the prep table that allows us really to have more capacity during our peak hours, where we haven’t been able to particularly in some of our drive-through restaurants service quickly and fulfill the capacity that we wanted, so fewer products, better. One other thing and you talk about insights and I want to mention Jeremy, historically, we lost some share based on our insights to non-traditional competitors, cafés and bakeries. At the same time, when we were pulling off some of our value offerings, bakery stepped up with value offerings and some of our trade went to non-traditional QSRs, as I said, bakeries and cafés. We have learned about that. We are designing our strategy to how we can go back to mitigate that, but that’s a deeper understanding of consumer insights market by market by market.
Next question is from David Palmer, RBC Capital.
David Palmer - RBC Capital
Thanks. In the past, McDonald’s would have operations upgrades like Made for You or the beverage station and that will allow your marketing machine to get cranking over several years oftentimes driving the sales layer. I am trying to figure out if some of these changes that you are doing with the prep tables could be an enabler from an innovation and marketing standpoint as well as something that helps you with peak hour capacity and execution. Could you comment on that please?
Yes. I will make one comment on the marketing piece and there is – again there is another capacity piece to this. On the marketing end, David, you are right, one of the things that we have done and actually we didn’t do it nearly and strongly with Made for You back in 1998. We implemented Made for You, but we really didn’t come out with a strong marketing campaign that was correlated to it. We have individual markets that didn’t start to benefit, but we didn’t hit it as strong. To that point, even today, customers don’t realize to the greatest extent that at McDonald’s we are making that sandwich, preparing that in the back of the house after you place that order. What does this mean? It means that there is a notion of that again that relationship and the awareness the customers have about who we really are as McDonald’s and what we are able to deliver in that kitchen which is a customized sandwich for you. It's something that we really need to be able to advance in our marketing messages more now. Challenges has been there has been a little concern as to whether or not and how hard we can go with that messaging if we didn’t think we had more capacity headroom. So with that in mind we have done some things with the kitchen and Tim maybe a little bit high density.
Yeah well the high density UHC cabinets we have allows us more capacity and the prep table enhancements not only gives us flexibility and customization with other toppings it gives us the capacity and some of the existing products that we had that we had not to get really operationally technically but we had a cross over and replenishing during peak hours was the last thing you want to do but with the refrigerated rail that we’re adding and we should have this all into the system between the May - June timeframe. It is all just some flexibility with different variety of the toppings, jalapenos, avocado, (indiscernible) and different spice sauces if you will. There is a lot of flexibility and more customization. So it's capacity on existing, it gives us flexibility for new products and new toppings as we go forward.
And then we got to tie those together David to your point we have got to tie the marketing messages and awareness into driving this. That’s one of things that you are referenced quite a bit when you talk about coffee. We referenced PR, marketing and the operational pieces together to drive that category and we will do it again.
Next question is from Jeff Farmer, Wells Fargo.
Jeff Farmer - Wells Fargo
Just following on the I don’t know throughput side you’ve discussed the high density, the prep tables, lot of other plans but are you guys planning to add labor to these restaurants? How should we think about that moving forward?
That’s another priority that we have and in fact our (indiscernible) is right now working with all of our operators on just that. Staffing, positioning and scheduling as far as putting the right people on it at the right time particularly during our peak hours. We have to have the additional staffing required for some of the complexity that we have. That was I think one of the stumbling’s we had last year with all the new products we brought in all at the same time or within close proximity. So definitely it is a priority for us and beefing up staff and particular on peak hours and weekends.
Next question is from Jeff Bernstein from Barclays.
Jeff Bernstein - Barclays Capital
Just a question on kind of broader Europe and I think we have talked about this few quarters about but France seems to have joined the UK and Russia perhaps in recent months. I know Don you mentioned the string of positive comps there and that leaves I guess Germany as the weak major market. One, I’m just wondering if that’s fair and two, I’m just wondering how we should think about ’14 whether or not Europe could be the silver linings for the broader company it does seem like at least on the macro data that we see that the trends are stabilizing or perhaps improving across broader Europe. I’m wondering if that is the case where the brand McDonald is seeing that and if what would be a good way to play the improving European macro and if there is anything specific to talk about in Germany and I know you mentioned new leadership but anything else that we should expect to help send that comp to the positive side?
I think Tim mentioned some of the things that are taken place in Germany right now and I believe that, you know what’s different about Germany aspect is that this we had a refocusing before. We put something’s in place that were customer focus. We only executed them for shorter period of time and we pulled them out. I think that’s been a lot of learning’s relative to what we should do in Germany along with the fact that whenever you execute a “best practice” it can’t be adopted. It has to be adapted which is also the difference between McBaguette and Casse Croute. So relative to Germany that’s one of the things that we knew we had to be able to do.
France, I want to echo a comment I made around cautiously optimistic. I think our French team as are we; we have seen some a trend, a positive results. France is still an economy that’s got some troubles to it. There is a VAT increase that I mentioned, we also have some, there is some decisions that will be made soon relative to the French government from a social charge and austerity based prospective. We will have to take a look at, we hope that it will stimulate the economy which will be good for everyone but right now France is still at a point where the 2014 IEO projection is to be down 10 basis points and so it is not a market that is come out yet but we have seen some positive things and in the face of all of those our teams have done a fabulous job. Southern Europe is an area that still has some challenges. And those are macroeconomic challenges. And we just got to make sure we maintained relevance in that area. So Europe as we always say, Europe is not a country. And so when you divide it across the various segments, we see some positive areas and then we see some areas that are still difficult. So we are optimistically looking at performance across Europe, but there are still some challenges there.
And just to add, Jeff, the IEO projections are really modest going forward, the UK plus 50 basis points and Germany plus 50 to 80 basis points.
Alright. Our next question is from Howard Penney from Hedgeye.
Howard Penney - Hedgeye
Hi, thanks very much. I have two questions for you if you don’t mind. The first one is on the high-density tables and when I hear additional capacity or additional customization is the sense that occurs in the – I think slower service times more than I do faster service times and I apologize for this question, because I actually haven’t those tables in news, so I don’t really understand how they work. So, how does additional customization not equal slow at service times? And then two, can you may be provide a definition of what met internal expectations means, just because the use of the triple times relative to initiatives in 2014 that really haven’t delivered whether it’s reps or (indiscernible)? Well, they may have met internal expectations, they didn’t really drive the business forward and they are also now using that term associated with the dollar, the new dollar menu and more? Thank you.
Hi Howard. I will take the piece on internal expectations and I’ll let Tim to talk more about the high density kitchen and impact on operations. But when we say internal expectations, we have clearly a business case for each and every individual initiative that we implement. We have certain criteria that we establish whether that be based upon guest count growth, it might be sales growth, profitability aspects. So we look at those business cases and we have internal expectations set around certain targets. We also have expectations set around the overall accretive nature of an initiative to the broader business. And so when we look as we measure whether or not something was effective and whether or not we are successful we measured against those internal criteria. You guys typically hear us talk about the consolidation of all of the initiatives, which then roll up into an incremental benefit in a comp sales or something that might be associated with our operating income at a total level.
Howard, on the capacity, anytime during our peak hours, if I can keep people in place and not have their feet moving to restock or to get something else or have crossed over last year, we deleted angus it’s a slow moving product for us. So we are working with two proteins and a beef in the kitchen. When I can have the capacity in the prep table, well people don’t have to move, I am just putting different toppings on. You have got the protein coming down the prep table like an assembly line if you will and we are just adding different condiments on. And again, monitoring the pace and the rate of new products that we bring and giving our crews and management ample time to train and get used to before we switch it up and change it on.
Alright. Our next question is Greg Badishkanian from Citigroup.
Greg Badishkanian - Citigroup
Across your biggest markets, have you noticed any change in the competitive environment over the let’s say the last month or two that’s kind of a deviation from the trend?
Well, in the U.S. last month in fourth quarter, we had I guess a higher competition as it pertains to value and discounts and so on. And I would say maybe a little bit more in China in the fourth quarter and maybe specifically in Australia, but it’s a very competitive market out there, lot of price going on and it’s a fight for market share. It’s a street fight and we are getting at it.
Next question comes from Sara Senatore, Sanford Bernstein.
Sara Senatore - Sanford Bernstein
Thank you. I actually wanted to follow-up on margins, because the restaurants, company-operated restaurant margins look better broadly speaking than I would have expected given some of the sluggish top line and what you have said about your leverage point. So the two questions are can you just talk a little bit more about where there might be opportunities there on that line item. Going forward, you said costs are going to be a headwind, but just how well you can manage that line? And then related note, the outlook for food away from home and food at home inflation and positive fruition [ph] but I don’t think we’re really seeing that in the commodity markets. Can you talk about what you think of as kind of your sweet spot translation where you have the ability to take price but it's not so much that it's a real drag on margins physically with U.S. and then broadly. Thanks.
In talking about margins the fourth quarter actually did exceed our own internal expectations when we started the quarter. So if you recall I gave some guidance that imply we expected margins to be down a little bit more in the fourth quarter than they really were and if you look as we look at the reasons for that it was really France and Russia outperformed in the fourth quarter relative to their initial expectations and actually Germany didn’t decline as much as they had originally expected. So Europe was a big piece of that but also the U.S. as I alluded to earlier some of the check benefit that we got from the Dollar Menu and More in the two months it was in was to the positive side as a ledger and also their cost came in just slightly under where they had expected for the quarter.
So it was a combination of factors in different markets that led to that. When we think about 2014, you know food away from home projection of 2.5% to 3.5% the reason I said in my remarks that we expect an update shortly is with the commodity trends and everything else that’s going on. That number might come down a little bit. Now certainly it does also include labor in the restaurants and I mentioned minimum wage increases in 14 states is a piece of impacting that as well but right now we’re going to continue to monitor that indices. We’re also going to look at food at home again that only grew 40 basis points this year. I doubt it will grow 2.5% to 3.5% which is the current forecast based on where commodity trends are but at the end of the day we’re going to look at the pricing as we always do to try to balance growing traffic in the restaurants but also looking at profitability all through that screen that Don mentioned of continuing to improve our relevance with our customers and value is also one area to where relevance to customers matters.
All right we’re running a little low on time, we’re getting close. So we’re going to take a couple more. Next is Andy Barish from Jefferies.
Alex Chan – Jefferies
This is Alex Chan for Andy. I wanted to go back to talking about APMEA. During 2012 it seemed like check was really down and traffic kind of held up and this past year in 2013 that kind of reversed I guess how do you find the balance there and when you look at that how do you think about China and kind of avoiding that same issue?
Well China specifically they got as an industry hit the QSR and ideal [ph] with the chicken situation that happened in December of 2012 and then the rehit of the Avian influenza and a downturn in just the macroeconomics. Something not unlike what we saw back in 2008 we bounced back in 2009 and 2010 and ’11. So we in China specifically we stick to our strategy. We feel we have got a sound strategy; we’re being strategic on our openings. We are being strategic on our menu pricing and our points of distribution.
Okay. Our next question comes from Will Slabaugh from Stephens.
Will Slabaugh – Stephens
I had a follow-up question on margins at the restaurant level in particular. At the Analyst Day you talked about the three straight years of margin compression. So I wondered if you can speak more specifically to that path and margin stabilization. Could that occur this year and then maybe more specifics around what that expansion might look like and how that might take place from here?
As we looked at the margins over the last couple of years actually just recently looking at a kind of a detailed breakdown by quarter-by-quarter by the line items. One thing that was consistent across the years is that you know the cost pressures kind of in general were in a fairly tight range. It wasn’t a huge spike one way or the other, absent commodities which could have more of a significant impact but they weren’t a significant driver of the margin decline as much as the variation in the top line. And I know we sound a bit like a broken record, but the importance of driving comps in our business to margin profitability is so important and then getting back to that relationship with the customer, improving our relevance is going to lead to that improving top line, which then has that margin flow-through benefit and restaurant level cash flow growth, it’s really the key to getting the economic engine moving in the right direction again.
Alright. And this will be our last question, Keith (indiscernible) from UBS.
Strengthening the brand to differentiate, it was one of the stated intense and another one was the primary focus of the cash flows is to reinvest in the business. I am just wondering given that strength in underlying cash flow generation in a balance sheet that, yes, I think it clearly provide incremental capital should you want to do, why not accelerate investments now both re-imaging and kitchen investments simultaneously. Is there an operational hurdle to doing so, because it seems like this is a major competitive advantage that McDonald’s has, because in acceleration of this reinvestment in this environment be one of the ways to rekindle and reignite that relationship with the consumer? Thanks.
Hi, Keith. I am going to speak to (indiscernible) and I will ask Pete to speak to the other part. The notion of accelerating reinvestment, one of the things that we found across the business and history has dictated to us is that you have to have a balanced focus as we grow the business. So one of the reasons that you haven’t seen us just say we are going to put all of our dollars right into China and let’s just go hard, because we also have other emerging markets that we also want to grow and we want to grow consistently. By growing consistently, it allows us to build up the associated infrastructure from a supply chain perspective, the talent that we need to manage the market and build out the real estate development as well as our ability to be able to put dollars into market and create awareness within those markets to build comparable sales to be able to be a sustaining business model. And so as we look at some of the areas around our capital investment and deployment, we want to be balanced and measured. If it’s something like a kitchen based reinvestment, there is a pace that you can’t go at in the restaurant and at the same time make sure that you are maintaining the penultimate focus, which is to focus on customer satisfaction and expectations.
If we change all of the market at one time and went out and got a bunch of general contractors, what we would find is that we would lessen our ability to satisfy customers and we wouldn’t spread out these activities and execute and affect the plan. So this is one of the reasons you guys talk about we will have a moderate and a steady pace, but on a base as large as ours, our steady pace is pretty aggressive for other people. And so this is the reason we say that. There are some other implications than Pete to probably talk about a couple of those from a financial perspective.
Yes, Keith. I mean, it is much less about the capital, because as you know, we have the ability to throw more at it, but you alluded to operational, it is sequencing and getting these things done in a way, it takes a lot of planning and resources both internal and external contractors to change out the kitchen equipment in 14,000 restaurants around the U.S. So all of the time and energy you need to focus on that to the extent you also try to focus on accelerating re-imaging and a lot of the same kind of contractors or internal people, are needed for both types of projects, you do start to dilute the effect and not get the desired outcome. In addition, we have over 2,000 franchisees in the U.S. So this has to also be done through them considering their individual capacity, their individual cash flows their individual organization strengths. So while I agree with you on paper, it sounds like going faster could be a quicker path to getting some of these relevancy issues dealt with that Don mentioned. The reality and practical nature of a large franchise system with somewhat limited resources in terms of the competencies to work on these kind of projects gets us to kind of the pace that we are adding. And to Don’s point, I think it is a fairly aggressive pace in and of itself.
Alright. We will close out with some final thoughts from Don.
So once again, thanks everyone for joining us on the call today. We really appreciate that and we appreciate your interest in McDonald’s. Our confidence in our brand and the competitive advantages of our systems are truly a reflection of our ability to learn from our past, to be quite purposeful and agile in the present conditions and environments that we operate in and strategically plan and evolve with our customers as we look to the future. As we mentioned from the onset we are confident in the McDonald’s business and we’re confident that we have the right information, data and business acumen to address the key markets and the other opportunities that we have going forward. So thank you all once again and have a great day.
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