McDonald's Corporation (NYSE:MCD)
Q1 2014 Results Earnings Conference Call
April 22, 2014 11:00 AM ET
Kathy Martin - VP of Investor Relations
Don Thompson - President and CEO
Pete Bensen - Chief Financial Officer
Joe Buckley - Bank of America Merrill Lynch
Brian Bittner - Oppenheimer
John Glass - Morgan Stanley
Jeff Farmer - Wells Fargo
David Tarantino - Baird
David Palmer - RBC
Jason West - Deutsche Bank
Will Slabaugh - Stephens
Matt DiFrisco - Buckingham Research
Jeff Bernstein - Barclays
Sara Senatore - Sanford Bernstein
Karen Holthouse - Credit Suisse
John Ivankoe - JP Morgan
Alex Chan - Jefferies
Hello and welcome to the McDonald’s April 22, 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 call over to Ms. Kathy Martin, Vice President of Investor Relations for McDonald’s Corporation. Ms. Martin, you may begin.
Good morning everyone and thank you for joining us. With me on the call are President and Chief Executive Officer, Don Thompson and our Chief Financial Officer, Pete Bensen. 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 applies to our comments. And these documents are both available on our website at www.investor.mcdonalds.com, as are any reconciliations of any non-GAAP financial measures mentioned on today’s call with their corresponding GAAP measures.
For now, I’d like to turn it over to Don.
Thank you, Kathy and good morning everyone. We began 2014 with our strategies and our business miles sound and intact. From a financial standpoint, our system’s number one goal remains enduring profitable growth, which starts with continuing to grow customer visits and comparable sales. From our diversified geographic portfolio that leverages the entrepreneurial power of local ownership to the breadth of our menu across day parts and meal occasions, our strategies, infrastructure, and investments support this goal. And while we expect the market dynamics to remain similar to 2013, we do have experienced effectively competing in challenging operating environments and I remain confident in our ability to be successful at McDonald’s.
Our global growth priorities are focused on ensuring that we remain relevant and appealing, so that more customers will visit us more often. We’re focused on optimizing our menu so that we offer our customers food and drinks that have strong appeal, on modernizing the customer experience in our restaurants, so that that experience for each customer is more memorable; and on broadening accessibility so that we deliver on unparalleled convenience. The key to our growth lies in our ability to place the customer at the center of everything that we do.
Over the past few months, I had the opportunity to visit our priority markets, the U.S., Germany, Japan and Australia with Steve Easterbrook, Pete Benson and Tim Fenton. We focused on more deeply understanding how each of those markets are adjusting their plans to address current challenges and adapt to the environment and to our customers’ expectations.
There were four opportunities that were common to these markets and are being fortified in many other countries in which we operate. First, we're strengthening our planning process to more effectively bridge consumer insights into the right customer center plans and actions, while striking the right balance against our internal financial objectives. Second, we're strengthening our marketing messaging to better resonate with customers and create stronger awareness. Third, we're enhancing our affordability platforms to ensure our value offers are consistent and clearly message. We want our customers to feel good about the value that they get when they visit us at McDonald’s. And finally, we're more effectively balancing our focus on the core menu including the Big Mac, Egg McMuffin and our world famous fries.
Our core products are familiar favorites for our customers. They truly represent McDonald’s to all of our customers and at about 40% of total sales, they are an incredible business asset for us that requires a constant drumbeat of communication.
Now our area of the world our local market teams are translating these learnings along with specific market findings into comprehensive action plans to improve the customer experience. A good example is the recent changes made in U.S. marketing to more directly align our marketing efforts with targeted consumer segments. I’ll talk more about this change and actions being taken in the other priority markets a little bit later.
It’s important to underscore that it will take time for consumers to notice the changes and reward us with increased visits. This is not about a silver bullet; rather it’s about optimally sequencing multiple customer focus initiatives and executing them very well. While, we expect results in these core markets to remain volatile in the near-term, we are confident in our ability to improve overtime.
Now beyond our priority markets, we continue to pursue targeted growth initiatives that drive system wide performance. In addition to our ongoing emphasis on menu, these include brand extensions like McCafé beverages, desert kiosks and delivery; they include increasing our global footprint through new restaurant opening in both established and emerging markets and by continuing to modernize our restaurants through reimaging.
And also by leveraging the investments that we have already made in the restaurants, particularly relative to restaurant technology like our global point of sell platform and in-store wireless access to support our digital efforts focused on engaging more deeply with our customers and differentiating the McDonald’s experience.
Finally in addition to market level activities, we are also evaluating opportunities to enhance shareholder value, while maintaining long-term financial strength. Now Pete, will speak more about this area of focus in his comments.
Let me switch gears now and discuss global results. Year-to-date March our global comparable sales increased 50 basis points with positive performance in all segments except the U.S. Operating income was up 1% in constant currencies and earnings per share was $1.21, a 2% decrease in constant currencies.
Comparable guest counts for the quarter continue to be negative. Our priority markets of the U.S., Germany, Japan and Australia drove that decline. Comparable guest counts would have been positive excluding those markets, while recent signs indicate economies maybe stabilizing several of our major markets, the projections for the informal eating out industry call for flat to modest growth in 2014. With this as a backdrop, April global comparable sales are expected to be modestly positive.
Let’s now move to performance by area of the world and address our priorities going forward. In the U.S., comparable sales for the quarter were down 1.7% and operating income declined 3% driven by negative guest counts due impart to severe winter weather. The U.S. is focused on strengthening the customer experience through better operations and service execution, balanced focus between our core and new products and enhancing marketing effectiveness, while maximizing our opportunities to grow our breakfast.
Because service is such a foundational element of the customer experience, we recognized the need to elevate our service levels to ultimately build visits. During the first six months of this year, our franchise and company-owned restaurants are engaged in what we call a reset, which emphasizes the importance of proper staffing, scheduling and positioning of crew to build restaurant capacity, particularly during peak hours.
Now early I mentioned changes that have been made within our U.S. marketing group. We’ve adjusted our marketing calendar so that we are introducing the appropriate number of new and promotional products. And we are better sequencing them to maximize restaurant execution and the contribution to comparable sales.
We are also looking to harness the power of our marketing strength especially in support of our core menu. We are focused on creating a greater emotional connection between customers and our core products through our advertising and media spend. Those things combined with the fresh perspective of our new U.S. Chief Marketing Officer, these balanced menu changes and focused media strategies will allow us to strengthen our appeal to customers by offering them what they truly want, great food and great service at an affordable price.
Finally, as the leader of the important and growing breakfast day part, we’ll continue to build on the strength of our morning business. Today customers choose McDonald's because of our great product, cooked in our restaurants and our kitchens. We grab fresh eggs, we grill sausage and bake it, we bake biscuits and we toast muffins, all to serve up a delicious breakfast that is accompanied by our outstanding McCafe coffee. These things truly set us apart and position us to continue growing this day part into the future.
Now moving over to Europe. Comparable sales were up 1.4% for the quarter and operating income was up 4% in constant currency. Positive comparable sales performance in the UK, France and Russia was partially offset by Germany’s negative results. While we’re encouraged by positive comparable sales trends and recent economic indicators that appear to be stabilizing in many markets across Europe, we remained cautious in the near-term, given a tenuous operating environment. Both the UK and Russia have successfully focused on growing breakfast, while balancing the core menu with strong promotional activity that is resonating with local customers.
In France, successful marketing support for premium products and limited time offers along with the stronger affordability platform have contributed to the 8th consecutive month of positive comparable sales growth amid of declining IEO industry. Germany is one of the priority markets with persistent negative sales and guest count momentum.
The new management team is working to rebuild consumer trust through a more relevant and consistent affordability platform. We’ve also adjusted our menu and marketing calendar to do a better job of connecting with customers, by reducing and better balancing our core menu favorites with new food and beverage offers.
Now let’s shift to Asia Pacific, Middle East and Africa where comparable sales were up 80 basis points for the quarter and operating income decreased 2% in constant currencies. Solid comparable sales performance in China and many other markets was somewhat offset by weakness in Japan and to a lesser extent Australia.
In China, comparable sales increased 6.6% for the quarter, partly reflecting the lap of the residual effects of consumer sensitivity related to last year’s supply chain issue in the chicken industry. China’s ongoing focus on brand extensions like delivery and dessert kiosks is strengthening our appeal as a convenient brand.
Sales from our delivery business continue to grow at a double-digit pace. And while about 30% of the total restaurants in China offer delivery, these restaurants are concentrated in our key cities and offer additional customer benefits such as minimum delivery times and 24-hour service.
We continue to see significant growth potential throughout APMEA. In China, we plan to open about 300 new restaurants this year. We also continue to accelerate our franchising efforts; about 15% of restaurants in China are franchised as of the end of the quarter and we are on track to achieve our mid-term target of 20% to 25% franchise restaurants.
In Australia, recent comparable sales are negative due in part to the shift and timing of the monopoly promotion this year. The market is enhancing its affordability platform by adding new meal bundles to the Loose Change menu to strengthen our value offer and remind customers that we have something for everyone.
Japan continues to experience negative comparable sales in guest count trends amid a highly competitive environment. Looking ahead, Japan is focused on offering more relevant food and beverage choices, increasing the focus on the family business and repositioning the affordability platform to rebuild our customer connection and stabilize our performance.
As we look forward, the market is also monitoring consumer reaction to the 3% consumption tax increase that occurred on April 1st. Around the world, we’re working hard to ensure our actions are driven by what our customers want and need from us today and tomorrow. As our business continues to generate significant levels of cash, our philosophy regarding the use of cash remains unchanged.
Our first priority is to reinvest in the business to capitalize on the sizeable long-term growth opportunities that exist. And after reinvesting in the business, we’re committed to returning all of our free cash flow to shareholders through dividends and share repurchases. In the first quarter, we returned $1.2 billion to shareholders through dividend and share repurchases combined.
I want to close by reemphasizing my confidence in McDonald’s future. Approximately 70 million customers per day across a geographically diverse portfolio of over 35,000 restaurants is a very strong foundation from which we operate. Our infrastructure and our fundamentals are sound. We’re leveraging the power of our proven business model, our investments in restaurant capabilities and modernization and our hard earned competitive advantages to pursue the sizable opportunities that are before us.
At the same time, we’re thoughtfully evolving our approach to remain relevant, making appropriate adjustments to navigate near term challenges while driving enduring profitable growth for our system and for our shareholders over the long term. Thanks again everyone, and I will now turn it over to Pete.
Thanks, Don, and hello, everyone. The McDonald’s system entered the year with the realistic view of our near term opportunities get a firm focus on our path to long term success. We are diligently managing those things within our control while continuing to position the McDonald’s system for future growth.
The battle for market share is expected to persist given projections for flat to modest category growth in our major markets this year. But over the long term the $1.2 trillion global and formal leading out category should grow more significantly, and I expect McDonald’s to fully participate in that growth.
One of the reasons I am confident in McDonald’s future is the strong phase off of which we operate. First quarter results were in line with our expectations and highlighted the resiliency of our system and financial model. Though top line growth was challenged, McDonald’s generated $1.9 billion of operating income. This is an impressive number. But I am even more encouraged by the significant long term opportunities we see to drive future growth.
Turning to first quarter performance. We are primarily a franchiser with 81% of our global restaurants franchised; as such our profitability is driven primarily by top line performance. Modest comparable sales growth combined with higher expenses and lower gains from sales of restaurants contributed to a 60 basis point decline in our combined operating margin to 28.9% through March. The largest component of operating income is our franchise margins, representing approximately 70% of total restaurant margin dollars, franchise margins which are driven by a relatively steady and predictable stream of rent and royalties grew to approximately $1.8 billion in the first quarter, a 3% constant currency increase driven primarily by expansion. The consolidated franchise margin percent decreased 60 basis points to 81.1%, highlighting the need for stronger comparable sales gains to offset increased expenses and maintain this margin percent.
Global company operated margin dollars grew to $723 million while the margin percent decreased 10 basis points to 16.1% due to higher labor, commodity and occupancy cost which were offset by positive comparable sales. In the U.S. company operated margins decreased 10 basis points to 17.3% as the positive impact from higher average check primarily driven by pricing was offset by negative guest counts and higher commodity and crew labor costs.
First quarter commodity cost in the U.S. rose nearly 3% driven primarily by higher protein cost. We expect similar pressure in second quarter than easing throughout the second half of the year. The full year outlook for the U.S. grocery basket remains a 1% to 2% increase.
At the end of March the price increase in the U.S. was about 3% higher versus a year ago. While the food away from home inflation index is 2.3% through March, it is projected to be up 2.5% to 3.5% for the full year. In addition we have seen more significant increases over the past two months in food at home inflation which is also projected to increase 2.5% to 3.5% for the full year. We watch these indices closely, yet are also mindful of cost pressures not only in 2014 but next year as well, when making our pricing decisions.
Turning to Europe, company operated margins increased 30 basis points to 17%, as strong performance in France and the UK was partially offset by higher commodity costs in Russia due to the impact of the weaker Russian ruble on import cost. Europe’s grocery bill was relatively flat in the first quarter and we expect more pressure in the second half of the year with the full year increase still projected at 1% to 2%. And across Europe, the average menu price increase excluding Russia is about 2%.
In Asia Pacific, Middle East and Africa, company-operated margins declined 60 basis points to 14% as positive comparable sales were offset by higher labor, occupancy, and other costs, while the margin percent grew in several markets including China and Australia refranchising in Australia and the weaker Australian dollar negatively impacted the segment’s overall margin percentage. In addition, the new restaurant openings primarily in China contributed to the lower margin percent, though to a lesser extent than in 2013.
G&A for the quarter increased 4% in constant currencies. Over half of this increase was due to our sponsorship of the Winter Olympic and parallel Olympic games in Sochi. We expect to experience a more significant G&A increase next quarter due to our worldwide convention and cost related to other initiatives such as restaurant growth, capacity enhancements and our digital capabilities.
First quarter effective tax rate was 32.4% and represented a significant increase versus the prior year rate of 30.1% which was aided by a tax benefit of nearly $50 million. We continue to project the 2014 full year rate to be between 31% and 33%. We [already] committed to investing in our business to drive future growth and returns, we allocate capital in a discipline measured way opening new units across a diversified portfolio of markets, while making prudent investments in existing restaurants.
We are on track to open 1,500 to 1,600 new restaurants this year, including about 500 in affiliated and developmental licensee markets. We also expect to reimage over a 1,000 existing restaurants. The rollout of the new kitchen equipment in the U.S. is progressing nicely and we are on track to have it installed in all restaurants by mid-year.
As I discussed at a couple of investor conferences last month, we are moving with more urgency to address recent financial performance in our priority markets. In addition to these efforts which Don covered we're actively looking at ways to improve shareholder returns by optimizing our capital structure, while maintaining our long term financial strength; optimizing our ownership structure including certain refranchising activities especially in markets outside of the U.S. and scrutinizing ongoing G&A while appropriately supporting our franchisees and our growth initiatives. As I said at the conferences these additional areas of focus do not represent a change in strategy or financial philosophy, they fit squarely within our business model.
We are not beginning with a given target in any of these areas, but instead are evaluating them with the ultimate screen of creating value by doing what is right for the business over the long-term.
Financial discipline has been a cornerstone of a plan to win and that certainly will continue because I believe a strong financial foundation is a critical component to building enduring profitable growth.
It's premature to comment on any specifics, but we expect to provide an update on our progress over the next couple of months.
Lastly, let me touch on foreign currency translation, which negatively impacted first quarter results by $0.03. At current rates including the stronger euro, we expect second quarter EPS to be minimally impacted with a full year negative impact of about $0.03 to $0.04. As usual, this is directional guidance only, because I know rates will change as we move throughout the year.
In closing, I'm confident in our fundamental business model and our competitive position. We're the global leader in a $1.2 trillion industry, yet have less than 8% market share providing significant opportunity for future growth.
Our geographically diversified portfolio and various ownership structures allow us to optimize our investments within a market. We are aligned with our outstanding owner operators and suppliers to leverage our distinct competitive advantages. And we are making strategic investments today to seize those opportunities to create long-term value for our customers, shareholders and the entire McDonald’s system. Thanks.
Now I’ll turn it over to Kathy to begin our Q&A.
Thanks Pete. We’re going to open the call now for analysts and investor questions. (Operator Instructions). So, our first question is from Joe Buckley of Bank of America Merrill Lynch.
Joe Buckley - Bank of America Merrill Lynch
Thank you. Could you give us a little bit more color on the U.S. kitchen assembly prep tables, maybe how many stores have them currently and I know you said you expected the rollout to be complete by mid-year, but also in addition to the number, since what you’ve learned so far in terms of speed to service or greater product assortment to variety?
Hi Joe, this is Don. Just a little bit on the prep tables. The high density prep tables and I think that’s what you’re talking about relative to the kitchen changes in the U.S. are really, they are key enabler for the future menu and the reason that they are is that they give us a few things we don’t have today. One of those being room to add more ingredients another being [material well] which enables us to include fresh ingredients. It also helps us relative to the way that the kitchens are structured so that we have a mere image of time and it’s on both sides of our preparation table. And we won’t have to ergonomically; you won’t have to reach across the table for our crew to be able to prepare some of our foods, our sandwiches and our products.
These things together really help support our future vision of the menu and that doesn’t necessarily mean that we are going to add a lot of things, but what it does means is it gives us the capability to optimize some of the products we have and it gives us the flexibility to have some new toppings that will help us to be able to customize some of the food products that we have. The U.S. is on track to meet its completion goal by mid-year and it’s going quite well.
In addition to that Joe, the other thing that the U.S. is doing now and I mentioned it in my comments is what we call is reset, which is focusing back on staffing and scheduling and positioning. This is really, really critical because at this point in time and with the volumes that we have in the restaurant, we want to make sure that we can handle the peak hour capacities that hit the restaurants.
And so, a combination of those things with the way that we’re rationalizing the menu to make sure we are not implementing too many new products with a better balance of focusing on the core and new products those things all together are really what this major focus in the U.S. is right now and it’s kind of a back to the basics with some enhancements in terms of our productivity and capability in the restaurants.
Our next question is from Brian Bittner from Oppenheimer.
Brian Bittner - Oppenheimer
Thank you. It just feels like the biggest opportunity here in the near-term is Europe, it’s 40% of profit contribution very similar to the U.S. and your operating profit did decline in the U.S. and APMEA, but it was positive 6% in Europe and I think this was despite your largest European market Germany being negative. And so, just focus on Germany for a second, tell us really what you think is going on that can help turnaround some of those self inflected balloons in that country? And really I just feel if Germany gets turn Europe can really accelerate from here and therefore the profits of the company can really accelerate from here. So, if you could just focus on Germany for a moment that will be helpful?
Absolutely Brian, so a couple of things in a broader set. As we talked about the key priority markets and I mentioned some of things that we saw relative to commonalities. And those things really are what I will consider to be a translation of consumer insights into the action plans very strong and making sure that we are not trying to merely drive profitability on the end, but we’re focused on customers and the insights around customers.
There are several things relative to Germany and these things are being addressed now by the leadership team that’s there. One is Germany is a very price sensitive market. And if we look at our performance, we have a couple of main issues; one being our core EVM movement and from a competitive perspective actually the bakeries in Germany are doing quite well.
What customers have mentioned to us is that there is several things that we need to focus on; one is to reestablish our relevance because our menu boards have done a little bit out of whack. What I mean by that we’ve implemented a lot of new products similar to some of the implementations in the U.S. system and it really has confused customers to a certain extent.
The other thing has to do with our pricing and our strategic relationship on the menu board. And this basically is the relationship between the value-based components and the rest of the limited time offers and the core EVMs. We’ve got to make sure that there is a much more rational and strategic pricing structure our teams are working on that. And lastly is the balancing of marketing and that is the balance between our core menu that I’ve talked about with Big Macs, Royales or Quarters, fries, how we leverage and talk about those things along with value along with limited time offers, offers like the (inaudible) products in Germany.
And so, the combination of having a consistent balance there with having a consistent messaging around affordability and also making sure that we reestablished the relevance particularly with the offers we convey via our menu boards and marketing are the things the market’s focused on.
As we were having our session in Germany it’s clear that the new leadership team that we have in place there is focused on these things. We also had a chance to meet with the franchisees in the Germany. They are very understanding of the situation that we’re in there. And frankly one of the things that galvanizes McDonald’s system is when you have poor performance and an impacted cash flow. And I know that our franchisees along with our company team there and it is a new team are all focused on improving the situation there and improving our aggressiveness in the marketplace.
Next question is from John Glass from Morgan Stanley.
John Glass - Morgan Stanley
Thanks. Pete when you talked about optimizing the business model little more, can you of the three big buckets you’ve outlined, which do you think is going to have the biggest impact or potentially the biggest impact to shareholder returns? And can you talk about how you plan to convey this information, is it in next quarter or is it inter-quarter and is this the whole plan or is it just kind of an update, we’ll get a lot of these updates along the way?
All right, good question John. I think you have to take -- the three levers that I mentioned, you really have to take those in combination with what Don said in his comments about the focus on the four priority markets. So, taking all of that together is really, the combination of all of that is what’s going to drive the value over the long-term for shareholders and the system, not anyone of those items in isolation.
And as Don mentioned, to turn the sales trends line in those big markets, it’s going to take a little bit of time. And so, as we look at what else is there within our business model that in the meantime we can do to be accretive to value, looking at opportunities on the balance sheet as we said though we want to maintain that single A rating that’s been a cornerstone of our business model over the last 50 plus years and is an important piece of our financial strength and flexibility.
Refranchising; at 81% franchised obviously that’s our primary method of doing business. While we’ve done refranchising over the last couple of years, we think there is opportunities to accelerate that. And so, of the financial lever, that's probably the one that has the most opportunity to drive value. And that by its nature is going to be a multi-year plan when we talk about the details. It's going to be a multi-year plan and it's really primarily focused outside the U.S. And, but it's also prudent for us to take a look at our G&A spend especially as we know there are growth opportunities in areas like digital where we want to allocate more funds and rather than have all of that be incremental, we're looking for ways to reallocate so that we can finance those and live within a certain G&A envelope.
So, you can expect to hear from us by the end of the second quarter. And I think what you'd expect to hear is something broadly that covers kind of all of those areas and not just one or two of the specifics.
Next question is from Jeff Farmer from Wells Fargo.
Jeff Farmer - Wells Fargo
Great, thanks. Good morning. What are the opportunities you see at breakfast? Have you increasingly focused on a day part as a potential same-store sales driver? It seems like it's been, your attention there has been up to a little bit here recently?
Thanks Jeff. First of all relative to breakfast, I mentioned in my comments, customers choose breakfast at McDonald’s because our breakfast tastes great. It has very, very high consumer score, freshly prepared products every morning as I mentioned, we actually crack eggs, we cook in our restaurants. This is not a microwave deal, we actually cook. We have grills and fryers and ovens. And so that's the reason that we're able to prepare breakfast.
The other thing is our breakfast model is also focused on how we serve up that breakfast, quickly the customers that are on the go. And so, we continue to focus on those areas of strength that we have. And we have been serving breakfast now for over 30 years and it is our strongest, one of our strongest dayparts clearly, clearly one of the strongest from a profitability perspective, the strongest. And so we will continue to focus on our breakfast opportunities. The U.S. is focused today primarily on breakfast be a coffee and then our handheld sandwiches that we have at breakfast and also on some of the quality and freshness use that I have just talked about.
And so those things will continue to focus on, continue to focus on the operational opportunities we have there in staffing and the scheduling and positioning of breakfast as well.
Next question is from David Tarantino from Baird.
David Tarantino - Baird
Hi, good morning. Just one quick clarification on the last question, then a separate question. First, on the breakfast sort of initiative or focus there; is that being done in response to this competitive activity, for example, the Taco Bell launch and maybe could you comment on whether that is having an impact on your business or not? And then the second question comes back to the focus on the reset initiative in the U.S. And it sounds like maybe some of the initiative there is focused on better handling the complexity, but one of the things that you haven’t talked about is whether you’d be interested in reducing some of the menu complexity to sort of fine-tune the operations and whether or not that’s an opportunity; so perhaps could you comment on that as well? Thanks.
Thanks David. Just a couple of points, one is there has been breakfast competition for a number of years in the U.S. market. And we’ve had some of our major competitors that may run at breakfast and seems every year there is a someone new that is making a run and none of them have really stopped their focus on breakfast, whether that’d will be the closer end and competitors or if that’s sandwich shops or that’s taco shops or anything else. Everyone has an opportunity and they wanted to look at breakfast.
We have not seen an impact relative to the most recent competitors that entered the space. One of the things that happens at breakfast if anyone enters, customers would try the breakfast that it’s new, it will be something that they have not seen in the marketplace. So we expect customers to try. But what we also are confident in is our ability to execute at breakfast with again the things that I mentioned relative to being a restaurant to cooks and we have a delivery service that’s capable of satisfying the time need if you would of consumers.
I think that new entrants into the market always bring a different level of attention to breakfast which in many cases supports us. Our breakfast continues to be a positive driver in our business in the U.S. And actually sometimes when these entrants come in, it forces us to focus even more on being aggressive relative to breakfast. I know you have just recently seen the coffee execution in the U.S. and our free coffee offers which really are about supporting our breakfast and supporting our breakfast foods as much as they are about reintroducing Americans to a delicious cup of McCafe coffee. So those are the things we do there.
On the reset end, I did mention in my comments a bit about reducing, potentially this reduces the complexity. When you have a number of builds in the restaurant, basically what you are doing is you are leveraging the various condiments and products in the restaurant to build those sandwiches. If you can go to a more streamlined menu board approach and then still have those comments or condiments, so the customers can customize a bit,, it will help in terms of reducing if you will, complexity. Having said that though, customers want very taste. And so we need to be able to deliver that. They also want familiar favorites like the Big Macs and Quarter Pounders, Filet-O-Fish, Nuggets price and we need to be able to deliver on that. And we will be able to do both of those things the system that the U.S. is putting in place on reset just calls us back to a basic operations focus on our restaurant. And it helps us to enable better productivity with some of the things such as the high-density prep table and the high-density kitchen set as we have.
Next question is from David Palmer from RBC.
David Palmer - RBC
Good morning. In your prepared remarks, you mentioned that you’re strengthening your planning process to effectively bridge consumer insights with the right customer centric plans and marketing. I am curious about what that means, have we already seen the fruits of these changes in your marketing, are big changes coming soon, perhaps you can give us a sense of what you think is the marketing opportunity after some self diagnosis? Thanks.
Several different points, thanks David for the question, several points mentioned. On the consumer insights, we have tremendous amounts of data within the McDonald's system. Question is whether the data is then being translated directly to the specific action plans that we see being executed in the marketplace. And that is a combined effort between the franchisees and the market our leadership teams and our supply chain and our supply chain leaders. So we’ve got to make sure that we’re translating those consumer insights.
The whole notion here is that you can’t be driven based upon optimizing profitability, even in the face of external pressures relative to the P&L. We still got to remain grounded in the consumers and that is what we saw at some slight gaps on the priority market. So we’ve got to get back to that consumer focus while mindful of some of these additional cost pressures to make sure that the plans are robust enough. But that is combined with several other things that I mentioned, one is the marketing messages. So if we are more streamlined and focused relative to this consumer insights to action plan, then the marketing focus and the messages won’t be so disbarred. And what we’ll be able to do is focus that strength and highlight that strength a little bit more solidly.
The other thing that we saw was that affordability is one of those things that tends to get a little bit of less focus in tougher times and so in many of the markets, we fell off of our affordability messaging a bit, in some of the markets they are coming back on that. And then the core menu balance, we were chasing a few too many limited time offers. So for these primary focal markets, this is going to take time. I mean our planning process, you know us well, we plan with the franchisees and we plan not just two or three months ahead, we plan six months, nine months and usually a year ahead of time.
So it’s going to take a while to see some of these things layered in. But it is about a series of multiple initiatives, it’s not a silver bullet and these things will take a bit of time. But I feel confident that our markets now are focused on leveraging the right processes, incorporating the right discussion points with the franchisees and moving the business for the long term in the appropriate manner.
Next question is from Jason West from Deutsche Bank.
Jason West - Deutsche Bank
Thanks. Just one around the overall portfolio review, as part of also looking at CapEx and organic growth rate that’s been picking up a little bit the last few years, and I know you guys taking a harder look at whether that’s the right growth rate for the business and the right CapEx spend for the business?
Jason, an outcome, so the refranchising plans are being built up market by market. So as we said, we didn’t start this with a particular targeted mind, but we want the markets to come back to us based on their knowledge of franchisees, their local business environment, their growth potential et cetera and come back to us with a more aggressive refranchising plan than they have today. And certainly one of the outcomes of that will be, as we get more franchised that is less capital intensive. So, it will allow us to grow at the same pace, at this pace that we’ve been growing at 2.5% to 3% new units with less capital.
And so, it is definitely an outcome, it’s not the primary objective of looking at the refranchising, but it is certainly an outcome, it makes us a little less capital intensive. But it also makes, it converts that a company operated earning stream into the more stable and predictable rent and royalty franchising income stream which we think is the most valuable piece of all of this.
Next question is from Will Slabaugh from Stephens.
Will Slabaugh - Stephens
Yes, thanks guys. Regarding the U.S., can you talk about how you’d gauge the customer reaction so far at the Dollar Menu and More? And how you think you’re positioned there versus your peers to lower end? And at the same time, could you kind of talk about that in the context of necessity there for a dramatic innovation to premium end as a big lever or is it at pressing in the near term at least as driving value and getting people in the door through your value proposition there?
Okay. I want to make sure, I kissed the last part of that again possibility, Will, but I’ll give this is shot. Relative to Dollar Menu and more, again stepping back relative to value menu in the U.S. during roughly the last 10, 12 year history, the U.S. has evolved the Dollar Menu to ensure the menu offers our liable customer preferences several times. Those changes have been made over this 10 year period to make sure we stay relevant. But we’re also mindful of the profitability aspects and the execution aspects of these menus within the restaurant. And we want to make sure that we provide the right things for our customers and we can do that over a sustained period of time.
So, when we look at Dollar Menu and More, it is another of those evolutions. Dollar Menu and More as a percent of total day sales seems to be relatively in line with our historical averages. And we’re not seeing any dramatic change to the usage of Dollar Menu and More. And so right at this point in time Dollar Menu and More has performed to the expectations that we have had.
I think the last part Will that you have mentioned was relative to, with the relative to premium products and the role that premium products played, I would say is there is a balance between what we just talked about with affordability Dollar Menu and More our core menu offerings and our premium base products.
So when you see Clubhouse Burger in one of the local window -- one of the national windows you will probably see coming up in a local window, it maybe some mentions of breakfast, maybe some mentions of affordability or mentions of a limited time offer product. So Clubhouse Burger work grade nationally which you will also have to marry that along with some of the value messaging, you will also hear some beverage messaging and breakfast messaging.
So that marketing calendar has to accommodate all of those, there is definitely a place for new food and innovation, new beverages and innovation, we just want to be mindful of the core offerings we have giving them the appropriate leverage in the marketing calendar as well as dayparts like breakfast.
Next question is from Matt DiFrisco from Buckingham Research.
Matt DiFrisco - Buckingham Research
Thank you. My question is with respect to the price and I wanted to know how that might look with obviously a lot of states having some minimum wage and California going up to increasing their minimum wage over a couple of years here. In your planning process, is that 3% price that you mentioned domestically being held, is that what we will see carried out and already assumes to absorb some of that minimum wage or is there an ongoing dialogue with franchisees as far as what type of minimum wage response they might have?
Yeah, Matt. You know there are actually 13 states at the beginning of the year that raised their minimum wage anywhere from $0.10 to a $1. And that’s before any potential federal minimum wage impact. So as I mentioned in my remarks we look at the traditional indices that tend to guide our pricing decision. So food away from home projected to be up 2.5 to 3.5 this year. I think inherent in that is you do see franchisees generally around the industry not just McDonald’s anticipating some of these higher input costs. So they have got what the states have already enacted today. They have got the discussion about a potential at the federal level for a lot of them, the healthcare mandate kicks-in in 2015 so they have to be mindful of that. So these cost pressures are definitely on everyone’s mind as you think pricing, yet as Don mentioned you have to strike that right balance between everyday affordability and providing them premium products that will drive them into the restaurant as well. But as we get too focused on individual profitability and less focused on the customer that’s when we start to run into some of these challenges.
Our next question is from Jeff Bernstein from Barclays.
Jeff Bernstein - Barclays
Great, thank you very much. Just focused on the U.S. business and the competitive environment perhaps obviously ex the weather and I think you have talked about kind of the QSR promotional activity kind of ramping up, I know you mentioned the free coffee promotion; you guys are doing more locally perhaps we have seen kind of buy one get one Big Mac type products. So I am just wondering whether you could talk first and foremost just about the competitive environment specially with you guys having perhaps lowest share to some of your competitors over the past couple of quarters. And as it relates to that, the breakfast which it seems like so far so good that it’s fairly steady at I believe you said roughly 25% of sale I am just wondering if you can give us some insight that we don’t perhaps have on the broader category and maybe how the category is growing relative to how your 25% has grown or contracted over the past year or so? Thanks.
Thanks Jeff. I will try to answer; I think you got about four or five different questions in there, buddy. But the first one relative to the U.S., U.S. comparable sales trend stabilized during the first quarter of ‘14 and we saw sequential improvement in our reported results comp results, as well as narrowing of the gap to the QSR sandwich competitive set. And excluding the impact of this year’s severe winter weather, our U.S. comparable sales for the first quarter would have been relatively flat. We had about 1.4%, a little over 1.4% impact due to weather, which we don’t often talk about weather because you know next year one it’s much better, we probably won’t talk about it either, but truth of the matter is it did have some level of impact to us, but for you I will put that in the appropriate perspective. We don’t plan around weather at McDonald’s, we plan around customers.
A couple of other things; we continue to see some, the IEO industry in the U.S. is still relatively flat. So, we know that there is going to be a market share battle, so we’ve got to focus on those things that our customers are focused on and desire. So in the U.S. there is a focus around breakfast and coffee as I mentioned, there is focused on balancing our core menu along with some of the limited time offers like you just saw with the Clubhouse Burger and Chicken Sandwich. And we’ve got this basic focus on operations to ensure that we can satisfy the needs of customers particularly during the peak hours.
So that gives you a pretty overall perspective I’d say of our U.S. business and the state of that. From a breakfast perspective, I mentioned it a little bit earlier, our breakfast is strong and it continues to be a solid performer relative to our overall day part segments. And what we want to make sure is that we just continue to focus on the strengths that we have. And actually we have not talked as much about the quality aspects of our breakfast, we haven’t talked as much about the fact that we have restaurant business that cooks. There are entrants into the marketplace that don’t have the same capabilities we have. And so we're going to leverage the strengths that we have and leverage the capabilities we have to inform customers of the fact why we’ve been in the breakfast business for over 30 years and why we have become America’s favorite place to eat breakfast and we don’t plan on giving that up.
Next question is from Sara Senatore from Sanford Bernstein.
Sara Senatore - Sanford Bernstein
Thank you very much. I just want to follow-up on the U.S. business and in particular in the context of some of the commentary about maybe focusing on profitability, maybe the expenses resonating with customers. So, can you just talk a little bit about the margin structure there? First, is it still the case that you need a 3% comp to lever expenses, should it be higher because it sounds like you are looking more for traffic driven comp? And then I guess what’s the right margin, company-operated over the long-term, if I look back 20, 25 years it’s averaged something close to 18% in U.S. and Europe. Do you see anything that suggest it should go up or down from here or structurally just that is going to change with your margins? Thanks.
Hi Sara. I just want to make a quick comment and then I’ll turn this over to Pete on margins. First of all, we have a fantastic group of franchisees in the U.S. business. Matter of fact, next week we have our worldwide [convention] where our franchisees from around the world will be there and we're looking forward to the dialogue and discussions we’ll have.
So when we talk about profitability, what we're talking about is very viable businessman and businesswomen who look at the overall environment and are looking at some of the implications of commodities along with legislative pressures and then they will make decisions relative to their businesses.
So, if we talk about a focus, losing a bit of the focus on the customer, it’s not because we don’t have solid business people or we have people that are trying to squeeze the business, they are looking at the overall perspectives of profitability, which they should do. What we've got to make sure is that our focus relative to profitability starts and ends with a customer focus and those visits to the restaurant and that's why we talk about the balanced plans. So I just wanted to reiterate that fact, I don't think we could have better franchisees, but just like us within the company, we've got to make sure that we all stay focused on the customers.
And in terms of the company-operated margins, Sara, we've historically said in a normal environment and we've defined that as being kind of a 2% to 3% inflationary environment. In that kind of normal environment, we need a 2% to 3% comp to maintain margins. And our assumption in that is that half of that comp is coming from check and half of that is coming from traffic. And so, what you saw this quarter is we've got a disproportionate share, the comp was negative, while we had over 3% price increase.
So, we had a disproportionate impact of the price increase this quarter is why you saw margins down only 10 basis points. So, we, as Don mentioned in those four priority markets getting the sales and guest count trend lines stabilize and going back positive is what's going to have the most significant impact on our margins.
We've always stayed at the top-line gain and we really need that comparable sales growth and the traffic growth to be able to benefit and leverage that profitability. So that's our focus and really there has been no structural change that would cause us to believe that overtime we can't continue to grow those margins as long as we're generating those positive comps.
Your next question is from Karen Holthouse from Credit Suisse.
Karen Holthouse - Credit Suisse
Hi. What are the -- in your prepared comments you mentioned there is going to be some increased investments on the digital side in G&A and how does that maybe relate to some of the things we’ve seen in the past about testing for mobile app or what sort of form some of that medium or longer term digital initiatives might add, what sort of form they might take?
Thanks for the question, Karen. Relative to our overall digital strategy, this is something that we have been looking in many of our markets around the world for some time. However, it’s not been what I would say a systemic strategy where we’ve leveraged the overall strength of McDonald’s.
So, our digital vision is to bring in entirely new level of convenience and fun to the McDonald’s experience. And what we have done to be able to move that forward is identify a couple of areas about opportunity relative to that digital strategy one is the field -- really around experience and the fact that technology can enable us to enhance the customer interactions with our brand and many people would know of that by payment, ordering, redemption type opportunities, as well as customer relationship management.
The second area is an area of engagement; it’s really how we engage customers both with us telling the story of some of the things we mentioned, the quality, messages around McDonald’s, the opportunities within the McDonald’s system, as well as our marketing campaigns and engaging social media to a stronger level.
So, we are going to continue to do that. And from a global strategy perspective it’s really a framework that then allows the local markets to be able to move forward more effectively, will also leverage the strength of McDonald’s system globally relative to our strategic partners as we move forward.
So, we’ve got several markets that are test markets around the world and we are leveraging from the things that they’ve already done. And we are really looking to be able to scale the best ideas we have while those things are then combined with some of the global strategies and strategic partners that we have that are much larger in terms of their scope to help us along on our digital journey.
Our next question is from John Ivankoe from JP Morgan.
John Ivankoe - JP Morgan
Great. Hi, thank you. I think at this point just wanted to tie a couple of things up. Don, I don’t think anyone either within McDonald’s or outside of McDonald’s would have said that you are an organization that was not run without consumer insights over the last two years. In other words, you have always been a consumer insight driven company. So I just wanted to get a sense from your perspective what really will change quantitative, qualitative, what have you over the next couple of years? And maybe with that you mentioned, you have answered to a question in terms of how you plan with franchisees over a 6 or 12 month period in terms of products and promotions what have you. So not necessarily in terms of the cost of G&A but maybe how that G&A is being spent, is there a possibility of changing the way that decisions are made in the speed of which various decision are implemented at a market? In other words, do you need to change kind of your entire decision making process and how things get implemented at the store level as we are clearly in the market that’s moving much faster than it was over the past decade or so?
Thanks for the question, John. We will always remain focused on being locally relevant. And that’s the reason we have as you know John some of the market teams out there in the field, and they do a great job. And that is also to help us move quicker. So when it comes to many things at a local level, that’s the way we will continue to operate by leveraging those local teams and the local insights on consumers.
You asked a question about whether or not things have changed relative to consumer insights and data, we have always had data, we’ve always attempted to leverage those insights, as we put forward the plans. The only thing that’s different, and we’ve been through this in cycles is that when you have external pressures, a number of them, sometimes our focus can shift a little bit more to how we ultimately will drive profitability at a restaurant level to handle some of those cost structures, and we lose a little bit of the front-end of those insights. And as a result, we focus more on the margin side of the business than we do on the guest count side of the business. And we know guest counts correlate to our overall results of profitability.
So all we’re saying that’s happening in the markets, now is a refocusing on that front-end of the insights and a refocusing on how those insights need to translate to plans that are customer focused. First, we always will have the profitability aspects in mind as we plan but it’s got to be customer focused first. And all of the markets and our franchisees are well aware of this, but it can happen in cycles and when it does, we just have to make sure we call that out and we go back to the drawing board around how we move this business based on customers.
And our last question is from Andy Barish from Jefferies.
Alex Chan - Jefferies
Hey guys, it’s Alex on for Andy. I want to go back to the European business and ask you a little bit more about Russia and whether or not you saw any impact from the political unrest in the region and how that business is trending and if anything is kind of changed there in terms of the strategy with respect to value and premium products.
Thanks Alex, Pete and I will kind of double team this one a little bit. First part relative to Russia, one of the things at McDonald's, and we’ve done this in all of the markets around the world. First and foremost will always be the safety of our employees and our guests. That is of the highest level importance to us. There has been no major incidents related to their safety in these current markets whether it’d be Russia or the Ukraine or Crimea or anything has happened in the current situation. Our restaurants generally are operating as normal, some are temporarily adjusting that evening hours based on customer traffic and we have three restaurants in Crimea that have been closed due to suspension of necessary financial and banking services. And so that kind of gives you a state off relative to Russia. There are some financial impacts and currency impacts and I ask Pete to speak to those.
Yes, Alex. During the quarter, the ruble was down about 14% and it was down a little bit more subsequent to the quarter end. And why that’s relevant is Russia imports almost 50% of their food that they use in the restaurants and those imports are denominated, both in euro and U.S. dollar. So when the local currency devalues like that, they have a financial impact. So locally, they had a 200 basis point impact to their margins in Russia from the devaluation that translated into about a 55 basis point impact on total Europe company operated margin solely from the devaluation. So if you assume the ruble is going to stay at this depressed level the rest of the year, that’s something we’re going to be battling with for the rest of the year in our European margins.
That said, Russia has some of the most profitable restaurants around the system, so they are about 10% of our consolidated margins but they are less than 5% of our overall operating income. So in the grand scheme of things to the overall profitability, they are less than 5% but they do impact the margin line somewhat disproportionately because of those imports and because of the high volumes and the high margin they do run.
Okay. That’s all for Q&A. And I’m going to turn it over to Don for a few final closing thoughts.
Thanks everyone again. And as we wrap up this morning’s call, I just want to make a couple of comments about where we are positioned as McDonald’s and where I see us? We remain committed to our strategies as we make thoughtful decisions to mitigate some of the short-term pressures and grow this business over the long-term. This has been consistent in terms of our approach, I have even more energy and passion around it today than I did 23 years ago, when I joined the company, because I know that this is a solid leadership team and we’re well aware of what it is we need to accomplish.
I’m confident about our future; we have defensible competitive advantages, some of those we’ve talked about; our resilient model, and the alignment across our owner operators, our suppliers and our company teams to drive enduring profitable growth for our shareholders and our system.
So, I thank all of you for your participation and for your thoughts about McDonald’s and we hope that you have a great day. Thanks again.
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