Q3 2010 Earnings Call
October 21, 2010 11:00 am ET
Jim Skinner - Vice Chairman, Chief Executive Officer and Chairman of Executive Committee
Peter Bensen - Chief Financial Officer and Corporate Executive Vice President
Donald Thompson - President and Chief Operating Officer
Mary Kay Shaw - Vice President of Investor Relations
Joshua Long - Stephens Inc
Mitchell Speiser - Buckingham Research
Peter Saleh - Telsey Advisory Group
Hello, and welcome to McDonald's October 21, 2010 Investor Conference Call. [Operator Instructions] I'd now like to turn the conference over to Ms. Mary Kay Shaw, Vice President of Investor Relations for McDonald's Corporation. Ms. Shaw, you may begin.
Mary Kay Shaw
Thank you. Hello everyone and thanks for joining us. With me on the call today are Chief Executive Officer Jim Skinner; Chief Financial Officer Pete Bensen; and for Q&A, Chief Operating Officer, Don Thompson will be joining us via phone from Mexico where we are celebrating our 25th anniversary.
Today's conference call is being webcast live and recorded for replay via phone, webcast and podcast. Before I turn it over to Jim, I want to remind everyone that, as always, the forward-looking statements in our earnings release and 8-K filing also apply to our comments. Those documents are available on investor.mcdonalds.com as are reconciliations of any non-GAAP financial measures mentioned on today's call with their corresponding GAAP measures.
And now, I'll turn it over to Jim.
Thank you, Mary Kay, and good morning, everyone. I'm pleased to share McDonald's latest business results that reflect our continued global strength. For the third quarter, global comparable sales were up 6%. Operating income increased 11% on constant currencies and earnings per share reached $1.29, a 15% increase in constant currencies.
Our momentum is continuing into October with global comparable sales expected to increase 5% to 6%. Our strength remains broad-based with each area of the world contributing to our growth. And we're continuing to grow market share in our major markets.
In an informal eating-out category that varies from markets that are in decline to markets that are just growing slightly. These results marked our 30th consecutive quarter of comparable sales increases and this is truly a testament to our ability to perform in any economy. We continue to deliver what our customers are looking for: great value, outstanding convenience, a modern restaurant experience and relevant menu offerings, with an emphasis on local taste. And it's all resonating with our customers.
In the United States, comparable sales for the quarter were up 5.3% and operating income grew 7%. And most important, we continue to significantly increase traffic into our restaurants.
On the big menu news, this summer was the extension of our Beverage platform with the launch of strawberry, banana and wild berry smoothies and the rehit of frappes. Sales from the smoothies launch well exceeded our expectations in both products are being purchased throughout the day. Both of these high-margin beverages continue to sell at a strong pace. U.S. also drove quarterly results with value across the menu including the continuation of our Breakfast Dollar Menu. And on the convenience front, we're continuing to be available for more guests more often with nearly 40% of our U.S. restaurants now open 24 hours and more than 80% open by 5:00 a.m. in the morning.
In August, we launched the Angus Snack Wrap line with three choices at $1.99. This new introduction performed very well and has lifted sales of our entire Angus Burger category.
Our new beverage and snack wrap platforms contributed to the trailing 12-month period ending in August and delivered the highest guests counts in more than 20 years in the U.S., even as the overall industry continued to be stagnant.
We're innovating and we're executing and it's giving more people more reasons to choose McDonald's. Our customers continue to give us permission to stretch our brand, and we're delivering at the quality, value and speed of McDonald's.
This month, we're featuring our core products of McCafé beverages through a monopoly tie-in with Walmart gift cards. And in November, we will advertise the always popular McRib on a national basis for a limited time, something we've not done for years.
Early next year, we will be launching oatmeal with maple brown sugar, apples, raisins and cranberries available all day. And in market test, our customers love the taste, nutrition profile and the expanded menu choice.
Now turning to Europe, we had another strong quarter. Comparable sales increased 4.1% and operating income grew 12% in constant currencies. Now while the overall informal eating-out category in Europe remained in decline, we continued to take share in all of our major markets.
The key driver of growth across Europe continues to be our focus on modernizing and elevating the customer experience. More than 2/3 of our restaurant interiors in Europe are now reimaged and provide an ever-more contemporary and relevant environment for our guests and the people working in our restaurants. Meanwhile, our customer satisfaction scores improved across the continent as we work to continually enhance our service with the biggest gains coming from drive-thru times and order accuracy.
Across Europe, we're striking the right blend of variety and choice, broadening our accessibility and appealing to a wide array of consumer segments. In Germany, for example, sales benefited from the launch of McWrap, a premium range of chicken and beef wrap sandwiches and, of course, everyday affordable pricing across the menu. Germany and many other markets feature a Coca-Cola glass promotion with the purchase of an Extra Value Meal driving some of our highest Extra Value Meal sales in history.
We also saw success with the reintroduction of menu favorites, the M sandwich in the U.K., a premium burger with Artisan bread and the popular Double Cheeseburger in France. The Beverage platform, while different than the U.S., also contributed to results. We've recently launched Frappes, Europe's enhanced milkshakes, in several markets including France and Switzerland where it is contributing to the growth of the snacking daypart. And we are now the largest seller of coffee in the U.K., as premium bean-to-cup and specialty coffees continue to attract the growing number of consumers especially when a great McDonald's breakfast is available to go along with it.
Looking ahead, we know the economic environment remains challenging with austerity measures continuing to be implemented. In January, the VAT will increase in the U.K., Holland and Portugal and others could follow. Yet we remain confident that our business model will endure. We expect our customer focus, menu pipeline and the ongoing modernization of our restaurants will continue to deliver long-term results.
Now looking to Asia-Pacific, Middle East and Africa, where we also achieved strong growth, comparable sales for the quarter increased 8.1% and operating income grew 15% in constant currencies. Results were strong across the segment with nearly half the markets delivering double-digit comparable sales increases. We're driving results through a focus on convenience, value and a balance of core and local offerings. Australia made gains with new menu items including a promotional addition to its extremely popular Angus platform. The new sandwich, Angus the Third featured the popular tomato chili relish and scored extremely well with our consumers.
The market also rolled out a new patty for all premium chicken sandwiches driving an increase in sales across the entire premium chicken category. The addition of the new Breakfast Roll and Breakfast Wrap helped grow comp sales and guests counts during the breakfast daypart. And Australia continued to focus on running better restaurants as it achieved some of its best service scores on record with improvements in drive-thru speed and accuracy leading the way.
Our other major markets in APMEA, China and Japan also delivered. Value continues to be a key driver. China's Value Lunch program remains popular and continues to grow sales and traffic. The Value Lunch is now moved into nearly every market in greater Asia and accounts for more than 10% of the total sales in the region.
Outstanding operations continue to drive growth and differentiate the experience in China with the market consistently achieving some of our best customer satisfaction scores. Our strategies in China are resonating with the consumers and our fundamentals are strong as evidenced by China's third quarter 12.7% comparable sales increase.
Meanwhile in Japan we remain competitive through relevant menu offerings and promotions. We delivered gains from a strong Big Mac campaign and a new lemon chicken sandwich, both of which proved extremely popular. Japanese consumers also reacted favorably to our recent Food Strap promotion which offered miniature models of our iconic products such as Big Mac and fries for customers to actually strap to their cell phones. The program was a huge hit and helped drive sales profits and new guests visits as we combined the popular local trend with the popularity of our iconic products.
Japan's other big win was the launch of its value breakfast featuring McDonald's Sausage McMuffin and Sausage McGriddle helping drive sales and revitalize our Breakfast business.
So those are a few of the highlights around our continued momentum. We're delivering the food and beverages our customers want and the value that they expect and an overall dining and brand experience that is modern, relevant and in step with our customers' lives.
We're also continuing our commitment to financial discipline. We have a strong balance sheet and the highest credit rating in the industry allowing continued access to capital. And it continues to facilitate access to credit for our owner/operators to reinvest in their restaurants.
We remain committed to returning all of our free cash flow over the long-term to investors through a combination of dividends and share repurchase. We recently announced an 11% increase in our quarterly cash dividend to $0.61 per share or the equivalent of $2.44 annually. Combined with share repurchases, we expected our total cash return to shareholders for 2010 to reach an approximation of $5 billion. Overall, I'm very pleased with our latest quarterly performance and confident that we'll continue to keep driving our business forward.
Now while it's been said by economists that the recession has technically ended and signs of progress are slowly emerging, the global economy remains fragile and consumers continue to be cautious. By continuing to innovate, invest and deliver what our customers want, we will continue to gain market share and grow our business. Thank you. And now I'll turn it over to Pete Bensen, our CFO.
Thanks, Jim. Hello, everyone. Third quarter marked yet another strong performance for the McDonald's system. Our alignment behind the Plan to Win again generated significant increases across all of our key measures: comparable sales and guests counts, market share, operating income and returns. Combined operating margin, our primary measure of overall profitability increased 150 basis points to 31.4% for the nine months. This is a direct result of growth in both our consolidated franchise margins and our company-operated margins along with effective G&A control.
In the U.S., the successful introduction of McCafe Smoothies in July and the ongoing demand for our core menu drove gains in both comparable sales and guest counts. While our pricing remains relatively flat versus a year ago, we are especially encouraged that our traffic growth was about 1.5x that of our comparable sales growth through September. Lower food and paper costs along with top line growth contributed to an increase in company-operated margins of 270 basis points to 22% in the third quarter.
Equally important, our U.S. franchisees are generating significant increases in their annual cash flow per restaurant, now averaging over $350,000, a 15% increase over a year ago. This speaks to the health of our overall business and contributes significantly to our operators' willingness and ability to reinvest in their restaurants.
On the cost side, our third quarter basket of goods in the U.S. decreased about 6%, contributing around 200 basis points to the margin expansion, similar to what we experienced in the first half of the year. However, the comparisons become unfavorable in the fourth quarter as we face a 1% to 2% increase in commodity cost compared with fourth quarter 2009. This still results in our overall food and paper costs being down 3% to 4% for the full year.
In Europe, the grocery bill declined to a more modest 1% in the third quarter. We now project commodity cost will be down 2% to 3% for the full year. This means that Europe will experience a slight increase in commodity cost in the fourth quarter compared with a decline of 3% in fourth quarter last year.
European company-operated margins increased 160 basis points in the third quarter to 22%. Comparable sales gains in Russia, the U.K., Spain and many other markets coupled with lower commodity costs were partly offset by higher labor costs. Menu prices increased an average of 2% to 3% across the segment over the past 12 months, but varied by market. As we head into the fourth quarter, some of these price increases will roll off and the current economic environment will impact our pricing power adding to short-term margin pressure, but nothing we haven't successfully navigated through before.
In Asia-Pacific, Middle East and Africa, company-operated margins increased 90 basis points to 18.9%. Positive comparative sales were partly offset by higher labor and other costs around the region. We have an effective price increase in APMEA of about 1% and similar to Europe, it varies by market.
Now turning to franchise margins. Third quarter franchise margin dollars rose to $1.7 billion, an increase of 9% in constant currencies. The consolidated franchise margin percent increased 60 basis points to 83.3% driven by positive global comparable sales.
The third component of combined operating margin is G&A which we continue to actively manage. For the third quarter, G&A was up slightly due in part to increased incentive compensation accruals based on our strong results. Fourth quarter G&A should be relatively flat resulting in a full year increase of about 3%.
On the other operating income line, similar to last quarter, we experienced lower gains on sales of restaurants in the third quarter compared with the prior year. More broadly speaking, the components of other operating income often include items such as gains, asset disposition costs, asset write-offs in part due to reimaging, and other unique items. Since many of these items are transactional in nature, it makes comparisons between certain quarters difficult. This was the case in the third quarter, and we also expect comparisons will be challenging in the fourth quarter where our current estimate for total other operating income is less than half of the $67 million recognized in fourth quarter 2009.
Let's now move on to something I know you're all very interested in, the cash generated from our operations. Our first priority for this cash is to reinvest in our business to build strong sales, profitability and returns. We have slightly trimmed our 2010 CapEx estimate from $2.4 billion to $2.3 billion, primarily due to currency translation and fewer completions of reimaging projects in the U.S. versus our original budget. This was a purposeful and strategic reduction which I will discuss in more detail in a moment.
Approximately half of our capital expenditures are spent on our existing restaurants. As we expect to reimage approximately 1,800 restaurants around the world this year, I wanted to provide you a brief update on the activities in our three major segments.
In the U.S., we have completed about 40 sites and expect another 350 restaurants to be reimaged within six months. We're being very deliberate in our approach, testing different designs, closely examining our costs, and making sure that we have adequate sales history post-reimaging to evaluate the returns. In short, we're focused on doing this right versus doing it quickly. While it is still early, given the relative small sample size and limited timeframe, preliminary results are in line with or better than our initial 6% to 7% incremental sales list estimates.
Most importantly, we're encouraged by the support of our owner/operators who are leading this transformation of this brand in the U.S. In Europe, we have reimaged about 500 restaurants through September primarily in our largest markets: France, the U.K. and Germany. Europe plans to have about 90% of its interiors remodeled by 2012. Exterior reimaging tends to take longer due to permitting time and other regulations.
In APMEA, we are leveraging some of the European designs and are focused on both interior and exterior remodels, particularly in China and Japan. Australia is virtually 100% reimaged.
In addition to reinvestment, we are spending the other half of our capital expenditures to open new restaurants. We are on track to open 1,000 new restaurants this year. Approximately half of these openings will be in APMEA including 150 to 175 in China. Another 250 new restaurants will be opened in Europe, primarily in Russia, France and Germany.
The U.S. has already opened about 100 restaurants, well on its way to a total of 150 new restaurants this year. And the remaining 100 restaurants will be opened in Latin America and Canada.
Now let's spend a few minutes talking foreign currency. As you know, exchange rates have changed significantly since I last updated you. At current rates, we now expect currency translation to negatively impact fourth quarter earnings per share by only $0.01 resulting in a full year benefit from currency translation of about $0.01.
As I have said before, current volatility renders any estimate outdated within days, so please take this as directional guidance only. As most of you know, we believe constant currency results provide a more complete picture of the underlying strength of our business.
In closing, I'm proud to say that the focused execution of our system behind the Plan to Win, the entrepreneurial power of our owner/operators who are widening the gap versus our competition, and our disciplined operational and financial controls continue to drive our business forward.
We will be entering 2011 from a position of strength. We remain confident in our sales momentum and our system alignment has never been better. We are currently finalizing 2011 planning, visiting markets around the world and meeting with our local management teams who are focused on executing against our key business drivers, optimizing our menu, modernizing the McDonald's experience and broadening our accessibility.
Though the global environment remains challenging, I'm confident McDonald's can continue to deliver long-term growth and value for our system and our shareholders. Thank you. Now I'll turn it over to Mary Kay to begin our Q&A.
Mary Kay Shaw
Thanks, Pete. I'll now open the call for analysts and investor questions. [Operator Instructions] First question is from David Palmer at UBS.
Two areas of curiosity for me, ongoing curiosity, I suppose. The pricing decisions that you make and just generally speaking, the outlook for Europe. You gave us some comment there about pricing rolling off and limited pricing power in some European markets. I think that was you, Pete, that said that. Perhaps you could talk about pricing power being on the eve of inflation. And obviously, there's a lot of markets where it looks like you sure do have pricing power. How are you thinking about that?
Sure. What we know is as we look at and we've dealt with it in our European business over the years, as VAT increases start to come along, we have to be very smart about how we handle that through the menu board. We know the wrong answer is to immediately increase prices the full amount of that VAT increase. So we look at doing it in smaller pieces. Sometimes, we try to get a little bit ahead of the VAT increase, do it in small chunks. But really, if you look across the whole continent as you indicate, the economies are in various forms of recovery. So we really look at the individual markets, what's the consumer's appetite to pay a little more? What is going on with inflation? So as you point out, as we look at least preliminarily into Europe next year, we think commodity costs will be up about 3%. That is not an unreasonable number for us to manage through. And if inflation is a sign that the economies are picking up a little bit and the consumer will be able to pay a little more, then we certainly ought to be able to handle that through the menu board. But as we sit here today, we're just not exactly sure in which markets and when that will be. But to our business model in total, that type of increase in commodities is not insurmountable.
And David, our business model, this is Jim, will endure there in the European marketplace particularly when you look at these VAT increases. They're not robust increases. They're incremental increases. And the population there wouldn't be able to absorb enormous increases. And so I think as we operate throughout the year, as Pete indicated, we'll be able to mitigate the impact of those increases in our business model. We'll be able to perform well in that environment.
Mary Kay Shaw
The next question is from Jeff Omohundro at Wells Fargo.
I was just wondering if you could elaborate on the impressive domestic sales momentum that was reported throughout the quarter and in particular in the September period. And also particularly interested in the mixed sustainability of the frappes and smoothies into the fall and into the cooler weather. And if you consider continuing the marketing support of those items out of their traditional season.
Jeff, this is Jim. Don, of course, very close to that combined beverage initiative in the U.S. and he's in Mexico. Don, can you take Jeff's question?
Yes, Jim. A couple things. One is frappes and smoothies are performing very well. Again as we mentioned, they're exceeding expectations that we had. You asked about the seasonality. The products do have some seasonality to them. Having said that though, that has all been kind of baked into our model as we look at the overall sales contribution. It's important to note that everyone kind of grabs hold to frappes and smoothies, keeping in mind breakfast is a strong contributor in the U.S. We still have a tremendous amount of sales coming in from Angus. Angus is still performing well. Jim talked about the Angus Snack Wraps. There will be additional media and a continuous weight of media relative to frappes and smoothies in the U.S. But also even broader, we still have an opportunity relative to the broader McCafe coffee. So I know the U.S. team is going to be marketing those products as well. So there's quite a few things that will be coming up. Jim talked about the McRib, which is something we haven't done nationally. We've done in the spot markets but nationally. So ongoing strength-wise relative to the U.S., the U.S. plan is solid and we're looking forward to also a very strong 2011.
Mary Kay Shaw
The next question is from David Tarantino, Robert Baird.[Robert W. Baird]
Pete, I have a question for you maybe falling on to the first question about the cost outlook and how you might manage that heading into 2011. I know you mentioned European commodities are expected to be up 3%, but if you could maybe give a broader picture of what that might look like globally including in the U.S. and also talk about labor trends. And with that, are there any efficiency opportunities maybe that you could use to offset some of that pressure?
I don't have a global commodity number, but in the U.S., we think the number is closer to a 2% increase. And again, that's a very manageable number for us and nothing that we're terribly concerned about. So all in all, from an input cost side, we feel pretty good about heading into 2011. Labor, virtually all markets around the world are seeing increases in labor, but nothing that is again out of the ordinary or something that's so extreme that we'd have to do something dramatic in our pricing or suffer some dramatic hit to margins. So both commodities and labor, while going up, are in line with kind of what I'd -- go back to kind of some more normal trends for our business. And historically, we've said in the U.S., we need a 2% to 3% comp in normal times and Europe probably a 3% plus comp in normal times to grow margins. And so I consider this more normal times from the input cost side. The question will be exactly at what point will we be able to take some of that pricing? But our early look at some of the 2011 plans, markets are anticipating they'll be able to take some pricing next year. From an efficiency standpoint to offset some of that, we're constantly looking at operations within the restaurants. And one of the big enhancements we're in the process of rolling out through the U.S. is our new POS system which makes it easier for the crew to take the orders, easier to get the order right, they can do it faster. And basically what that means is increased throughput especially during our peak hours which makes us more efficient per labor hour.
Mary Kay Shaw
The next question is from John Glass, Morgan Stanley.
On the U.S. remodeling program you talked about, Pete, just remind us where you thought you'd be at the year-end and where you're coming out and again the specific reasons. Was there something about delaying getting construction permits or was there something about not getting enough data to read? And you talk about a 6% to 7% lift in here. Can you talk about though over time if you have a greater expectation? What the sort of three to five-year expectation is in terms of sales lift to those remodels?
Yes, John. I'll give you a perspective and certainly if Don or Jim want to jump in, they can do that. I think we started out with an aggressive goal this year. We felt we'd do 400 to 500 starting out and it looks like we'll probably end up doing 200 by the end of the year, maybe 225. And really, as I said in my comments, as we started the initial wave of this, we wanted to make sure that as we really have one chance to get this right. And while we realize there's an opportunity to strike right now because we have the financial strength and the momentum, that's still not a reason just to go quickly if you don't have everything exactly nailed down. So we're making sure we've got the design's right, that we've got the quality of the materials right, that we've got the pricing right and, like I said, it's because we really have one chance to do this right and we're going to do it. I would see that 200 number this year probably go up to 600 in 2011 based on the plans. So there is momentum and something that we're very encouraged about the operator participation in. When we talked about the sales lift, the 6% to 7% was our initial estimate. And that lift, just to remind you, is incremental to what's happening in the marketplace and that we know over time that, that sales halo continues in that restaurant. We don't have a five-year track record of these things in the U.S. to tell you over five years what's going to happen. But our instincts tell us that those sales will continue to be positive primarily because of the opportunity it gives us to introduce new menu items, introduce new customers back to that restaurant, et cetera. So we're very bullish on the opportunity it provides not only in year one, but sustaining.
John,I think it's really important to note, and Pete mentioned this, in the U.S. one of the things we've been able to benefit from is the fact we've seen France and Australia move forward. In particular, Australia move forward even more aggressively relative to reimaging. So we've been able to take some of those ideas and the things that did work very well from those markets and really employ them in the U.S. designs as we move forward. Another point is that the U.S. designs are both internal and external at the same time. And so we're not just doing the internals of the restaurant. Some of those have been done a while ago. We're refreshing those. But this is the full reimage process that we're going through. So we wanted to make sure we got it right. We consciously slowed down and went back and revisited the design. Some of them we didn't think actually were aggressive enough in designs, and the franchisees have been a major, major part of how we've looked at that. When we've looked at the results in Australia and in Europe, across Europe, the second and the third years have been very positive as we continue to move forward largely because of the reasons that Pete mentioned around menu as well as the awareness from customers. And the last point is, we know that as we get more and more of these done in the marketplace, there is a broader synergy that takes place from a consumer awareness perspective and that allows us to be able to reap the benefits of that in even stronger sales. So we feel real confident about where we are in the U.S. and I know that as we move into next year, the franchisees are ready to be more aggressive as well as our teams are ready to be more aggressive as we move forward. We've got the right designs now. So we feel pretty good about it.
Mary Kay Shaw
The next question is from Andrew Barish at Jefferies.
Just a question on kind of European brand relevance. I mean, do you think you've made kind of a sea change in your European business over the years? And does that show up in terms of more breadth on the daypart, less kind of weekend, special occasion business? And how does that make you feel just kind of going forward with maybe some economic bumps in the road, are you better prepared to kind of ride those out than maybe in the past?
Andy, this is Jim. I don't know that we could point to a sea change in Europe in specific. I think we've seen a sea change and the relevance for our consumers across the globe. And so Europe, of course, is pursuing the same Plan to Win that we're pursuing in Asia-Pacific, Middle East, Africa, the United States. We're very aligned around the consumer relevance issues and what we're doing around reimaging menu and all of the every day affordability access and improvement in the drive-thru which is a big one for Europe because they are adding more and more drive-thrus now. And as you heard from my comments, the improvement on customer satisfaction particularly in the drive-thru accuracy and speed of service in markets outside the United States, and including the United States, is paying dividends. But I don't think that there's anything there in the brand that would differentiate Europe relative to a sea change that changes the visit mix or the opportunity for our customers to visit McDonald's. If that's what you're asking. And maybe I didn't understand the question, but I think that's...
Mary Kay Shaw
The next question is from Jason West at Deutsche Bank.
I just want to touch back on the margin outlook for next year and I guess focus a bit on the U.S. Just how you guys -- you mentioned you think you have some room to take price in some markets. I'm wondering if you guys are still looking at the CPI away from home as kind of an indicator on where you'd like to focus the pricing. And if you could talk about the overall competitive environment in the U.S., if you feel like things have started to flatten out or even get a little better?
Jason, it's Pete. As we have said before, you touched on it. One of the things we look at is what's going on with the food away from home index, and that's actually up a little bit on a trailing 12-month basis ended September. But also during the last economic downturn, if you will, we started to look also at food at home, what's going on at the grocery stores. Because as Don likes to say, the refrigerator is starting to become a big competitor of ours. And so food at home is still flat to down slightly as we look at the period. So we will be keeping an eye on what's going on both at the grocery stores and in the competitive market as we look at our pricing. But obviously, the momentum that we have, some of these premium beverages, while they don't necessarily qualify as a price increase, but introducing these premium beverages with high margins is definitely helping an accretive to cash flow as maybe we aren't able to take price on some other items. But we'll definitely be actively looking at the opportunities. And again, with some optimism, the economy is going to start to get a little bit stronger next year and we'll get some price increase.
Mary Kay Shaw
The next question is from Matt DiFrisco at Oppenheimer.
Just looking at, I guess, following on that, the question about the premium beverages. And as we look at it leaving the U.S. more so and going global with some of these new products that have been very successful in the U.S., on a gross profit dollar basis, and I guess overall on a regional margin basis, should we expect then factoring in everything that you highlighted as far as commodity costs and labor pressure? Would Europe then potentially be going back to the days of actually maybe potentially having higher margins again than the U.S. if you look on a store level, if I'm looking at your branded company-owned basis, as we bring in these higher gross profit margin items and higher margin items to the stores?
Hey Matt, this is Don. And a couple of things on that. One is the other areas of the world. Clearly Europe has looked at some of the other premium beverages, is particularly looking at frappes and smoothies. They've done one offering of those type beverages, but they're looking at the U.S. execution. APMEA is looking at the same thing. From a margin perspective, keep in mind that as we implement some of the higher margin products, we're also looking at our tiered value offerings. So we're also looking at what we do in terms of breakfast offerings to stimulate that daypart which is a huge opportunity for us across the big four in Europe. We're looking at the same things relative to the regular value menu. They brought back in Europe the Double Cheeseburger in France. And the question is relative to what happens economically. To Jim's point earlier, our model allows us to be able to flex the pricing in and out of that relative to what the economy will yield and what the discretionary spending will look like. So keep in mind, it's not just about the implementation of beverages. That's one part. But it's also what we do with the rest of that menu. What beverages and higher margin products allow us to do is to be able to afford to execute our value platforms so that we can continue to gain market share and grow guest counts. That's really the biggest goal that we have in economic downturns, protect and grow the guest counts which then yield us higher levels of profitability.
Mary Kay Shaw
The next question is from Joe Buckley, Bank of America Merrill Lynch.
One statistical question. You shared with us the China same-store sales number for the third quarter of 12.7%. Could you share with us what that was up against in the third quarter of 2009. And then a broader question again on margins. I'm curious on the 2% commodity inflation outlook in the U.S., how visible that is to you, how much of that you might have contracted or hedged? And just in general on the margins, if I'm not mistaken, the 22% level, both the U.S. and Europe, is probably an all-time record, and I realize there is some seasonality around that. But when we talk about the sustainability of the 2009 margin performance, if you do have even just a slight headwinds in food costs, are these levels sustainable?
All right. Joe, the 2% increase in the fourth quarter in the U.S., we have a pretty fair amount of visibility in. So a fair amount of that is contracted, locked in. And so that number feels pretty solid to me. And even heading into 2011, I'm not going to give specific percentages, but we're probably more contracted at this point in time versus any other year previous. So while it's still early, our 2011 estimate feels pretty good too. The quarterly margins, the third quarter margins are actually kind of just off of their all-time highs for both Europe and the U.S. But as I think about 2011 more broadly and think about some of the comments I made earlier, in an environment with about 2% inflation and normal wage increases, in that environment, really a 2% to 3% comp is what we need to grow the annual margin. And so with the momentum that we have and the outlook of being able to take some price, to keep driving the guest counts with these beverages and the breakfast value, et cetera, we feel pretty confident that's doable.
I think Joe, we get this question often, obviously we get it externally and internally, and our answer is always the same. We focus on the top line growth and ensuring the traffic into our restaurants, and the rest has to take care of itself. It doesn't mean that we're not smart about how we price on the menu and how we introduce new products. But we play it as wise, if you will, relative to the commodity costs other than what we are able to hedge, as Pete mentioned. And so the concern that I have with the segments around the world and the planning process is what are we doing about continuing to drive top line and preserving the increases in traffic into our restaurants. When we take care of that, as Pete mentioned certainly at the 2% to 3% level, all else falls into line.
And Joe, you asked a question about last year's comp in China. Last year, the quarterly comp was our easiest comparison. It was a negative 10.7, but still this year's number and the momentum going on there, we're extremely proud of the team in China and what's going on there.
And Pete, for Joe too, and for everyone else on the call. One thing that's really impressive about China now is they're being able to benefit from not only the historical regular menu, but also breakfast now is becoming a stronger and stronger daypart for China, the Value Lunch program that they have in place. They did some very aggressive things with summer drinks this year. Jim mentioned drive-thru expansions earlier. We're confident in the development plan. So China is -- has a very good strategic plan both now and again as we move into 2011. So it's not just about whether or not you comped on a weaker number last year. The way that we're comping now and the opportunity for continued growth is pretty strong.
Mary Kay Shaw
The next question is from Larry Miller at RBC.
Can you guys give us any sense of how the business in the U.S. breakfast is trending since BK rolled out their new menu? And then the second part of that is looks you guys had a nice acceleration in September in same-store sales, looks like the fast food market overall is getting better. Any thoughts you could share relative that would be great.
Hey, Larry. This is Jim. First of all, relative to the overall segment and the improvement, we continue to look at the same things. As Pete mentioned, the consumer spending, the consumer confidence went down in September, unemployment still at 9.6% and the recovery, we think, is going to be elongated in America. And so if you look over the next 12 months, I think people are still talking about maybe getting to 8.5% or 9% unemployment when we know that normalized unemployment rates in a robust economy are 4% or 5% at the most. And so we've got a long way to go there relative to consumer confidence and that confidence of people being able to put food on the table at home or away from home. And I think jobs have a lot to do with it. So the improvement in the overall segment in September, I don't think is necessarily an earmark or a bellwether of things to come relative to the overall recovery except to say that we're certainly pleased with our performance and the fact that the rest of the industry is starting to come around is good for them. But I think in an overall indicator, that's probably not something that we would look at to say, "We'll, we are in the middle of a recovery."
And we continue to outperform the industry. So our gap with the industry continues to be significant. And we're proud of that. And regarding the breakfast question, we haven't seen any impact from the Burger King rollout.
Mary Kay Shaw
The next question is from Jeff Bernstein of Barclays.
Two things, one, just a follow-up on the European results. I know there's a lot of speculation around the deceleration in August and clearly this was a very strong re-acceleration in September. Just wondering whether you can offer any incremental thoughts, and it is going to be tough to pass along all of the VAT increases on the menu board. But in terms of the austerity measures, perhaps McDonald's positioning versus where you are on the U.S., perhaps you're more lower end or maybe which markets you might think are most or least vulnerable with the big changes coming up in Europe. And then separately just on the shareholder value front that you guys mentioned earlier. Is there any potential to increase leverage perhaps to return more capital to holders either through additional repo or dividend? I think you guys have talked about the potential willingness to move in that direction.
I'll let Pete respond to most of that, but let me just respond to the big ballyhoo over August in Europe. Europe had a little bit of a glitch in August mostly around France. Everybody got all concerned. That's because France did not run the promotion that many of the other markets ran in August which was the Coca-Cola glass promotion. And they did not perform as well as the other markets. And yet it was not a trend. It was a one-month occurrence. And we're still optimistic and they're back on track and things are moving along well there.
Jeff, can I just add something to -- Jeff, you mentioned lower end in the U.S. Just as a point of clarity, smoothies, frappes, Angus, salads, those aren't lower end. And we have had a good mix across the menu board and it's really important to note that value still only represents 10% to 11% if you look at the regular menu value offerings and platform. The coffee beverages, McCafé beverages, are definitely not lower end, and consumers tell us that they prefer the beverages. And there's a tremendous amount of those beverages sold during the morning daypart as well as across the afternoon. All dayparts are up in the U.S. business. So just a point of clarity. I think that when you look at the U.S. business, it may appear that it's value-driven. But value helps, but we've got good mix across the board just as we have in Europe.
And specifically about which markets are going to be hit harder with the austerity, et cetera, Jeff, I guess as we look at the continent I would just look at the last couple of years performance. That's what gives us the confidence. We know that while we prefer a more robust environment to operate in that if times get a little tougher, that we've got the ability to continue to attract customers and to continue to perform well. Regarding additional leverage, our debt balances are up this year a little bit compared to last year and that's consistent with our plan that every year as the business performs well and grows bigger that we have an opportunity to add some incremental leverage to the balance sheet to return cash to shareholders. But we're not planning to do any significant leverage event.
Mary Kay Shaw
The next question is from Mitch Speiser, Buckingham Research.
Mitchell Speiser - Buckingham Research
My question is on Europe, and in particular, Germany, U.K., France. Can you update us on what the drive-thru mix is in those markets? And what the opportunity is over the next couple of years in terms of increasing that mix? And on the frappes, do you think it can have the impact that it has had in the U.S. and if these drive-thru mix and frappes growth could -- should we view it as perhaps an offset to what is happening in Europe with VAT taxes and weak economy and austerity plans? And just as a sidenote to that, can you let us know the experience you've had when VAT taxes have gone up in Europe and how comp trends have changed?
Mitch, in Europe our drive-thru percentage is about a little over 60%. And that's probably about the same in those big markets. So that's not the percentage of sales through the drive-thru. That's the percentage of restaurants that have drive-thru. And the percentage of sales in those restaurants is closer to 45%. And so when you think about the U.S. being 67% drive-thru, that's a huge opportunity for us to increase that. And that's why Jim had referenced it, it's a focus area for Europe. They know there's opportunities not only to add more drive-thrus to satisfy that demand, but also to improve those drive-thru operations to attract more customers. Historically, as Jim mentioned, these VAT tax increases are probably going to be more incremental than they are substantial. And in the past, you've had VAT increases that have tended to be more substantial and so you had to take a longer period to get those bled into the menu board, if you will. And so again I'm not sure there's a historical comparison for us to make, especially considering the economic environment and all else that's going on. But again, I get back to the confidence we have in our ability to manage through this with our business model and new products. The beverages certainly will help. I don't know that they'll have -- at least as of now as you look into 2011, they probably won't be as impactful in Europe as they are in the U.S. But certainly over time, all of the markets have beverages in their plans and on their plates to take a look at.
The other thing that I would say is if you look at Europe, the populations are very supported by social programs. And so when you talk about austerity in these countries, it's much about the benefits. If you look at France now, they're talking about raising the retirement age to 62 years old. Everybody's in a big flap. But what does that do to discretionary income for customers who could visit McDonald's? It's de minimis. And so the impact around a number of these austerity programs will not have a severe impact on discretionary spending of our consumers because they are supported at very high level already relative to social services and the other support they get from the government. So we've been able to absorb that over the years and, as Pete said, we will be able to do this as well during the coming months.
Mary Kay Shaw
The next question is from Keith Siegner, Credit Suisse.
I might turn around the answer from that question a little bit. Looking at the U.S. business, with the free WiFi, with the McCafé, with the snacking and now most importantly with this new remodel program, does this change at all the mix in drive-thru versus eat-in let's say sit and stay or could it potentially increase that mix a little bit? And if that were to happen, does this change or open up maybe some of the new product development over the next couple of years if that happens?
I think it could possibly change the mix over time. That is not why we have pursued those strategies. We pursued those strategies because we want to offer our customers those opportunities for convenience, and they're relevant to their lifestyles today. And I think when I look at the population and their lifestyles today, I couldn't make an argument, I think, for a change in their behavior is relative to the use of the drive-thru. The convenience of how people are on the move all the time now, I don't know that we would see a substantial change there. Having said that though, it doesn't mean that we won't pursue other menu opportunities over time to enhance the opportunity for people to come into the restaurant as compared to going through the drive-thru.
Mary Kay Shaw
The next question is from John Ivankoe, JPMorgan.
What kind of benefit are you seeing for the new point-of-sale system, whether in cost? And I guess that includes cost of training and speed of service with the new hardware platform. And secondly, Pete, I mean you kind of mentioned it regarding a leverage event but your profitability per store, your debt to EBITDA, your debt to free cash flow seems to be so conservative right now and the cost of debt being at extremely, extremely low levels especially for a company like yours, even on a 10 or perhaps even a 30-year basis. Could you kind of walk through just a little bit more in terms of why it doesn't make sense for McDonald's to pursue a leverage event at this point?
I can take the first one. New POS benefit, and we call the system new POS. What we're seeing John is first to benefit in terms of the ordering ease for the crew in the restaurants, which does give us some benefit in order-taking time. So we do see some benefit there, which as you know, seconds mean additional capacity. And so we're happy about that one. The broader benefits of the new technology system is that it opens up additional applications such as handheld order-taking within the restaurant and as well outside the restaurant. It also opens up additional visibility relative to how we can get the orders back into the kitchen. And again, increase the speed at which we have the food prepared. So we do see those operational benefits relative to the new technology system and also some additional platforms that we could benefit from.
And regarding the conservative position of our balance sheet, John, that's kind of our profile. Our strong credit rating is important to us. It's important to us as a company, but also to the system. So even though we don't guarantee or do anything like that with our loans for suppliers and owner/operators, the strong credit rating of the corporation provides a halo for them and they're able to borrow at rates inside that of our competitors. And so that's important to us. And we're going to return at least $5 billion to shareholders this year. And we plan to grow free cash flow and return all that next year to shareholders and incrementally increase the debt. So we think that's a very successful model for us and one we're very comfortable both from the way we operate the business, the way the system is financed and the value we're providing to shareholders.
Mary Kay Shaw
The next question is from Nicole Miller Regan at Piper Jaffray.
Joshua Long - Stephens Inc
This is Josh [Joshua Long] in for Nicole. I just want to circle back to your gap to the overall QSR industry. I think previously, we had quantified that. And then also, any commentary and has that continued to accelerate of late, as it had in 2Q?
Josh, the gap relative to competition has continued. And I think you're primarily talking about the U.S. It's just where we normally talk about the gap. However, I will say that we're going market share in all the major markets around the world. So we're continuing to grow share even in cases where some of our competitors may be growing a few more units. So that part of the business is strong. In the U.S., that gap again does maintain and we're continuing to gap the competition. And I'd also offer, our numbers last year were still positive numbers. And so we're gapping the competition at a time when their comp numbers are in some cases going up against much softer comps than we had. So again, business is pretty strong in the U.S. right now.
And that gap for the quarter was about 5% in the U.S.
Mary Kay Shaw
The next question is from Sara Senatore at Sanford Bernstein.
Two follow up questions, one was on China and one on the U.S. The first on China, you gave us the comparisons year-over-year and some of the initiatives that sound like they've been very successful. But we're hearing that at least in some of the bigger cities, there's been a decent amount of price being taken in, at least some of the menu items. And so just trying to get a sense of, a, are you taking more price there in, let's say, other emerging markets that you might develop markets? And, b, does it vary depending on your geographic -- on what geographic region we're talking about, big cities versus sort of the smaller cities inside the country. And then I'll throw in my question on the U.S. so just in case I get cut off which is, can you just update us on some of the health care legislation? I know your company has been in the news with talks about waivers and that kind of thing. So I just wanted to see if you have any sort of incremental data.
This is Jim. I'll talk about the health care, while these guys figure out what to tell you about the pricing in China. First of all, the Act was signed into law in March of 2010 and now they're going through a lot of sorting out of the details relative to the full implication which doesn't happen until 2014. And so the Administration continues to work very hard with companies like McDonald's to sort this out to make sure that we are implementing this the appropriate way so that most people that have access to health care are going to be covered appropriately. The flap that I'm sure you're referring to had to do with the limited benefit plans, the mini meds as they were called, that covers some 30,000 people in McDonald's, but 1.4 million people across America, which is interesting to know. And there was a headline saying that we were going to drop coverage. Well, we were never ever going to drop coverage. We're always going to provide coverage. But the regulations around the insurance companies and their obligations to cover these mini med plans was in jeopardy without a waiver. Well, now we think that Health and Human Services is going to be very good about giving waivers to companies that are going to be able to continue to cover these very important people on these smaller plans. Other than that, there's not a lot more to say about health care. Certainly there's a lot of pushback on the one side of the aisle relative to the Republicans and the midterm elections and everything going on here. But for us, the diligent work around proper implementation of this plan, both with our franchisees, through the Administration and were working closely with them to make sure we get it right, is where we're spending our time. And that's really all we have to say at the moment, and it's a work in progress.
And in terms of pricing, Sara, in China I would characterize any price increase we've had over the last 12 months as modest. We said the APMEA averaged around 1% and China was probably in line with that. In other emerging markets, I mean, Russia is probably the one where we've had the greatest input inflation and the highest amount of price increase.
Mary Kay Shaw
We had one other one, Peter Saleh from Telsey Advisory Group.
Peter Saleh - Telsey Advisory Group
I'm just wondering if you can give us an update on coffee as a percentage of sales and how that compares to last year at this time? And just where do you think that could go to over the next year?
Coffee percentages in the U.S., as you all know, several years ago we were at about, I think in 2004, we were at about 2% coffee. Total coffee's grown to over 6%. So a lot of -- and that really includes the whole McCafé line up. So really positive growth there. Jim mentioned U.K. In the U.K., we sell now the most coffee of any other purveyors that are there. We see opportunities in many of our other markets whether that be in Europe, across the other markets like France. Germany, we have 600 McCafé's that are there. So we're continuing to grow our coffee business there. So we do see coffee as a point of leverage and growth for us as we move forward.
Mary Kay Shaw
Okay. I think we're out of time now and out of questions. So I'll go ahead and turn it over to Jim for a few closing remarks.
Thank you, Mary Kay. Thanks for joining us this morning. In closing, I want to reiterate that McDonald's global business is strong, the system alignment behind our Plan to Win and its focus on the customer. We will continue to deliver results. We will further strengthen our leadership position through collective efforts around our menu, restaurants and the entire brand experience. In working together, I'm confident that we'll continue to drive long-term growth and become our customers' favorite place and way to eat and drink. Thank you, all. Have a great day.
Mary Kay Shaw
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