McDonald’s Corporation (NYSE:MCD)
Q3 2014 Earnings Call
October 21, 2014 11:00 am ET
Chris Stent - VP, IR
Don Thompson - President & CEO
Pete Bensen - CFO
Brian Bittner - Oppenheimer
Joe Buckley - Bank of America-Merrill Lynch
Matt DiFrisco - Buckingham
Nicole Miller Regan - Piper Jaffray
David Tarantino - Robert W. Baird
Jeff Bernstein - Barclays
Will Slabaugh - Stephens
Andy Barish - Jefferies
Jeff Farmer - Wells Fargo
Keith Siegner - UBS
Sara Senatore - Sanford Bernstein
David Palmer - RBC
John Glass - Morgan Stanley
Howard Penney - Hedgeye
John Ivankoe - JPMorgan
Hello and welcome to McDonald’s October 21, 2014 Investor Conference Call. At the request of McDonald’s Corporation, this conference is being recorded. Following today’s presentation there will be a question-and-answer session for investors. (Operator Instructions).
I would now like to turn the conference over to Mr. Chris Stent, Vice President of Investor Relations for McDonald’s Corporation. Mr. Stent, you may begin.
Hello, everyone, and thank you for joining us. With me on the call are President and Chief Executive Officer, Don Thompson, and Chief Financial Officer, Pete Bensen. Today’s conference call is being webcast live and recorded for replay by phone, webcast, and podcast.
Before I turn it over to Don, I want to remind everyone that the forward-looking statements in our earnings release and 8-K filing also apply to our comments. Both documents are available at www.investor.mcdonalds.com, as are reconciliations of any non-GAAP financial measures mentioned on today’s call with their corresponding GAAP measures.
And now I’d like to turn it over to Don. Don?
Thank you, Chris, and good morning, everyone. Let me start by saying that we are disappointed by our recent performance which fell short of our expectations. Global comparable sales decreased 3.3% for the quarter, operating income was down 14% in constant currencies and earnings per share was $1.09, a 28% decrease in constant currencies.
Third quarter results remain pressured by a number of internal and external factors. A significantly higher tax rate, which was due to an increase in tax reserves in certain foreign markets, impacted earnings per share by $0.26 per share. In addition, the supplier issue in China negatively impacted EPS by approximately $0.15 per share, and the estimated impact of store closures in Russia and the Ukraine impacted EPS by $0.01 per share.
Excluding the impact of these items, earnings per share for the quarter would have been relatively flat compared to last year. Pete will talk more about these impacts shortly in his comments.
This morning I’d like to share our strategy for growth and discuss the actions that we’re taking to improve performance in the U.S. and our priority markets of Germany, Japan and Australia. In some of our markets the reality is that we haven’t been changing at the same rate as our customers’ eating out expectations or, more specifically, their expectations of us at McDonald’s. So we’re changing. And we’re changing aggressively as we refocus on building the business for the McDonald’s system and for our shareholders.
The key to our success will be our ability to deliver a more relevant McDonald’s experience for all of our customers.
We have listened to our customers and we’ve listened to our customers around the world and better understand what their future experience should look like. Customers want to personalize their meals with locally relevant ingredients. They also want to enjoy eating in a contemporary inviting atmosphere. And they want choices; choices in how they order, choices in what they order and how they’re served.
These things make up the McDonald’s experience of the future, and we‘re building the future today. Our efforts to create this experience in our restaurants build upon the investments that we’ve already made including the Made for You operating platform, modernized decors and leading edge point of sale and mobile technologies, all brought together in a visible, tangible way to enhance convenience for our customers.
In addition to free Wi-Fi in most of our global system, we integrated Apple Pay across 14,000 U.S. restaurants including our drive-throughs. We are the only restaurant to offer this payment convenience in drive-through.
We’re also giving customers more choice in how they order and where they eat. Our multiple order point strategy in countries like France and Australia at self order kiosks as well as mobile orders and payment which support both counter and table service.
Even more importantly we’re offering our customers even more choice as it relates to our menu. This new concept which we call Create Your Taste combine the custom premium burger platform with the service enhancements I just described to deliver a new dining experience that complements our modernized restaurants. It’s all of these initiatives combined that create the McDonald’s experience of the future.
Now we've already moved beyond the innovation centre, we've already moved beyond the learning labs to initial implementation in markets including Australia, the UK and France. And while the food and service components of the experience of the future will look slightly different in each market, based on local customer preferences, I am excited about our ability to differentiate the brand and grow the business. In the US, we’ll fully activate this new experience in three markets by the third quarter of next year and plan to bring additional markets on board as they are ready. And in Australia, plans are already in place to scale the experience of the future across the country next year. We’re working through our global activation plan now and I expect to share more on our next call in January.
Let’s talk a little bit more about the US and the specific actions that we’re taking to improve our business today. There is no doubt the US is our biggest area of opportunity relative to financial performance. The questions I receive a number of times as well or not we can drive additional growth in this very important business unit. Quite simply, the answer is yes.
As you know, Mike Andres took the helm of the US business earlier this month. Mike is a progressive strategic thinker whose deep understanding of consumers and the market place is complimented by a significant industry experience. This past week Mike and I met with our US company and franchise leaders to discuss the tangible steps we’re taking collectively together the reverse business trends today. We also discussed the actions we’re taking to better connect with customers through our food, the service we provide and the experiences that we create.
We’re accelerating efforts to restructure the U.S. organization and provide more economy at the local level so we can satisfy our customers based on their unique taste and preferences in the markets. This shift will enable us to better harness and build on the thinking and the power of the 3000 plus franchises and their entrepreneurial spirit and our restaurant executives who are closest to local market conditions. Our strong menu pipeline in conjunction with greater autonomy in the markets positions these markets to deliver stronger business performance. This has been a historical strength to the US business and we’re putting it back at the forefront once again.
In January, we will simplify our menu to better highlight customers’ favourites and to make the experience faster and easier for our customers and our crew. This move will open up opportunities for local markets to pull from the robust global pipeline and introduce new taste in our key growth categories of burgers, chicken, beverages and breakfast. It will also enable regions to address the unique needs, taste and diversity of the local customers with products like the Chorizo Burrito, Cheddar Bacon Onion, The Clubhouse Burger, Mozzarella Sticks and other menu choices that we have both in the U.S. pipeline and the broader global pipeline.
The step after enhanced local relevance is providing greater personalization and customization on the menu. And Create Your Taste is designed to do just that.
Our marketing approach is another key priority for us and one where we’ve implemented a number of significant changes in the process, the structure and creative direction of our company. We’re also engaging in more transparent dialog with our customers and consumers in general as evidenced by last week’s U.S. debut of Our food Your questions. This build on the success of similar approaches in the UK, Canada and Australia. We are actively inviting customers to join the conversation about the topics that matter most to them relative to McDonald’s particularly the quality of the food we serve in our restaurants.
Conveying the facts and adjusting misperceptions about the freshness, quality and integrity of our ingredients appeal to our customers and supports the work we’re doing to offer greater menu choice.
I am confident in our ability to regain momentum in the U.S. given the actions that we’re taking and the pace at which we’re moving.
Now let’s move beyond the U.S. to China and Russia. The supplier issue in China had a significant negative impact on the market’s third quarter results. Comparable sales were down 22.7% for the quarter. We are aggressively executing recovery plans in the impacted markets. We were able to restore full menu to all restaurants in China and Japan by mid September, thanks to supply chain and resourcing teams who were able to shift to alternative product sources for the 5,000 plus affected restaurants in less than 60 days.
We’re actively taking steps to rebuild consumer trust. We recently launched a significant brand trust campaign in these markets and we’re providing compelling value offers to invite customers back. We expect it will take six to nine more months for our business to normalize in the impacted markets.
Let’s move to Russia where comparable sales remain weak due in large part to the uncertain economic and political environment which is negatively impacting consumer sentiment. With the instability expected to continue through at least fourth quarter and likely in the 2015, we remain focused on continuing to serve high quality menu items and provide a superior restaurant experience.
Another question I'm sure is on your mind is what are we doing to regain momentum in our priority markets outside of the United States particularly Germany, Japan and Australia. Germany’s third quarter comparable sales continue to be negative but showed some signs of improvement. We’re adjusting affordability to drive guest counts to our new single, double, triple burger platform that provides greater value across the burger category. At the same time we’re strategically increasing average check by promoting core, premium and snack items in the markets. Furthermore, the recent changes we made to the marketing organization including a new chief marketing officer and advertising agency will provide innovative thinking and bring fresh new perspectives.
Let’s now shift to Japan. While current results reflect the impact the supply issue in China, weak comparable sales trends had persisted the past several years in Japan. In addition to the work underway to improve food quality perception the market is working to strengthen its appeal to cost conscious consumers through a renewed focus on value. Any size strength have been added to the ¥100 menu and new value bundles are now being offered at lunch.
And in Australia, comparable sales in September were solid and represented the highest comp since August, 2012. The market is focused on leading with affordability and convenience by re-launching its loose change menu with additional value option in providing a new way for customers to enjoy McCafe beverages and that’s through the drive-through. And as I mentioned earlier, with aggressive support of the franchisees the market is scaling Create Your Taste in 2015 as part of our McDonald’s experience of the future roll out.
Around the world we’re changing and we’re doing it aggressively. Our business is financially strong and so is our conviction and the future of brand McDonald’s and what we know we can become for our customers. I’m excited about the work that's coming to life in our markets around the world; we’re tacking our challenges head on. We’re building on the power of our unique operating model of franchisees, suppliers and employees to position our business to deliver strong performance to our system and to our shareholders over the long term.
Now I’d like to turn it over to Pete for some additional texture on our performance.
Thanks, Don, and hello, everyone. In my nearly seven years as CFO third quarter 2014 was perhaps the most challenging because of the confluence of factors all pointing in the same negative direction.
Similar to Don, I will depart from the usual approach to my prepared remarks. Instead of walking through the income statement, I’ll begin by discussing the four most significant factors impacting quarterly results. From there I will provide the usual updates on some key quarterly numbers, commodities, pricing and currencies. Then lastly, I will address a couple of topics that I recognized are of utmost interest to you our spending levels and our business model.
Let’s begin by reviewing the significant decline in third quarter earnings per share versus a year ago which was primarily due to four factors. The first was a much higher effective tax rate of 44.4%. As indicated in our August sales release, we expected the third quarter rate to be above our annual range of 31% to 33% primarily due to a change in our earnings mix. Subsequent to that sales release, two additional factors drove the effective rate even higher, the tax and interest cost associated with an unfavourable foreign tax court ruling impacting 2003 through 2008 and the impact of additional changes in tax reserves related to income tax audit progression in certain foreign jurisdictions.
In total, the court ruling and our audit related reserve adjustments negatively impacted third quarter earnings by approximately $260 million or $0.26 per share. The second most significant factor impacting third quarter results was the China supplier issue. In early September, we estimated the total impact from loss sales, expenses associated with our customer recovery efforts and the tax effect of these items to be in the range of $0.15 to $0.20 per share. The actual impact was approximately $0.15 per share and the impact was felt in virtually every line of our P&L.
The markets most affected by this include China, Japan and Hong Kong which collectively represent about 10% of global system wide sales and about 5% of global operating income. Work is underway APMEA to rebuild customer trust now that our supply chain and restaurant inventories have been largely restored.
While we expect our business to fully recover, the pace of recovery is difficult to forecast. With sales trends showing signs of improvement our best estimate is that it will take at least six to nine more months for our business to return to a normalized level. Based on our current internal forecast we expect the supplier issue to have a negative impact on fourth quarter results in the range of $0.07 to $0.10 per share.
The third significant impact on this quarter’s result was the decline in the McDonald’s U.S. business. The segment operating income declined $107 million or about $0.07 per share primarily due to soft comparable sales which contributed to margin declines.
The fourth most significant impact on our third quarter earnings was the decline in Europe’s company operating margins driven by Russia and Ukraine, due to the economic slowdown, decline in consumer sentiment, store closures and weakening currencies in these markets. In fact, these two countries accounted for substantially all of Europe’s third quarter company operating margin decline.
Next I want to provide an update on some key financial items commodities, pricing and currencies. I’ll start with commodity cost for the U.S. and Europe. For the quarter U.S. commodity cost rose 3% primarily due to higher beef and dairy prices. This pressure is expected to continue into the fourth quarter. As a result, our revised full year outlook for the U.S. basket of goods is an increase of 2.5% to 3%. Excluding currency, Europe’s commodity costs were relatively flat for the third quarter.
We have reduced our full year outlook for Europe’s grocery basket to reflect an increase of no more than 1% which implies relatively flat commodity cost for fourth quarter.
In terms of menu pricing, the U.S. is running about 2% at the end of September versus year-to-date food away from home inflation which stands at 2.5%. At 2%, our current pricing is notably lower than the 3% pricing level we were at in June. We felt it was important to bring our pricing more in line with food away from home so we did not completely offset the prior year price increases that rolled off during third quarter. This pressured third quarter margins and we expected to continue into fourth quarter. As we’ve said before, our preference is to keep pricing at or below food away from home index as we continue to balance the importance of driving guest counts with profitability.
Our price increases in Europe vary by market with the overall segment averaging about 2% year-over-year.
Foreign currency translation negatively impacted third quarter EPS by a $0.01. At current exchange rates, which reflect a stronger U.S. dollar, we expect a negative impact of fourth quarter EPS off $0.05 to $0.06 with a full year negative impact of $0.09 to $0.10. As usual, take this as directional guidance only because rates will change as we move toward the end of the year.
Given these internal and external pressures we remain focused on those things within our control. At the top of the list is our overall spending. Starting with capital expenditures at the beginning of 2014, we announced the capital expenditures would be $2.9 billion to $3 billion for the year. In light of our recent performance and current market conditions we are proactively reducing this. Our 2014 spend will now be approximately $2.7 billion, which will be lower than our capital spend last year.
Through September we have opened about 750 new restaurants totally and expect to open about 1400 new restaurants this year fewer than the 1500 to 1600 originally planned. This reduction is driven primarily by fewer openings in markets like China in response to local market dynamics.
Earlier this year, we indicated we were scrutinizing our G&A spending. Internally, we refer to this initiative as resourcing for growth, a name that I think embodies the strategic intent of our process to identify key resources with the potential to be deployed more efficiently and effectively toward our critical growth drivers. For several months now we’ve been working with third party experts to thoroughly analyze our cost structure in both our corporate and U.S. functions including our overall organization structure and staffing levels in order to fund key growth initiatives.
Based on our preliminary work we are targeting to identify and redirect nearly $100 million in savings for future long term growth initiatives such as the digital strategy and McDonald’s experienced of the future. As we move forward, I do not expect a significant reduction in our total G&A expense but firmly believe that we are taking appropriate and prudent actions for the long term. We are balancing the need to curtail spending in certain areas in light of the present situation while remaining committed to funding our more significant growth opportunities. We expect to share more perspective on our 2015 G&A outlook in connection with our fourth quarter call in January.
As many of you have noted the McDonald’s business model and structure is somewhat differentiated in the restaurant industry. In our wholly-owned markets, which represent over 27000 restaurants, McDonald’s is the landlord and the franchisor. This secures long term tenure at our locations and allows us to make real estate and franchising decisions separately. We are co-investing with our franchisees in the overall success of the business. Accordingly, alignment is critical and our model is built on a highly collaborative approach which includes engagement with franchisees who operate 81% of our restaurants.
This approach also requires more time and resources both of which we believe result in better long term decisions that benefit both our system and our shareholders. We also believe that this partnership type approach has ultimately resulted in a superior and stable group of franchisees who generate industry leading average unit volumes and cash flows in virtually all the market in which we compete.
The business model has also served our shareholders well over time with our stock generating total shareholder returns that have exceeded both the Dow and the S&P not only for the last 10 years but over the last 25 years as well. While McDonald's total shareholder return has lagged the broader markets the last couple of years, we are confident that the actions we are taking in both the near and long-term will position us to continue to deliver significant shareholder returns.
We will continue to consider new opportunity to enhance both short and long-term value. Above all else, we seek to balance the needs of all stakeholders from our shareholders to our franchisees to the broader McDonald’s system. We use it as a critical screen for all decisions, because that has been the key our enduring profitable growth throughout our history and will continue to be going forward.
Even with softer performance, the McDonald's business model continues to generate significant amounts of cash. During the first nine months of 2014, McDonald's generated $6.2 billion of operating income, raised the quarterly dividend 5% to $0.85 per share and returned $4.6 billion to shareholders through a combination of dividends and share repurchases. McDonald's current three year cash return target of $18 billion to $20 billion is a testament to our ongoing commitment to built long-term shareholder value.
As we enter fourth quarter and prepare our plans for 2015, we recognized that improved results won't happen overnight.
Let me share with you our current view on how 2014 will close out. While our underlying goal is to change the trajectory of our financial performance, our internal projections assume continued sales and earnings pressure on the business in the near-term. Given the nature of the factors that I discussed, which are impacting our global business, we expect top and bottom-line performance to remain pressured in fourth quarter with comparable sales expected to be negative in October. Let me assure you that there is an acute understanding of the situation along with a strong sense of urgency to take the necessary steps to address our current challenges. Hopefully, you heard some of that on the call today.
We are confident that the work being done by our teams around the world will yield sustained profitable growth in the long-term. We have faced numerous challenges throughout our history and have always managed through these cycles. If you could travel the world and visit our franchisees and our restaurant teams, you would share our confidence that we will manage through these latest challenges as well. It all comes back to the strength of our brand, our business model and our approach to investing and growing the business over the long-term.
Our North Star continues to be the customer in better delivering on their needs. Since our founding in 1955, that has been the key to our growth and profitability. Thanks.
Now, I'll turn it over to Chris to begin the Q&A.
Thanks, Pete. I will now open the call for analysts and investor questions.
The first question is from Brian Bittner of Oppenheimer.
Brian Bittner - Oppenheimer
Thank you. As it relate to your U.S. performance, I believe the comp underperformed the industry by a little over 500 basis points in both July and August. And I was wondering if you could provide what that gap to the industry looked like in September?
Hey, Brian, this is Don. Yes, our comp gap in the month of September was a little over 600 basis points, so a 6.3%.
Next question is from Joe Buckley of Bank of America.
Joe Buckley - Bank of America-Merrill Lynch
Thank you. A couple questions, if I can. So you’re talking about a couple of changes in the U.S., a simplified menu effective in January and then three markets where you have either more extensive Create Your Own experience changes. Could you talk about what a customer in the U.S. restaurant is going to see broadly I would assume in January from a simplified menu? And then, what they are going to see and experience in those three markets that I think you are targeting for the third quarter? And then, just one financial question. Pete, the CapEx coming down make sense I think. How much more room is there for 2015 in terms of that CapEx number coming down more significantly?
Hey Joe. First of all, relative to consumers in the U.S. in 2015, they will see several different things. And I'll try to talk about a few of those. One, is because we are moving to more regionalize local windows again, which is a strength of the McDonald system, and we have moved away from that. They will see more regional products throughout the U.S. We have about 21 regions. We have over 150 odd cooperatives across the United States and so those markets will get to pull down from shelf promotions. And they can pull down from some of the broader menu pipeline offerings that we have. So customers will begin to see that again and there will be a stronger balance between the regional markets and then the national base marketing.
As you may recall, the regional markets typically will focus on offerings and promotions, the national markets will focus on the quality, the brand McDonald, what we are talking about relative to our people in larger events. So that's one major change that you will begin to see and customers will see.
The second one is going to be how we engage in conversation with our customers through both social and traditional medium. So this is going to be something that's more felt and heard relative to dialog than it's just basically seen. With the launch of Our food Your questions is a great example of that and that is a platform we will leverage across the year. You will see initial expansion of the experience in the future in those three markets that we talked about. Experience of the future is much more than just Create Your Taste, it is a broader service experience, it is a broader digitally engaged, if you would, mobilily engaged experience in the restaurants. And some of you may have seen that relative some of our markets like France or what's taking place in Australia.
Also, we will be launching the mobile app, the global app. In the U.S., it will include promotional offers, also some mobile payment opportunities such as Apple Pay and also some things possibly with our e-Arch Card.
And the last piece would be some of the markets may see some of the testing that would go on relative the various pricing structures that had been a balance pricing relationships across the entire menu board. So these are some of the things that will be out and about in the marketplace. And I’m sure our customers will give us appropriate feedback. But we look aggressively to get these things moving.
And Joe its Pete. Regarding the CapEx question, a significant majority of this year's reduction was due to a reduction in openings. And we are frankly scrubbing the pipeline and there is probably opportunity for that new opening number to go down a little bit more next year. What we are going to continue to investigate as we move to finalizing the plans over the next month to six weeks, is what is the level of reinvestment spending that we’re going to need around the experience of the future and some of these initiatives. So when we get back together in January, we’ll be able to give you more specific guidance not only on total capital but how that splits between new units and reinvestment.
Next question is from Matt DiFrisco at Buckingham
Matt DiFrisco - Buckingham
Thank you. I guess Pete, can you just talk about how may be in context the recent struggles globally, especially in APNEA may have impacted some of the things I think that people have also discussed or debated with you somehow opportunities possibly to refranchise take that 81% global number higher as well as maybe even divesting some businesses like Japan, is there any impact to the valuation of what we might get from those of the cash proceeds? Given the near term struggles if you can give us any sort of color on that or does that sort of push down and kick the can down the road a little longer on maybe being able to see some of those monetization of that?
Yes, Matt, for this year-to-date we’ve refranchised a little over 300 restaurants compared to about 225 a year ago. So we were starting to see a nice uptick in the activity, and 90% that refranchising this year was in our focus areas of Europe and APMEA. As you point out -- and a big bulk of those were in China. And so as you point out with the supplier ratio over there, our activities are probably delayed slightly, but I don’t think dramatically because this is a temporary event. It will return to normal and the business model is still attractive and still franchisable. So while it may be slightly delayed, we don't see it having a significant impact in either our timing or our ability to extract value from those refranchising transactions.
Next question is from Nicole Miller Regan at Piper Jaffray.
Nicole Miller Regan - Piper Jaffray
Thank you, good morning. On the technology front, I think I heard you say you are bringing some new technologies to U.S .markets. Can you talk about how you chose them and if they’re giving a full suite of offerings or is it going to be kind of a layered approach? And then just a follow up on a number or comment around APMEA in saying it takes six to nine months potentially to get to a normalized level. Could you define that is normalized less negative or positive? Thank you.
Hi Nicole, I talk a little bit first about the digital piece and then we can talk about the recovery efforts over in China specifically. Relative to digital, as you may recall, Nicole, a couple of years we began to focus quite intently on our digital efforts, and we have done several things. One is that we move forward to be able to bring in appropriate talent to support our digital effort. So we brought in Atif Rafiq, who had a tremendous background in the tech sector and more specifically with Amazon.
We also have been hiring quite a few digital leads around the world from world class organizations. And to that point we actually opened up our first digital office at San Francisco near Silicon Valley to continue to be able to recruit and bring in talent. That is a critical aspect of how we select the applications and the platforms with which we move forward.
We also have several markets around the world that had a jump start relative to some of the mobile applications such as France with mobile pay and actually some promotional offers.
So we have leveraged that. We did a major test in Australia to look at the actual global application what we call the global app, which is built upon our new path technology system and allows us to continue to add on different applications to support various needs from pay and order to other things such as music. We’ve talked about those in the past. That global app will be launched in 2015 with some of the promotional offers in the U.S. and we will continue expanding the already established mobile applications that we have in some of the markets outside of the US. So we are pretty excited about those.
We are also excited about the relationship that we have begun to cultivate the most recent of which was Apple Pay and we’re the only restaurant, as I mentioned, that will be able to allow consumers to leverage Apple Pay in the drive-through. And so and one of the only restaurant businesses that Apple has had a strategic partnership with. So that is the beginning of some of the things that we are doing; there are more things that we have in the pipeline.
Relative to the recovery in China, when we assess the six to nine months we work with the local markets and we look at their timeline, there are several things that have been done there. First of all in China, we had to make sure that we can solidify the supply chain. As I mentioned the folks did an aggressive job, a great job aggressively of being able to really reallocate our supply chain in 60 days to ensure we can get China and Japan back up.
We also wanted to make sure that relative to anything that has taken place in that market there are food safety processes procedures was robust as they should be and as we wanted them to be. We have hired outside food safety auditors to support those, the things that we do in that regard along with additional training of our employees.
So those things do take a look at more time. And then once we got supply back in the market place we began and launched our brand trust campaign which is a holistic brand recovery campaign focused on bringing customers back into the restaurant. As you know, in China, if there is an incident such as avian influenza or food scare or food quality scare it does take a while for customer to come back to any restaurant establishment. So that's how we have worked with our local market and some of the things that we have been doing and again we assessed it at six to nine more months before we see recovery.
Next question is from David Tarantino of Robert W. Baird.
David Tarantino - Robert W. Baird
Hi, Good morning. My question for Don on the overall strategy. I guess one of the hallmarks the way I understand it of McDonald's is the speed and consistency of the operations ,and I think you have highlighted some struggles on that front this year, and I just wanted to get an update on your progress on improving your operations. And then secondly, I think a lot of the initiatives you are talking about the experience of the future, sound like they might be adding more complexity to the system. So everything from localization to create your own taste. So I am just wondering if you could comment on your confidence level on being able to execute that that added complexity, if you will?
Thanks for the question, David. First of all you know anything that we would implement in an restaurant we have taken it require a bit of testing. So relative to create your case has been through the innovation lab, the innovation center and the testing protocols there it has been in a restaurant near the innovation center, we moved it out to Lagoona, we had had testing outside of the U.S. in some of the markets and now as we move forward in Australia, what they are really doing is the soft, the front side of the role out in the Australian market. And so we know that from an operational perspective we are able and capable of delivering this experience in the restaurant enabled by the technology advancements and the point of sale platform that we put into the restaurant. So on the operational side they are relative to Create Your Taste, we built very, very strongly that that is doable.
We know it is based upon what we have done already relative to basic simplification of the restaurant and rating ourselves for things like Create Your Taste and for basic customer satisfaction at higher level. In markets like the U.S. they been through what they call an operations reset. That operations reset combined with the minimum simplification efforts that our aimed at reducing complexity of low volume items. That's an important part. The complexity of low volume items are the things that we’re looking to simply and remove from the restaurants. When we do that we enable ourselves to be able to then pull down additional products that we can flow through our operating system in the U.S.
Now, one of the things that I would also add here is when you look at some of the things that we are looking to do in terms of products, those products are actually made easier based upon some of the investments we made whether they be the point of sale system or may be things like the high density kitchen where we have more condiments that we are able to make relative to putting those things inside the Made for You cooking system. So the Made for You system, simplification of some of the items and our focus on operations are the reason that we have high confidence in Create Your Taste relative to the in store capability.
The other thing that I mentioned at this point and some of you already know this, Create Your Taste is an in store execution as we began. That is the way that we are delivering on that expectation and experience in the restaurant. Customers seem to really really -- it appeals the customers in a great way and will continue doing that. We have a different solution that we are work on relative to the drive-through.
Next question is from Jeff Bernstein of Barclays.
Jeff Bernstein - Barclays
Great. Thank you very much. So a question on the U.S. business. I know in the press release and in your comments earlier you made -- mentioned I think that the issue at least from a sales perspective is more sustained, competitive activity I know over the past year or two. I think that was more down played, I think was more you guys in the management believe and that it was more self-inflicted, less about what these more peers might be doing. But maybe just in terms of that change in view, like what have the sandwich competitors done most recently that might have negatively impacting McDonald’s? And how much credit maybe do you give to the strength of whether it's just casual or whether it's the consumer push into better quality, healthy offerings? I mean, just seems like there is a confluence of factors that sound which might be now out of your control relative to self-inflicted. Any thoughts on that would be great.
Hey Jeff. We -- one thing we do not do too often, Jeff, and you probably won’t hear us do too often, and that’s talk about for fact that our focus is now on competitive pressure. What we do is acknowledge it; they’re folks in the marketplace that are doing some solid things. I would still hold true to the fact that our biggest challenge is what we do at McDonald’s and how we move forward. Do we have the aggressiveness in the local markets, have we allowed the aggressiveness in local markets or have we been a little bit more focused on an aligned national platform, which doesn’t leverage that local relevance. And if I look that, the local GRPs that I then assign against those local relevance products as they are putting for those in their local windows in the markets, we have not been as strong as we need to be. And I think that is one of the areas relative to our menu that you guys haven't seen and many of you have asked questions about. What is in the menu pipeline?
I think you'll get a broader chance to see that as the local markets, as we get back to what we've historically done with local markets. Allow them to pull down products that are relevant in their markets and to drive those aggressively. And so, we are going to do that.
Notwithstanding competitors that are there, competitors have always been in the marketplace. It can't be used as an excuse for us. What it is is an opportunity for us to build our business by taking back some of those folks who are visiting others right now.
Next question is from Will Slabaugh of Stephens.
Will Slabaugh - Stephens
Yes. Thanks guys. I wonder if you could touch a little bit more on the U.S. trends. In September in particular, what you would credit that slow down to, despite the interest you're picking up little bit? And if also you could speak the different day for us, such as breakfast where you did giveaway some coffee and then lunch and dinner where it seems like competition is both picking up on the value and premium end? If there is much difference in sales growth or declines, I needed those (inaudible)?
Will, so a couple of things. This year, as you just mentioned, in the U.S. system they focused on coffee and also there was NFL promotion. Last year, it was comping against wings, which do drive a higher average check in sales. While not as successful as we wanted wings to be last year. but by most measures it was still a solid promotion relative to going up against the NFL promotion and coffee. So those two things did not deliver at the same rate, while we were able to sample quite a bit of coffee. And our breakfast business overall is up on the year and continues to be up.
The challenge that we have had is that it has to be about more than breakfast. So when you look at that balance -- and I just talked about local markets, we have got to focus on that breakfast and coffee aspect, as well as focusing on larger sandwiches, which enhance and increase that average check. And so that was one of the gaps that -- the biggest gap I would say that we had in the month of September. What we comped up against and also the fact that our promotional efforts were more sample based in terms of driving coffee than they were more of a breakfast building base just for that particular month. And I know that the U.S. system understands and realizes that as we move forward.
Next question is from Andy Barish of Jefferies.
Andy Barish - Jefferies
Hey guys. Just wondering more near-term and then 2015 kind of the extent of the McOpCo margin decline kind of Q4 versus 3Q? And then, I know its early, but how are you guys thinking about what you need to start to drive those McOpCo margins back higher, whether its comps or the commodity environment for 2015?
Andy, good question. For 2014, as we kind of -- as I indicated in my remarks, we see continued pressure in the fourth quarter. Reflecting on the factors that were impacting the third quarter right, U.S. the biggest factor driving the U.S. decline vis-a-vis the decline in the second quarter was less pricing. And so, we would expect less pricing to still be a factor in the fourth quarter, as well as the 3% commodity increase. Those were the two biggest factors driving this quarter. And thus, we see it now will impact the fourth quarter as well.
In Europe, virtually a 100% of the decline was in Russia -- was due to Russia and Ukraine. 75% of that was Russia, the rest was the Ukraine. With the relatively favorable commodity environment over there, a lot of the other markets were doing fairly well on their margins actually. UK was driving it and Germany continued to be the biggest drag on the McOpCo margins outside the Ukraine and Russia for Europe. And it’s too early to give a picture on 2015. But as you point out, driving comps, our McOpCo margins are really a top-line gain and driving comp sales is going to be the biggest key to getting that going again.
Next question is from Jeff Farmer of Wells Fargo.
Jeff Farmer - Wells Fargo
Thanks. I did hear your comments on minor reductions for future developments. But why do you believe only a minor reduction is appropriate? And I guess, what you mean by that is just going back to what other timeframe was, the early 2000s U.S. (inaudible) sales were soft, you guys were losing shares. And I think it was in the early 2000, 2002, 2003 along those lines, you dramatically, dramatically got new development and then, within couple years life got better and realize that it's not all cause and effect, it’s not that simple. But again, just sort of thinking bigger picture here, what's the hesitation in pursuing your better is not bigger strategy in 2016 and beyond? Why don't you think that would not work again?
Hey Jeff, this is Don. And I ask Pete to comment as well. Let me just draw a little distinction here. Relative to what happened in the early 2000s, that development was taking place primarily in the U.S. business. So when we were -- in the U.S. business, we were trying to grow via development and that development was being driven across the market. We were not as sophisticated as we are in site selection. It was more based upon basically new unit movement or new unit sales, and that is not the appropriate formula. So today, if I look at where we are growing, that gives us some confidence relative to how we are growing, at what pace. When you're developing into markets like the Chinas of the world, the Indias of the world, some of the other markets across Europe and Asia, Korea, then those markets have yielded some more solid returns. And so, I just want to draw a little distinction. This is a very different approach. We have much high levels of site selection capability than we did then and it is not a concentrated and focused growth like it was in the U.S., it's a much more diverse portfolio.
Yes. And Jeff, I just add a couple of points. One, the starting point is dramatically different from 2002. I mean, we are starting from a much higher position of average unit volumes. And actually, our new store returns are doing fairly well. So as I said earlier to Andy, comps are the key to getting the margins and the profitability going again around the fringes. Turning a 100 or two openings up the portfolio for year is not going to have a dramatic impact. And in fact, the down point, our site selection capabilities are too old, the number of markets we are growing in is much more expanded than it was a little more than 10 years ago. So we feel it’s appropriate to skim back a little bit, but for the long-term perspective and growth of the business we are going to continue to open a units where it makes sense and where we are going to get good returns.
Next question is from Keith Siegner of UBS.
Keith Siegner - UBS
Thanks. Pete, of the over $200 million year-over-year reduction, APMEA operating profit dollars, how much of that reduction came from the loss of sales and the deleverage effect versus how much came from may be more discrete items like inventory write off as you throughout put (inaudible) or anything else that might be one time? If you could give us some color on those two pieces that would be very helpful. Thanks.
Yes, Keith, at the operation income level the China supplier issue that $0.15 translated into about $180 million of operating income decline. Roughly half of that was McOpCo margins. So that I would argue was that clearly was sales driven. Then the next biggest peach was our lower earnings pick up from our joint ventures notably Japan and while that had a little bit of inventory write off and some other costs, that result would also mostly sales driven along with royalty some franchisee support and then finally there were probably about $20 million that was truly inventory write off and an additional supply chain cost to get that supply back on par in China and Hong Kong.
The next question is from Sara Senatore of Sanford Bernstein.
Sara Senatore - Sanford Bernstein
Thank you. It’s just two kind of related questions. The first one is the overarching concern I sometimes hear is that McDonald's is struggling to resonate with millennial consumers, in particularly in the U.S. And so I was wondering if you could talk about the two strategies that I think you might be most targeted to that group and whether you are starting to see any initial signs that you are getting traction? And those are -- and my interpretation would be the sort of digital social media and then also the our food your questions and just whether or not that strategy is working because it sounds like you are not actually changing recipes in response to concerns, you just change kind of explain and alleviate some of those concerns. So if you just talk realistically about kind of the millennial question?
Thanks Sarah. The real point, so let me just broadly relative to millennial. If you look at the quick service restraint industry there is a decline relative to millennial usages of the quick service restaurant industry. I think that as we look at it as McDonald's what we believe that we are able to do is to appeal to some of those customers and clearly come into our business. And so as we look at it and I should say appeal to more of those customers and customers use our business now but appeal to more of the millennials. But it is a much broader aspect in the millennial. Our Food Your Question is about creating a dialog. It is not about a one question answer kind of a piece. Usually there is a back and forth relative to ingredients, platforms, integrity, sources in terms of where our food comes from. It may be relative to social responsibility. What we are doing relative to deforestation. So there are a number of questions that come up and it is about engaging in a dialog.
We want to make sure that we are a transparent brand. There are a lot of misperceptions out here relative to our food and what we want to do is make sure that we at least provide an opportunity for people to directly ask those questions. So this for us is just a way for us to better build this brand and tell the truth about McDonald's and our supply chain which is absolutely fabulous. And so that it the intent there.
On the digital front, we believe that digital, mobile technologies, kiosk related ordering the opportunities to be able to allow customers choice in their McDonald's experience is good for all of our customers. We think that there may be a skew clearly to a millennial, that would be probably and even stronger skew towards those that are younger than millennials, but as we move forward that is one of the things that we would be able to better define. We do know that the experience of the future resonates well with our customers around the world.
We have four more questions. So we will take those. First David Palmer of RBC.
David Palmer - RBC
Thanks. Just a follow up on that, the millennial issue has been well documented but I guess we should keep in perspective that the U.S. factory comps are up, I think around 2% lately. So do you believe that there is more of millennial issue with McDonald's and that's the differentiator and I suspect that you in your own self assessment see some other key differences there resulting in the widening gap to the industry and what you think those are? Thanks.
David, I believe that relative to the comp gap, so I think the comp gap is a combination of several things, some things relative to what we are conveying out there relative to what others are conveying in terms of the menu offerings. I think that is one of the challenges. I think it is also about the value that we are offering or not offering and that is another aspect of the comp gap. If you look at some of those changes, the question is whether or not our value and our food options are resonating as strongly and so I believe that that is the fundamental basis of some of the challenges that we are having.
Having said that one of the ways that we best address that is by ensuring that the local markets have the opportunity to move forward to products and the offerings that will resonate locally. When I say resonate locally that means resonate across the demographics of those local areas. So that is everything from millennials all the way up to those that are more mature in the marketplace that are coming to visit McDonald’s or other (inaudible).
So what we want to make sure we do is have the right food, the experience is right and we’re engaging customers to be able to have their choice and a great McDonald’s experience with great food quality and great service and a clean environment as we always done and at an affordable price. When we’re able to do that at McDonald’s we’ll be fine within the marketplace in terms of generating sales. The broader opportunity is to be even more relevant relative to the digital experience, the restaurant of the future and the customization opportunities for our food, and that’s what you heard us talk a little bit about today.
Next question is from John Glass of Morgan Stanley.
John Glass - Morgan Stanley
Thanks. I wanted to go back, Pete, to the G&A question and why you’re not seeing or don’t think you can actually get net positive reduction in G&A? Your G&A runs higher substantially higher at least on a per store basis than your peers and I understand you got more complexity but you’ve also got better scale. So I guess just two questions, you can respond to that but two questions I guess around. One, what is the chance you actually you will be able to see a net reduction in absolute G&A in ’15, not how much but just can you do that? And secondly, maybe help us understand the $2.5 billion in SG&A how much is actually G&A and how much is corporate versus what’s in the fields or in the divisions?
Hey, John. As we talked about from the very beginning when we start talking about this scrutiny of the G&A, we believe that there are significant opportunities to grow this business by investing in the digital strategy and this McDonald’s experience in the future, and so smarter for us we think to redirect resources to that. And as I indicated, we believe we’re targeting about $100 million from U.S. in core to repurpose, if you will, or redirect to those initiatives.
And we believe over time we’ve continued, we always look at ways to be efficient and more effective with our spend. If we thought minus three was our trend line for the next couple of years you’d be hearing a more dramatic cut and taking cost out of this business, because that would be the only way to continue to grow profitability if we saw that was a permanent change to our revenue stream. But we don’t believe cutting our way to prosperity is going to be helpful for the long term of this business and smarter for us we think to redirect these savings into these growth opportunity that Don outlined.
Next question is from Howard Penney of Hedgeye.
Howard Penney - Hedgeye
Thanks very much. Last night the CEO of Chipotle spent 10 minutes of his opening comments on his conference call basically attacking the legacy QSR operators with business models and I could just paraphrase as being broken, given the type of food they serve. And if I broaden those comments out to what CEOs of supermarkets like (inaudible) telling about more customers coming into the natural all natural organic GMO free products. is Mr. Ells first of all and the lot of things that you talked about today I can appreciate the need for the technology but it doesn’t feel like you’re really going in the direction where consumers are going. So just curious as to you think that Mr. Ells justified in his comment the legacy (inaudible) operators which I assume he included you in that comment. Thank you.
Hi, Howard, thanks for the question. Howard, we believe that if you look at the broader market and you look at what customers are asking for, they are asking for transparency they’re asking to know what’s in the food, they’re asking for integrity of the food. There are cases and there are markets where organics are drivers at a higher level. But I would offer is that the highest level is more about their transparency, integrity and also the ability to customize and have what they want on a sandwich or a burger.
I think it is what has given rise to so many very small but quite a few burger openings, specialty burger house openings. And so there is still quite a resonance relative to food, there is a big resonance relative to how I can customize. There is an appeal and you’ll see us in some categories looking to different products possibly organics we actually are doing it in certain markets. But I would it’s not the main driver if you would, we’re at the main drive but I mean we wouldn’t have the clearly the number of customers that we have today visiting the McDonald’s restaurant.
I will never say that someone else particularly (inaudible). I know Steve I use to visit his first restaurant when we entered into an initial partnership back then when we were sharing the McDonald’s supply chain system which helped him as he move forward Chipotle. But I would not say Steve is wrong or right, I think each individual organization has to look at that and look at it through the eyes of the customers and what customers are asking them to deliver. And so I think you’ll see a lot of changes though, Howard, I mean if these things become even more large, even more trendy then that something clearly we’ll look even more aggressively at. But we do have markets around the world that focus more on organics we have markets that focus more on locally relevant products. France just finished up one of their launches and it was basically speaking about French beef; we talk about Australian beef over in Australia. In the U.S., I think we have some additional opportunities to talk about the fact that the vast majority of our food at McDonald’s in the U.S. is produced right here in the U.S. so we have some opportunities to talk about that in the U.S. a little bit more.
Our last question is from John Ivankoe of JPMorgan.
John Ivankoe - JPMorgan
Great, thank you so much. Don, my perception is been that your previous health and wellness movement, and I am not talking about just organic but just health and wellness in general, but previously ‘80s and the ‘90s were driven from an older and drastic and maybe what’s different now is that the movement is being driven by younger demographic that's in younger demographic that according to your own data that you don’t have the appeal to as may be you did to that same age cohort 10 or 20 years ago. I mean - you haven’t even mention the words for McDonald’s about health and wellness and just what kind of an opportunity that you would have and if I can ask the question directly I mean why is that really front n centre in terms of lot of the product development work that we’re talking about today?
Great question, John, and actually it is. Health and wellness defined by many of the customers that we talk to coming to McDonald’s were visiting the informal eating out industry. And that's a big point those that actually visit the industry and buy food from the industry. We - its translated into real and fresh in many cases, and that has been a major driver of our strategies as we move forward. Customers want real food and they want to make sure they understand that its real food and they want fresh food. So they want to understand the sources or the origin, they want to make sure that I know what’s it, where it came from and the integrity of those sources.
And so what we’re trying to do is more visually depict that both in our marketing, in our foods of question and even more importantly at the important movement of truth which is in the restaurants and for those of you visit our restaurants and been behind the counters you’re seeing the freshness and the quality of our produce. However ,not everyone has done and seen that and so we want to make sure that we’re transparent enough to do that many times real and fresh is also conveyed. If you look at it relative to those products those offerings that are selling the most it’s based upon the component make up of the food itself.
So it may be differences in cheeses, differences in sauces all of these things either things that make up a great tasting burger or sandwich we’re offering today. And so this is a direction that we’re moving in and we’ll continue to stay close John with our customers relative to what it is they want and what it is that they want to see because we can deliver that as a McDonald’s system.
That concludes our Q&A. So I’ll turn it over to Don who has a few closing comments.
First of all, thanks for your participation this morning as we wrap up the call I really appreciate again all of you joining us. We have a clear plan to regain momentum in the U.S. and I think you’ve heard that and we want to regain momentum around the world as we aggressively advance programs and initiatives that are designed to deliver more relevant experiences and as we bring the McDonald’s experience to the future to our customers even faster. We’re ready to drive our business forward by creating real and noticeable changes for our customers and partnership with our tremendous system of franchises supplier partners and company employees.
Our actions are intention and they strategically address what customers want from us today. They’re based in the insights that we have gained from the marketplaces and they’re based in what customers will expect tomorrow. I'm excited about the work that we’re doing and I'm confident we will achieve our goals. I just wish you all a great day and a great weekend. Take care.
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